Between Scylla of weak growth and Charybdis of buoyant markets

Francesco Mazzaferro (European Central Bank, CC BY-NC-ND)

“The macro-prudential supervision tries to navigate between Scylla and Charybdis to prevent them from destroying the ship,” says Francesco Mazzaferro, Head of the European Systemic Risk Board Secretariat.

CE Financial Observer: What are currently the greatest risks in the European financial system from a macro-prudential point of view?

Francesco Mazzaferro: Today, we are confronted with buoyant financial markets, compressed yields, high equity prices and in some cases aggressive price dynamics in real estate markets, in particular in capitals and other economic and financial centers. All of this happens despite growth dynamics below potential and diffuse geopolitical risks worldwide.

What are the effects and what do they depend on?

The question is whether and how long this dichotomy can last. This might imply that either some assets are overpriced or growth will resume on a much stronger setting. The first scenario might lead to a reappraisal of risks, the second one would also impact yields and potentially hit investors.

Are the political reasons important for the re-pricing risk premiums in global financial markets?

For a few years it had seemed that markets became less sensitive to what you call ‘political reasons’. Or at least less sensitive than one would have thought before. This is perhaps also due to the accommodative setting of monetary policy worldwide, which may have been assuaging concerns of investors also on risks and vulnerabilities of a more general nature.

Which of the risks and vulnerabilities do you mean?

Let me first mention that ensuring the sustainability of growth is also a financial stability concern. Permanent low levels of progress in economic activity may exacerbate debt sustainability issues, make much-needed structural reforms – also in the financial sector – more difficult and entrench in the economy expectations of sustained low levels of interest rates, which in turn may generate financial risks. In sum, we need to learn how to navigate between Scylla and Charybdis: as I said before, a reappraisal of risks might hit the economy, and insufficient growth would weaken its capacity to be resilient to any shock.

What are the structural changes and the key risks associated with the shadow banking sector?

Our ‘bipolar’ world offers us, also in this case, two pictures: what you call ‘the shadow banking sector’ can act as an important source of funding when the banking sector must undergo some important restructuring, but it can also exacerbate existing vulnerabilities, or even produce new ones in the area of leverage and liquidity. Also here it is important to understand that we are confronted with risks, but also with opportunities.

Are the risks still in the darkness, and the opportunities are exploited by the few?

Market based finance needs to be regulated in a way to make sure that society would have more opportunities for investment or for gaining funding and be less exposed to risks of unsustainable bubbles and evaporating liquidity. Therefore, it is important to continue establishing macro-prudential policies beyond banking, as the ESRB has also stated in a recently published strategy paper.

What are the links between banking sector and shadow banking sector? Are they more risky now than before the great crisis from a macro-prudential point of view?

Large banking groups remain at the center of the financial system and play a key role also in financial markets. Concentration and interconnectedness with broader financial system – in this respect – continue to be an issue requiring close monitoring. A simple comparison to the past would not make justice to your question.

What has changed?

The degree of awareness of public institutions and the public opinion at the large. The increase in regulation may justify some request for proportionality. I observe, however, that the plans to return to a pre-crisis regime – despite considerable lobbying in that direction – are not easy to implement. Who would pay the bill, if the crisis repeats itself?

Last year the ESRB reported that it encountered difficulties in obtaining data on the shadow banking sector. What can be done to make these data more accessible?

The problem of data is not limited to market-based finance. On October 2016 we issued a recommendation on closing real estate data gaps. The ESRB and the regulatory world in general (think of ESMA) are also making headway in getting data collected through new EU regulations on derivatives (EMIR), alternative investment fund managers (AIFMD) and security financing transactions (SFTR). The recently published second shadow banking monitor offers more data than the first one, and progress is steady.

The Financial Stability Board informs that the implementation of the oversight and regulation of shadow banking is at a relatively early stage. Does the shadow banking sector require the same supervision as banks?

If your question means whether an activity based regulation is less biting than an entity based regulation…

Yes…

I do not know. We will have to see. Certainly, there has been an intense campaign from some market players (investment funds, pension funds, insurance and reinsurance, etc.) to state the principle that their business models pre-empt them from generating systemic risks as ‘entities’, and that exogenous systemic risks can be propagated only by only some specific business lines of their ‘activities’. The ESRB has been issuing several reports and studies to warn against complacency; the capacity of market players to generate and absorb systemic risks may be different, but vulnerabilities are endogenous to a global financial sector which is broadly interconnected and still so exposed to threats of regulatory arbitrage.

What are the biggest weaknesses of the banking sector in the EU?

Several public and private officials recalled the parallel case of the coal and steel crisis in the 1970-1980s. At that time Europe had a too large and unprofitable industry, which perhaps had grown so large also because of the incentives created by the establishment of the common market for coal and steel twenty years before. Moreover, Asian producers were entering the market with much lower prices. Our banking sector today is also very large – our Advisory Scientific Committee says that we are overbanked – and its capacity to produce profits – at least in today’s conditions – is limited, even if there are significant cross-country differences. I see for instance a much stronger sector in Scandinavia, where administrative costs are better controlled and structural investment in new technology is more advanced. This means that the banking sector can be performing well even with very low interest rates, like it does currently in Sweden.

Does the probability of a simultaneous default of banks increase or are there no such risks?

As you know, the European Central Bank, in its ‘Financial Stability Report’, computes on a regular basis a composite indicators of systemic stress in financial markets and sovereign bond markets, and the probability of default of two or more large and complex banking groups. In early 2017 that indicator signaled some perception of increased vulnerability (probably also due to forthcoming political events), but it seems to have normalized since.

Is it possible to have a common and coherent macro-prudential policy in the EU, where we have debtors and creditors countries, with for example varying amounts of households and governments debts ranging from 180 per cent of GDP in Greece to 8 per cent in Estonia?

There is no doubt that the EU is characterized by diverse features, both in structural terms (as the ones you mentioned) but also in terms of financial cycles. This is the reason why setting up national macroprudential institutions and assigning strong and independent mandates is so important. The ESRB has issued recommendations in the last years. However, I would like also to warn against financial nationalism. We all know from experience that having a single financial market is not only a tremendous chance for growth but also a potential vehicle for contagion, if we fail to address risk propagation. Across the EU, imbalances in one country may impact existing vulnerabilities in other countries. Therefore, we also need common regulation, a functioning mechanism for cooperation, a strong monitoring and – when needed – common instruments. The ESRB recognizes the need for robust national frameworks and a solid European cooperation.

Can you establish a safe debt to GDP ratio for non-financial corporations, households, or can you say where is the red line?

The capacity of households, non-financial corporations and the economy as a whole to withstand the risk of excessive indebtedness depends ultimately on productivity levels. I can take a debt only if I generate the future income to repay it. I observe that in a number of countries borrower-based measures are increasingly used by the respective macroprudential authorities to prevent or mitigate vulnerabilities when global indebtedness levels are higher, compared to income. In terms of ratios, this may be very different from country to country.

The ESRB will soon announce scenarios for next year’s stress-test of European banks. What risks will be included in them?

There is a procedure to communicate on this, and I would not like to make any personal statements.