Finance & New Risk Scenarios, rome - PowerPoint Presentation

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Finance & New Risk Scenarios, rome DecemBER 2016

Adrian Blundell-Wignall

Special Advisor on Financial Markets to the OECD Secretary General, for Financial & Enterprise Affairs Directorate.Slide2

The World Economy: The Key Moving Parts

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World growth came to depend on commodity super cycle an related investment: China a major driver, and now in reversal as excess capacity emerges globally.

The return on equity driven down below the cost of capital – low inflation, absence of investment & productivity.

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major risks

interacting with this:

(1) Political—the rapid hollowing out of the middle class.

(2) Financial markets—low interest rates & asset prices.

(3) Europe’s failure to deal with the banking crisis.

(4) Pushing Risk into shadow banking

(5) Emerging market risk: US tightening, a rising dollar and China and debt.

(6) Fintech risks to the traditional financial institution model.

(7) Brexit risk for Europe.Slide3

Political: Hollowing Out%; Changes in Shares of Employment by Pay Category 1997-2015

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Global Capital Expenditure: Dependence on Energy & Materials (now reversing)

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Sector Investment Misallocation

: ROE-COK in

Emerging Economies

, 2002-2015

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Low rates hurt banks (there is a banking crisis in Europe) and they may bankrupt pension & insurance companies. So why? To save lame-duck companies from adding to NPL’s? To boost asset prices?? To weaken the exchange rate???

Asset price bubble emerge—not supported by productivity growth.

Funds chase yield and alternative products, in order to catch up.

Redemption risk on asset price reversal with illiquid assets—disorderly markets.

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Low Interest ratesSlide7

1 Month Major Interbank Rates

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Evolution of Selected Financial Prices

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Evolution of REITSSlide10

The 4% Real Target of Many Pension Funds is not Realistic: Low Interest R

ates

C

ould P

ersist

for a

Long

T

ime

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Drop in interest rates increases exposure to longevity risk of mortality tables across countries – average shortfall for females, age 65

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Corporate Bond Issuance

and

Declining Quality

, 2000-2015

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OECD 2008 View on Dealing with the Bank Crisis. Did Europe Measure up?

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OECD publications consistently recommended three key elements of banking reform:

Deal with any troubled assets first

.

Recapitalise banks.

Regulatory focus

on a simple leverage ratio of at least 5% of the un-weighted (IFRS) balance sheet, and not to rely on the Basel risk weighting approach to capital rules.

Separate derivatives and other high-risk investment banking activities from insured deposit balance sheets that subsidises these activities and leads to an under-pricing of

risk. Maintain liquid assets. Reduce wholesale funding.Slide14

Non-Performing Loans (in % of Total Loans)

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Core Tier 1: Basel Risk-Weighted versus the Simple Leverage RatioSlide16

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Business Model Features That Drive Risk in GSIB BanksSlide17

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Distance-To-Default: BanksSlide18

Distance-To-Default of Large Banks by Region

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Credit Default Swap of Large Banks by Region

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Pushing Risk Into Shadow Banks

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Risky assets transferring to shadow banks as bank regulation proceeds.

US & UK banking and finance centres de-globalising much less than Europe and Japan.

OECD research shows that the problem of rising inter-connectedness is worst in Asia.

Chinese and Japanese institutions are moving into where European banks and non-banks are moving out.

Banks are more interconnected with shadow banks in Asia than before the crisis. Things improved in the USA. But they stayed the same in Europe.Slide21

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Holdings of Derivatives:

Banks vs Shadow Banks

(gross market value)Slide22

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Cross-Border Claims by Nationality or Residence:

Banks versus Shadow BanksSlide23

Emerging Markets & EU Debt & Bank Risks Building Up

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Low interest rates are contributing to build up of debt globally in the company sector. (China especially. Early warning sign).

US and other advanced countries own $-denominated Emerging Market financial and non-financial debt.

NPLs in China are hard to compare with advanced countries – maybe close to 6%.

USA rates set to rise and the $ moving up—with much non-investment grade debt in dollars and a lot from banks and non-banks.Slide24

Government, Household & Company Debt: Advanced and Emerging

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Global Non-Investment Grade EME Issuance

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PBOC New Exchange Rate Basket & Some ComponentsSlide27

International Reserves of Major Emerging Countries

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Fintech Threats: Distributed Ledgers

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Distributed

ledgers are much more transformative than

sharing

economy disruptions

(Uber, AirBnB) which

still involve hierarchical intermediaries

Could make society unrecognisable

Distributed

ledger technology is a shift towards a different underlying philosophy of economic organisation based on: distributed consensus, open source, transparency, and technological

communities

Technology threatens

all intermediaries under pressure from globalisation, information intensity, and connectivity.

Avoids

duplication and inefficiency.

Gets

rid of cross checking between individual ledgers and

databases.Slide29

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Distributed versus CentralisedSlide30

Blocks and Blockchain

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Blockchain is a

list of “blocks” and a “block” is typically a list of

transactions or records (first

developed for

Bitcoin). A new

block is “chained” to the previous block, using a cryptographic

signature.

Used

like a ledger shared and corroborated by anyone with

right

permissions.

Changes

in the ledger

reflected

in all copies quickly. Keys and cryptology determine who can do what within the

ledger.

Un-permissioned ledgers:

blockchain can be

un-permissioned, so

anyone

can add a

block,

but

consensus

is needed on what is

added including the code.

Older blocks cannot be

rewritten.

Permissioned ledgers

: consensus

achieved

by a set of trusted nodes and may have a

proprietor

(e.g. Ripple, the Estonian government, etc.).

Code

itself is developed and updated by the

proprietor.Slide31

Transformative vision

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Transformative

vision of the world is to have citizens participate in smart contract applications that work with the blockchain

database

Legacy contracts are typically archived signed

contracts

Smart contracts

contain the computer code that executes the contract—2 users sign and it is executed by the contract on the blockchain.

Problem

with

legacy

system

– it is located

in single institutions, with an array of networking and messaging—there is a single point of failure and

subject

to

cyber-attack

Smart

contracts

in distributed

ledger are hard to

attack.

Care required in regulation—distributed ledgers can help reduce the cost of finance; help in the fight against cyber crime; reduce bribery and corruption; reduce tax avoidance; and fight terrorism financing.Slide32

Brexit & Financial Services

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Will UK

financial

institutions

lose their Europe “passports

”?

US

and other non-EU banks that meet European regulatory standards are able to be licenced on an individual basis to provide services in

Europe

LCH

Clearnet Ltd (owned by LSEG), ICE Clear Europe, LME Clear Limited and CME Clearing Europe

Limited

operate in London.

UK

is

largest

market for OTC

euro

foreign exchange transactions and

largest

interest rate derivatives market in the world.

There

are other non-euro countries that clear euro-denominated instruments as well (i.e. the US and Singapore

)

EU lost a case against the UK in the General Court of the EU over the ECB claiming that euro contracts need to be cleared in euro countries (for supervision reasons). Treaty change required to do it.Slide33

33UK Services vs Total Goods and Services Balance of Payments with EuropeSlide34

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UK

Exports to

Region

in percent of

UK

Exports

to the OECD 22Slide35

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Number of

Institutions Included

in the United Kingdom

Banking Sector

by

Nationality in 2016