March 2018 BIS Quarterly Review: Volatility returns to centre stage after stock market wobble

Volatility returned to markets in February, puncturing a long period of unusual calm and highlighting the tricky task central banks face in normalising accommodative monetary policies.

The sharp correction in stock markets was sparked by anxiety about the US inflation outlook and its likely impact on interest rates, and shows how much risk market participants have taken on during the recent period of extraordinarily low volatility.

"No doubt, the wobble has shaken off some positions - the equivalent of pressing a 'reset' button. But the overall picture has not fundamentally changed," said Claudio Borio, Head of the Monetary and Economic Department of the BIS. 

"Policymakers need not fear volatility as such. Along the normalisation path, some volatility can be their friend."

The March 2018 issue of the Quarterly Review also:

• Examines the 5 February turbulence and the role played by exchange-traded products that bet on volatility. It highlights that complex and leveraged products can create and amplify market jumps, even if the core players themselves are relatively small.
• Documents the changing patterns of cross-border flows to emerging market economies in Asia. Shifting sources of international finance - from Japanese banks in the 1990s to European banks in the 2000s, with a growing role for Chinese banks today - have affected how shocks are transmitted across the region.
• Shows how foreign banks operating in the United States changed their operations and legal structures in response to a requirement obliging banks with $50 billion or more in non-branch US assets to put US subsidiaries under an intermediate holding company. While some banks downsized and others may have shifted assets offshore, they generally spared their trading books of agency and corporate bonds.

Six special features analyse aspects of the global economy and markets:

• Morten Bech, Umar Faruqui, Cristina Picillo (BIS) and Frederik Ougaard (Danish Financial Supervisory Authority)^* show that demand for cash has risen in many advanced economies following the Great Financial Crisis, even though consumers are using cards or contactless payment options more often and for ever smaller purchases. The authors argue that cash's increasing popularity is at least partly due to lower interest rates.

"The resilience of cash as a social institution reminds us of the importance of understanding the economic functions of money, beyond just the innovations in technology," said Hyun Song Shin, Economic Adviser and Head of Research at the BIS.

• Stefan Avdjiev, Hyun Song Shin (BIS), Mary Everett and Philip Lane (Central Bank of Ireland)^* argue that traditional national account statistics no longer reveal the full picture of economic activity as they fail to track the international footprints of global firms. Companies, their ownership and economic activity are not limited by geographical borders. Policymakers need to take a broader view when assessing risks to the financial system.

• Iñaki Aldasoro, Claudio Borio and Mathias Drehmann (BIS)^* find that household and international debt are useful early warning indicators of banking distress, particularly when combined with property price data. Indicators currently point to the build-up of risks in several economies.

"Fast-paced movements in financial markets hit the headlines, but slow movements in the background can matter more for the economy," said Mr  Shin. "Their importance becomes apparent only after some time." 

• Michael Chui, Anamaria Illes and Christian Upper (BIS)^* examine the financial stability and economic risks stemming from a rise in debt owed by large Asian property developers. Comparatively low leverage limits near-term financial stability risks, but low profitability has left many developers vulnerable to higher interest rates and declines in property prices.

• Vladyslav Sushko and Grant Turner (BIS)^* argue that a shift towards lower-cost passive portfolio management could reduce the amount of security-specific information embedded in prices. Fund flow patterns and market price dynamics might also change. In recent stress periods, passive mutual fund flows were fairly stable, whereas active mutual funds exhibited persistent outflows and exchange-traded fund flows were volatile.

• Bilyana Bogdanova, Ingo Fender and Előd Takáts (BIS)^* find that although bank valuations are currently low, price-to-book ratios are not generally out of line with historical patterns. The drivers are the same as before the Great Financial Crisis. This casts some doubt on explanations that see regulation as a major source of low valuations, and suggests that banks could improve their positions by tackling bad loans and controlling expenses.

*  Signed articles reflect the views of the authors and not necessarily those of the BIS or other institutions to which they are affiliated.