This note is about the recognition of policy failures by public authorities and their consequences on financial stability. Our macro-financial propositions point towards a global normalization process. At the heart of this process lays a disconnect between financial and real conditions. While financial conditions have been heavily influenced by central banks and their abundant offer of unconventional policies, real conditions – such as growth and inflation – desperately fail to respond positively, as illustrated by the recent Chinese turmoil and subsequent downward revisions of growth.

The following propositions complete our previous assumptions:

We view the resurgence of systemic measures (2), governance issues (3) and capital requirements (4) as a confirmation of the current normalization process:

  1. The origin of the recent Chinese turmoil is systemic.
  2. Central banks are increasing their alert level in order to avoid contagion.
  3. As things get tougher, they are forced to promote deleveraging measures that favor financial stability vs. growth. These objectives underline governance issues.
  4. Commercial banks have no choice but to adapt: capital increases, decreasing profitability and risk sharing ahead. Beware.

The following articles and research pieces illustrate our opinion.

 

Central banks are building further firewalls

The FT reviews the heavy artillery deployed by the Financial Stability Board earlier in November. The FSB published final proposals for Total Loss Absorbing Capacity (TLAC)to be applied to global systematically important banks. The FT reports: “Global banks must raise EUR 1.1tn in special debt by 2022”:

 

While previous global requirements have focused on equity, TLAC is about debt that can be converted into equity when a bank fails, essentially putting a lender’s creditors on the hook rather than the taxpayer. It also ends the equal treatment of bondholders and depositors, whose deposits are often insured by their governments.

The FSB, which will put the plan to the G20 later this month, confirmed a widely anticipated range for TLAC that will be 16 per cent of a banking group’s assets when measured for risk by 2019, rising to 18 per cent by 2022.

European banks have become increasingly concerned about rising capital demands, and are describing the latest round of regulation as Basel IV, the successor of the Basel III regulations that do not come into force until 2019.

“It’s not capital, it’s loss absorbency — there’s a big difference,” Mr Carney told journalists. “There is no Basel IV. There is the completion of Basel III . . . What we’re doing is ironing out issues that have been identified over time in terms of the application of Basel III.”

The FSB admitted that the TLAC rules could push up the cost of credit and hurt economic growth but said the impact would be “very limited” and was outweighed by the benefits of increasing bank resiliency by “at least one­ third”, reducing the likelihood of systemic crises and cutting the fiscal costs of dealing with them when they do occur.

 

Systemic risk is indeed the starting point of the maneuver. The inclusion of Emerging banks into the TLAC scope provides further insights:

Hardest hit are emerging market banks, which previously enjoyed an exemption from TLAC rules. Four of the 30 lenders that are so­ called global systemically important banks, or G­SIBs, currently have no senior debt instruments that count towards TLAC, the FSB said.

Four banks, Agricultural Bank of China, Bank of China, China Construction Bank and Industrial and Commercial Bank of China, will no longer have an exemption around TLAC and have been given deadlines for the lower and upper ranges of 2025 and 2028 respectively. The exemption, widely seen as a sop to the Chinese, was controversial because it undermined the principle of a global level playing field.

 

Central Banks: governance at stake

The timing and focus of the latest regulatory layer is at the heart of this note. We believe that central banks have no choice but to consider financial stability as a valid gauge for their policy efficacy. They had to revise the capital requirements of commercial banks, even though they conflict with the initial mandates of CBs: inflation, growth and employment.

Central banks have a natural incentive to underestimate the impacts of their decisions when it comes to financial stability and regulation. The latest rounds of stress tests give ample evidence of this contradiction. It is no wonder if fundamental questions of governance arise at this particular juncture: accountability, responsibility and concentration of power are (finally) at stake.

The memoirs of Bern Bernanke, “The Courage to act”, comes as a perfect illustration. J. Brattford Delong makes his own reading of the book in “The tragedy of Ben Bernanke”, an article published in the Project Syndicate:

In the end however, Bernanke did not deliver. Even though the Fed and many other central banks printed much more money than economists would have thought necessary to offset the impact of the financial crisis, full prosperity has yet to be restored. Bernanke increased the US monetary base five‑fold, from $800 billion to $4 trillion. But it wasn’t enough. And then, his courage failing, he balked at taking the next leap: more than doubling the monetary base to $9 trillion. In his last years in office, Bernanke was reduced to begging in vain for Congress to institute fiscal expansion.

 

‘So What went wrong?’ asks Delong. He reviews various analyses promoted by prominent economists: Bernanke himself, Kenneth Rogoff, Larry Summers, Paul Krugman and even Keynes. We will revert to this debate later on. Recall our initial proposition: global credit expansion is a source of concern, not a solution.

Back to the governance debate. Stanley Fischer, the vice-chairman of the Federal Reserve Board, adopts a hard stance against any constraints imposed to the Fed by politicians (the US Congress in this case). Please consider “Fed’s Fischer warns against shackles on central bank” by the FT:

In his speech at the National Economists Club in Washington, Mr Fischer said that accountability to elected officials and the public was “an essential complement to central bank independence”.

He criticised mooted restrictions, however, saying they would “represent a departure from the modern governance structure that has come to characterise the Fed and leading central banks around the world”.

 

This is amusing: which independence is Fischer talking about? Didn’t public authorities, central banks, politicians and international organizations rapidly team-up after the financial crisis? Why are politicians and central bankers all of a sudden re-discovering the virtues of independence? Are things getting tougher?

Earlier in the week, Senator Richard Shelby, the Republican chair of the Senate Banking Committee, made the case for his own legislative proposals, which would include more frequent reporting to Congress on monetary policy and more detailed explanations of decisions made by the Federal Open Market Committee.

“I believe the Federal Reserve should and must remain independent. However, independence is not contingent upon immunity from vigorous congressional oversight and accountability,” Mr Shelby said.

Mr Fischer acknowledged that the picture for central bank independence is being complicated by the rising prominence of financial stability concerns.

“Issues of financial stability have moved out of the shadows and into the centre of our concerns. The resulting challenges are only beginning to be understood — and they need to be understood and taken seriously if we are to reduce the probability of future financial crises.”

 

Financial stability issues were never ‘in the shadows’. Quite the opposite: it is one of the core lessons of the financial crisis.

Please consider our propositions:

We view the resurgence of systemic measures (2), governance issues (3) and capital requirements (4) as a confirmation of the current normalization process:

  1. The origin of the recent Chinese turmoil is systemic.
  2. Central banks are increasing their alert level in order to avoid contagion.
  3. As things get tougher, they are forced to promote deleveraging measures that favor financial stability vs. growth. These objectives underline governance issues.
  4. Commercial banks have no choice but to adapt: capital increases, decreasing profitability and risk sharing ahead. Beware.

Best regards,

Jacques

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