BIS Quarterly Review, September 2019 - media briefing

Claudio Borio's remarks | Hyun Song Shin's remarks

Claudio Borio

Markets oscillated. Trade tensions pushed them down; monetary policy propelled them up. But as this push-pull game went on, one asset price had only one direction to go: bond yields continued their downward glide, reaching a new nadir.

If the March Quarterly Review told a tale of two halves, this one tells a tale of two forces. Over the past three months, trade tensions between the United States and China loomed large, but other countries, such as Mexico, did not escape new tariff threats. As in the past, signs of an escalation in the trade skirmishes hit risky asset prices hard, dragging equity prices down and pushing corporate bond spreads up. And as central banks eased pre-emptively in response to the darkening economic outlook and tighter financial conditions, risky asset prices rebounded while inflation remained stubbornly low.

Against this backdrop, sovereign bond yields naturally declined further, at times driven by the prospect of slower economic activity and heightened risks, at others by central banks' reassuring easing measures. At one point, before the recent uptick in yields, the amount of sovereign and even corporate bonds trading at negative rates hit a new record, over USD 17 trillion according to certain estimates, equivalent to roughly 20% of world GDP. Indeed, some households, too, could borrow at negative rates. A growing number of investors are paying for the privilege of parting with their money. Even at the height of the Great Financial Crisis (GFC) of 2007-09, this would have been unthinkable. There is something vaguely troubling when the unthinkable becomes routine.

Naturally, much of the financial market action had the United States as its epicentre. Still, given the global scale of trade concerns, US financial markets' size and the US dollar's international reach, much of the world gyrated too. Central banks eased policy in advanced and emerging market economies (EMEs) alike. The latest one to join in was the ECB, which eased in a multi-pronged way, combining a cut in the policy rate further into negative territory, an extension of forward guidance - now linked to the attainment of the inflation objective - a resumption of asset purchases, and more generous terms on special financing for banks.

Exchange rates could not remain immune to the confluence of trade tensions and monetary policy responses. EME currencies depreciated most against the US dollar, not least following a weakening of the renminbi to below the psychological threshold of 7 to the dollar. But the greenback remained broadly stable against advanced economy currencies, in part owing to actual or anticipated monetary policy easing there - sterling's depreciation being an obvious exception. The exchange rate-monetary policy nexus became part of the trade rhetoric, threatening further tensions.

As the global economy weakened, financial market participants once again turned their attention to the inversion of the yield curve: long-term rates falling below short-term ones. This closely watched indicator of a future recession, in turn, fuelled financial market concerns, arguably pushing long-term rates down and inverting the curve further. In contrast to the past, however, the inversion reflects a historically low term premium - in part driven by central banks' asset purchases. The premium has not shown similar leading recession indicator properties. Indeed, as we explain in a box, there are reasons to be very cautious when interpreting the yield curve signals, not least as the Federal Reserve has been easing rather than tightening. Other indicators paint a less pessimistic picture.

That said, the credit standing of non-financial corporations in general, and the surge in leveraged loans in particular, represent a clear vulnerability. On the back of aggressive risk-taking and a search for yield, a growing portion of these bank loans to highly indebted firms have become the raw material for structured securitisations, known as collateralised loan obligations (CLOs). There are close parallels with the infamous collateralised debt obligations (CDOs), which resecuritised largely subprime mortgage-backed securities and played a central role during the GFC. A box examines similarities and differences between the two types of instrument and the broader market ecosystem. It concludes that while the picture offers less cause for concern, financial distress cannot be entirely ruled out, especially in the light of the concentration of some known bank exposures, uncertainties about the size and distribution of indirect ones, and the surge in market finance post-crisis. Moreover, losses on these asset classes, and leveraged loans more generally, are likely to amplify any economic slowdown.

Where does all this leave financial markets and policy? Despite the financial markets' ups and downs and concerns about a further global slowdown, financial conditions remain quite easy from a historical perspective. Corporate spreads are rather low and equity valuations rather rich. Economic conditions have been weakening, but so far at the global level a much larger and stronger services sector has contained the blow inflicted by a sharp slowdown in manufacturing. Inflation has generally remained stubbornly low. Above all, the monetary policy normalisation process has reversed: policy rates have started to decline again and central bank balance sheets to grow, in aggregate. The room for monetary policy manoeuvre has narrowed further. Should a downturn materialise, monetary policy will need a helping hand, not least from a wise use of fiscal policy in those countries where there is still room for manoeuvre.

Hyun Song Shin

During the GFC, the distress of large, complex, interconnected financial institutions undermined financial stability. Drawing on the lessons, financial regulators implemented reforms to mitigate the systemic risk posed by those institutions. A key reform was the publication in 2011 by the Basel Committee on Banking Supervision (BCBS) of a framework to reduce the risks posed by global systemically important banks (G-SIBs). This framework had two aims. First, to increase G-SIBs' resilience - so as to make them less likely to fail. Second, to reduce G-SIBs' systemic importance - so as to reduce their impact on the financial system in the event of distress.

In "Playing it safe: global systemically important banks after the crisis", Tirupam Goel, Ulf Lewrick and Aakriti Mathur assess whether G-SIBs' resilience and systemic importance have changed in line with the objectives of the framework. They find that, post-crisis, G-SIBs have indeed adjusted their balance sheets in ways that are consistent with the intended effects of the framework.

To assess trends in resilience, they estimate probabilities of distress (PDs) using a model that combines market indicators of distress, bank-specific risk factors and macroeconomic variables. Their estimates show a decline in PDs since the introduction of the reforms, with the main drivers being lower ratios of risk-weighted assets to capital and more stable funding. Furthermore, over this period PDs for G-SIBs were persistently lower than those for non-G-SIBs.

On systemic importance, the scores calculated by the BCBS to identify G-SIBs show that the systemic importance of G-SIBs has declined since the introduction of the G-SIB framework, relative both to other banks and to the broader financial system. Reduced complexity was an important factor driving this decline. Both the reduced PDs and the reduced systemic importance of G-SIBs are also consistent with the greater procyclicality of large banks, which grew more rapidly pre-crisis. Quantifying the incremental impact of the reforms is a promising line of future research.

Another feature examines how the composition of banks' counterparties has changed in recent years. "Non-bank counterparties in international banking", by Pablo García Luna and Bryan Hardy, exploits newly published details from the BIS international banking statistics. The GFC revealed gaps in the information available to monitor and respond to financial stability risks. In response, the BIS international banking statistics have been the focus of greater efforts to incorporate more detailed sector information about banks' counterparties.

The feature reviews the coverage of the enhanced data and highlights some insights from the data. Consistent with the greater shift in financial activity from banks to non-bank financials, the data show that business with institutional investors, hedge funds and special purpose vehicles accounts for an increasingly large share of banks' international activity. Such institutions are not only large borrowers of bank funds but also important sources of cross-border funding. Households too are an important source of funding for banks. Cross-border deposits by households are largely accounted for by non-resident home country nationals making deposits with banks back home.

A third feature looks at the growing market for green bonds. In recent years, green bond issuance has increased substantially and the composition of issuance has come to resemble that for conventional bonds. "Green bonds: the reserve management perspective", by Ingo Fender, Mike McMorrow, Vahe Sahakyan and Omar Zulaica, discusses how central bank reserve managers can incorporate environmental sustainability objectives into their portfolios. They find that green bonds' safety and returns support their incorporation into reserves portfolios. At the same time, the lower liquidity and small size of the market constrain green bonds' eligibility as reserve assets. Moreover, central banks have increasingly promoted actions to address climate-related risks in the global financial system.

In "Financial conditions and purchasing managers' indices: exploring the links", Burcu Erik, Marco Lombardi, Dubravko Mihaljek and Hyun Song Shin analyse how financial variables can be used to "nowcast" PMIs. PMIs are reliable concurrent indicators of real economic activity. For example, in early 2018 PMIs started to foreshadow weaker export orders and industrial output growth, well before a slowdown in global economic activity became visible in traditional macroeconomic indicators during the first half of 2019.

Changes in PMIs are closely correlated with equity indices and corporate bond spreads. This is not surprising, as these asset prices incorporate forward-looking information on future economic activity and profitability as well as on current financing conditions. Perhaps more surprisingly, PMIs also correlate with the strength of the US dollar. This correlation goes against an explanation based on trade competitiveness: it is when the dollar is strong that PMIs outside the United States are weak, contrary to the view that a strong dollar should stimulate activity through gains in trade competitiveness. This points to a role for the dollar as an indicator of global financing conditions, and provides a useful conceptual bridge to the international macro literature.