The Bank for International Settlements does not get enough credit. It is known — among those who know about it at all — by the soporific label “the central bankers’ bank”. Some, no doubt, even mix it up with the more derogatory category of “gnomes of Zurich” — unfairly so, since it is based in Basel, does not do any banking and is quite an amazing fount of wisdom about the global economy and financial system.
In the past, for example, the BIS has helped to understand the problem of zombie companies and shown how financial growth can harm economic growth. And in my FT column this week, I pointed out how BIS researchers have highlighted that despite our talk of shortages, global supply chains have delivered greater volumes than would have been predicted before the pandemic — including of such crucial inputs as semiconductors that are causing so much anxiety among policymakers.
This month the BIS has been on another roll, with a special feature of its Quarterly Review devoted to non-bank financial intermediation (NBFI). That, too, has the sound of something to make your eyes glaze over, but you should care because it is where the next financial crisis is most likely to emerge from.
NBFI is what it says on the tin: financial transactions and relationships carried out through (“intermediated by”) financial actors that are not banks. This is a part of the financial system that is changing extremely fast, and much faster than regulation, which is, in any case, less comprehensive than for banks. Here are three recently emerged types of NBFI that the BIS highlights: so-called decentralised finance in crypto assets, open-ended mutual funds investing in bonds and new patterns in dollar borrowing in emerging Asian economies. There are also articles on private capital markets and environmental, social and governance finance.
The BIS’s press release and the foreword by its general manager Agustín Carstens give a good overview, but do dive in to learn about any of these specific areas, mishaps in which could very well affect your wallet some day soon. In fact, they already may have.
Take dollar funding in emerging Asia. The issue here is that as countries have developed and grown a domestic financial industry, many local investors hold assets in US dollars and have liabilities in domestic currency. When the cost of insuring against that mismatch jumps, which happened in the financial ructions triggered by the pandemic in March 2020, their need to get hold of dollars can suddenly increase, to the point of overwhelming funding sources for normal times. This is the sort of thing that can add to a global squeeze on dollar funding, which can lead to the unexpected dysfunctions in the US Treasuries market that happened when too many investors tried to offload US government bonds simultaneously which, in turn, forced the Federal Reserve into a massive intervention to support the market. And that is something that affects all finance everywhere.
What about the other two examples? Open-ended bond funds are easiest to understand: they can amplify market swings by being forced to dump bonds in fire sales when too many investors try to redeem their fund shares at the same time.
Decentralised crypto finance is newer and weirder to most people. It consists of automated algorithms that make possible programmable or “smart” contracts on crypto blockchains — meaning that holders of crypto assets can enter various forms of lending, investing and other transactions that are “self-executed” by the algorithms when specified conditions occur. The goal is the logical end point of the crypto dream of a financial system without any centralising intermediaries at all — but, as the BIS points out, this is a “decentralisation illusion”. Not all eventualities can be programmed in and, even if they can, a lack of co-ordination can lead to instability and runs. In these cases, some centralised action will be called for, which will favour those at the heart of the natural concentration to which blockchain technology after all leads.
Do read up on the details. I will simply note the common thread. It is that NBFI is prone to the same core problem that banks have: a perception of liquidity that is only achievable so long as not too many people try to avail themselves to shift their positions in the same direction all at once. This is made worse and harder to appreciate by the many ways of racking up leverage — investing with resources that are not your own — that fancy new products provide. It is no accident that Carstens’ foreword is titled “Non-bank financial sector: systemic regulation needed”. If NBFI carries the same risks to the economy as banks, it should be regulated as banks.
The logic is correct. But it leaves the BIS and other regulators in a dilemma. It means the current situation — where banks are heavily regulated and NBFI, well, not so much — is unsustainable. But you could take one of two diametrically opposite routes from that acknowledgment.
Both banks and non-banks provide essential, systemic, liquidity and payment services. You can either replace the bank/non-bank distinction with a distinction between systemic and non-systemic activities, and say liquidity and payment functions must be as safe outside of banks as inside banks. But that may be impossible, or only possible by quite brutally forcing some activities (say Treasury repo activities, used for liquidity management) to only take place within a heavily regulated institution, or equally brutally, supplant some activities altogether (say crowd out crypto by introducing programmable central bank digital currencies).
Or you can give up separating the financial world into systemic and non-systemic universes and accept that systemic risks can arise everywhere. The logical consequence of that is to acknowledge that, in a crisis, central banks may have to come to the rescue of any exotic financial product that may have taken on a systemic function: the ultimate central bank put. But then you are driven in the direction of Lord Mervyn King’s idea of the central bank as a “pawnbroker for all seasons”, committing in advance to lend (and not just to banks) against any asset, but at a pre-agreed price.
Financial policymakers will find the end point of either of these two directions extremely unpalatable. The question is whether there is any good alternative.
Other readables
In the aforementioned column, I argue that the global economy’s supply response to seesawing demand in the pandemic has been smoother than many give it credit for — and a fascinating article in Nikkei Asia suggests we may soon be facing a global glut of semiconductors.
An excellent note from the Resolution Foundation sets out how to think clearly about the Omicron coronavirus wave. This variant is much more contagious, so it will have to be much less virulent than Delta if we are going to avoid much larger death numbers, threats to the health system and the need for deeper and longer lockdowns. In the face of that uncertainty, we may be better off with tighter restrictions immediately.
The LSE’s Centre for Economic Performance dissects UK labour shortages.
Numbers news
The IMF has just updated its global debt database — and found that global debt now amounts to $226tn. I moderated an online discussion with the IMF’s Vitor Gaspar, World Bank chief economist Carmen Reinhart and law professor and debt expert Anna Gelpern, where the mood was rather bleak about the prospects for orderly debt management for poorer countries.
Source: Economy - ft.com
