Continuing risks in the financial system at the start of 2017

2 January by Myriam Vander Stichele

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The stock market indexes and derivatives Derivatives A family of financial products that includes mainly options, futures, swaps and their combinations, all related to other assets (shares, bonds, raw materials and commodities, interest rates, indices, etc.) from which they are by nature inseparable—options on shares, futures contracts on an index, etc. Their value depends on and is derived from (thus the name) that of these other assets. There are derivatives involving a firm commitment (currency futures, interest-rate or exchange swaps) and derivatives involving a conditional commitment (options, warrants, etc.). markets are again showing a higher level of “exuberance” than when the financial crisis started to unfold in 2007 in the US. The financial system seems to have survived instability shocks from the Chinese financial markets in early 2016, and, later in the year, from the remaining weaknesses of the European banks, especially the threat of a potential collapse of the oldest Italian bank, Banca Monte dei Paschi di Siena and Deutsche Bank.

However, the lack of real financial reforms and the slow or weak implementation of approved, due to the enormous lobbying power of the financial sector and insufficient political will, means that many financial stability risks remain that are threatening already shaky political systems, and vice versa. Among others, the European Systemic Risk Board and theIMF’s Global Financial Stability Report sent clear warnings that risk taking is high while the existing risks to financial stability are underestimated.

A remaining problem is that too-big-to-fail (TBTF) banks have not been slimmed down and the risky activities have not even really been separated or split off from basic banking activities. Proposed EU reforms to do so, through a Banking Structural Reform Directive, have stalled without popular protest. According to the IMF´s 2016 Global Financial Stability Report, “more deep-rooted reforms and systemic management are needed, especially for European banks”. A German Economic Scientific Council warned that bank reforms are insufficient. The Financial Stability Board FSB
Financial Stability Board
The Financial Stability Board is an informal economic group that was created during the G20 meeting in London in April 2009. It succeeded the FSF (Financial Stability Forum) that had functioned since the G7 in 1999. The Board is made up of 26 national financial authorities (central banks and finance ministries), several international organizations and groups that devise financial stability standards. Its raison d’être is to enable cooperation in the fields of supervision and the observation of financial institutions.

Financial Stability Board : http://www.fsb.org/
agreed on a 2016 list of 30 TBTF global systemically important banks (G-SIBs). These financial conglomerates that could put the financial system at risk are finally getting subject to requirements for extra capital reserves (e.g. total loss-absorbing capacity (TLAC)) that should avoid bail-outs with public money and discontinued critical banking functions in case the G-SIBs fail. Worse, there is still no global system in place to orderly resolve these G-SIBs in case they fail, so that many are still not excluding bail-outs with tax money or perhaps corporate money (e.g. German industry buying up the shares of Deutsche Bank) in case of a global crisis. There is also a 2016 list of nine global systemically important insurance companies (G-SIIs) whose resolution frameworks still need to be operationalised. A new category has joined the list of TBTF global systemically risky financial players about which warnings have been issued several times, and EU and international plans are under way to deal with them: “CCPs” or central counter parties , i.e. the clearing houses that take on the risks when derivatives Derivatives A family of financial products that includes mainly options, futures, swaps and their combinations, all related to other assets (shares, bonds, raw materials and commodities, interest rates, indices, etc.) from which they are by nature inseparable—options on shares, futures contracts on an index, etc. Their value depends on and is derived from (thus the name) that of these other assets. There are derivatives involving a firm commitment (currency futures, interest-rate or exchange swaps) and derivatives involving a conditional commitment (options, warrants, etc.). contracts fail to be paid. At least it seems that globally active hedge funds Hedge funds Unlisted investment funds that exist for purposes of speculation and that seek high returns, make liberal use of derivatives, especially options, and frequently make use of leverage. The main hedge funds are independent of banks, although banks frequently have their own hedge funds. Hedge funds come under the category of shadow banking. , which use extreme speculative strategies with borrowed money, are not attracting more funds than the already huge amount of $ 3 trillion which they currently manage.

The low interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
in the US and the EU are undermining the current business models of pension funds Pension Fund
Pension Funds
Pension funds: investment funds that manage capitalized retirement schemes, they are funded by the employees of one or several companies paying-into the scheme which, often, is also partially funded by the employers. The objective is to pay the pensions of the employees that take part in the scheme. They manage very big amounts of money that are usually invested on the stock markets or financial markets.
, insurance companies and banks, because their profit Profit The positive gain yielded from a company’s activity. Net profit is profit after tax. Distributable profit is the part of the net profit which can be distributed to the shareholders. margins are too low. In a particular paradox, savings banks like the German Sparkassen that were not involved in speculative business and proved to be healthy and resilient in the crisis, are now under threat. Their business model is based to a large extend on the interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. rate differentials. Consequently, banks are moving more towards obtaining fees from market-based finance, whereby they are intermediaries and do not bear the risks, including through securitisation, asset Asset Something belonging to an individual or a business that has value or the power to earn money (FT). The opposite of assets are liabilities, that is the part of the balance sheet reflecting a company’s resources (the capital contributed by the partners, provisions for contingencies and charges, as well as the outstanding debts). management and shadow banking. The current low interest rates have encouraged worrisome risky financial strategies, concentration of some assets such as real estate leading to asset bubbles, and a high level of private and governmental debt (loans, bonds), not in the least involving corporate debt in emerging markets. When interest rates increase, as began in the US on 14 December 2016, debt repayment will become more difficult, and large money flows, already flooding the markets due to central bank Central Bank The establishment which in a given State is in charge of issuing bank notes and controlling the volume of currency and credit. In France, it is the Banque de France which assumes this role under the auspices of the European Central Bank (see ECB) while in the UK it is the Bank of England.

ECB : http://www.bankofengland.co.uk/Pages/home.aspx
supplies of cheap money (known as quantitative easing or QE), will withdraw from emerging and unstable markets. This will exacerbate the challenges to financial stability in emerging market economies already rocked by low commodity prices and financial outflows. At the same, QE that needs to be considered as a subsidy to the financial sector, will continue in the Eurozone.

The low interest rates and QE have been encouraging all kind of investors, including pension funds, insurance companies and even individual savers, to take many more risks on the financial markets in order to obtain some profitability. However, as different volatile moments in 2016 have shown, profitability can very swiftly dwindle due to mistrust or a political or financial event, triggering a withdrawal of money, not in the least from investment funds Investment fund
Investment funds
Private equity investment funds (sometimes called ’mutual funds’ seek to invest in companies according to certain criteria; of which they most often are specialized: capital-risk, capital development funds, leveraged buy-out (LBO), which reflect the different levels of the company’s maturity.
. Experts and the media have been warning about new investment strategies through Exchange Traded Funds (ETFs) which manage in 2016 more than $.33 trillion through passive index funds, i.e. automatically buying and selling shares according to their performance on the stock market. Only a few fund managers (BlackRock, Vanguard, State Street) dominate this market. These funds own the shares of many listed companies, meaning that they have an impact on these companies’ behaviour, the economy, job creation and even inequality.

The rise of non-bank financing and the shift to market-based finance (e.g. through stock markets, bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock-exchange. markets, investment funds, shadow banking, money market funds MMF
Money Market Funds
Mutual investment funds that invest in securities, including money funds.
and securitisation) brings about new challenges. Regulators and supervisors do not yet have full oversight over data, let alone of the risks and how to solve them. Market-based finance is also being used for public goods such as infrastructure projects, including roads, energy grids, schools, prisons and hospitals, which are being pushed for through the G20 G20 The Group of Twenty (G20 or G-20) is a group made up of nineteen countries and the European Union whose ministers, central-bank directors and heads of state meet regularly. It was created in 1999 after the series of financial crises in the 1990s. Its aim is to encourage international consultation on the principle of broadening dialogue in keeping with the growing economic importance of a certain number of countries. Its members are Argentina, Australia, Brazil, Canada, China, France, Germany, Italy, India, Indonesia, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, USA, UK and the European Union (represented by the presidents of the Council and of the European Central Bank). ’s new “Global Infrastructure Hub”, for example. A major problem is that market-based finance spreads the risks throughout the financial system and society, increasing inequalities (the market is not interested in the poor). Many financial instability risks also remain in China’s shadow banking and financial system, about which not all is known. BREXIT and Trump’s election might change the way in which the London and New York financial centres are regulated and are working, eventually spreading their risky strategies even wider around the world.

Political decision-makers in the G20, EU and US (Trump) agree with the financial sector lobby Lobby
Lobbies
A lobby is an entity organized to represent and defend the interests of a specific group by exerting pressure or influence on persons or institutions that hold power. Lobbying consists in conducting actions aimed at influencing, directly or indirectly, the drafting, application or interpretation of legislative measures, standards, regulations and more generally any intervention or decision by the Public Authorities.
that further financial reforms are not needed – rather, that the opposite is true. In the EU, this has been visible in the EU opposition to the Basel Committee on Banking Supervision’s completion of bank reforms by preventing too-lax risk assessments by banks when approving loans (through its own “internal model” of risk weighing), as well as by the weak EU review of bank reforms. There is little agreement among the G20 on what to do, and the German presidency of the G20 is emphasising implementation and not further reforms.

In terms of financial stability, nothing has really been legislated to prevent the markets from being on shaky financial stability grounds. This can be easily disturbed by financial, political and even climate change events, resulting in a wall of money being flashed to other profitable or presumably safe assets (such as bonds at 0 percent or negative interest rates), while some assets might not be easily sellable. Finally, during the last months of 2016, the efficiency and non-conditionality of central bank interventions (QE, low interest rates) were very much in question. Low economic growth is blamed for many problems, but financial and monetary policies might be at the core of the lack of demand and unequal purchasing power. At the same time, the current growth model as such is not questioned. As an example of this inconsistency, the ECB is buying up bonds from big oil companies in contradiction to climate change policies. Such bonds might become stranded assets.

Who will act when the instability threatens to become a new financial crisis, or at least act to prevent another crisis from occurring?


This article was first released in the ‘EU Financial Reform’ newsletter which is published by SOMO and German NGO WEED. Source: https://www.somo.nl/continuing-risk...


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