Energy shocks, high inflation and persistent geopolitical tensions put central banks' focus squarely on securing macroeconomic and financial stability
In a nutshell:
- A worsening and uncertain economic outlook poses risks to national and global financial stability in 2023 that firms will need to weather.
- Banks have broadly remained strong; nonetheless regulators are focused on enhancing market resilience wherever practicable, mindful also of vulnerabilities in the non-bank financial intermediary sector.
- Regulated firms must be ready to adjust not only to deteriorating economic conditions, but also to (sometimes rapidly) changing national macro-prudential policies as well as prudential regulatory interventions.
- Global regulatory co-ordination will play an increasingly important role, but the independence of national regulators and central banks may face increasing challenge domestically.
Financial stability in the spotlight
2022 looked set to bring green shoots of stronger recovery, sustainable economic global growth and progress towards climate change targets following two very difficult years. The consensus of global regulators was that banks had generally weathered the effects of the pandemic well and shown good operational resilience, although some non-bank financial intermediaries fared a little less well.
Unfortunately, global economic conditions have worsened, the macro-economic situation is uniquely uncertain, and a longer term high inflation regime is now looking very possible. Broader geopolitical tensions, most notably from the war in Ukraine, have aggravated already rising interest rates and inflation, and led to supply chain issues and increased volatility in the commodities and financial markets, in turn impacting liquidity. Diminished liquidity in turn raises the risk of disorderly asset price adjustments and unexpectedly large margin calls. Other causes for concern include turmoil in the crypto-markets, and an increase in cyber risks, while the impacts of climate change continue to make themselves felt across the globe.
Central banks have sought to respond, sometimes with mixed results. Interest rates and bond spreads have risen in anticipation of further tightening of monetary policy, and valuations of fixed income assets are reducing. The speed of the US Federal Reserve's efforts to shrink its balance sheet, at a time when other major central banks were doing the same, stressed bond market liquidity. In the UK, the Bank of England had planned to reduce its gilt holdings over the next 12 months; the UK Government's announcement of a sizeable fiscal package, swiftly followed by an unprecedented warning from the IMF, exacerbated rising bond yields and resulting in a liquidity crisis for pension funds - the Bank of England instead found itself taking emergency action through a temporary programme of buying long-dated gilts to prevent 'material risk' to financial stability.
In terms of prudential regulation1 , what will all this mean for regulated firms in 2023?
Interest rates and yields are likely to continue to rise, which creates the potential for increased earnings for banks. However, as government support is withdrawn or limited, higher levels of debt and risker corporate borrowing may leave businesses struggling with higher funding and operating costs, and unable to repay to their loans, in turn leading banks to recognise impairments or losses. So far, banks have mostly not used their capital and liquidity buffers to meet loan demand, and some were reluctant to do so, taking defensive actions to maintain liquidity levels well above the regulatory minimum. Insurers remain strongly focused on credit risks arising in the corporate and banking sector.
National and global regulators are carefully monitoring the broad range of potential challenges to financial stability as governments begin implementing their pandemic exit strategies. Their hope is to rebuild some macro-prudential policy leeway where feasible in the context of domestic economic conditions. In the UK, for example, the Financial Policy Committee presently proposes to increase the countercyclical capital buffer (CCyB) rate to 2% from July 2023 to ensure that in challenging conditions to come, banks retain the resilience to lend in times of stress and can continue to support households and businesses; this will however be kept under close review in light of any significant deterioration in economic conditions. More ambitiously, Norway and the Czech Republic are aiming for a 2.5% CCyB in early 2023, and Iceland and Denmark hope to reach 2% by the end of this year.
Firms can expect to see national regulators selecting policy options in line with proposals developed through various Financial Stability Board (FSB) workstreams aiming to improve the resilience of non-bank financial intermediaries, including work on open-ended funds, margining practices, the liquidity structure and resilience of core bonds markets, and on the resilience of money market funds. Further work will also be done to ensure effective resolution regimes for financial institutions across sectors, enhance cyber resilience, tackling financial firms' reliance on critical service providers, and on the implications of FinTech for financial stability. Finally, although – or because - regulators credit the reforms implemented to date with ensuring that banks could continue to lend throughout the pandemic, there is determination to complete the remaining elements of the post-crisis reform agenda.
Coordination of these efforts by the FSB and other supra-national bodies will be critical to success in tackling the current risks in the global markets that may threaten global and/or national financial stability, and in ensuring the consistency of policy responses within existing international financial standards. However, there are some indications that this may not be so straightforward: the geopolitical environment is somewhat less supportive of global international cooperation and free market forces; protectionism seems to be on the rise.
As the costs of higher interest rates to public finances becomes more starkly visible, the tensions between regulatory prudence and a strong political desire to ensure growth through lending and investment seem likely to increase. Some compromises may be possible - the PRA's proposals for a "strong and simple" capital structure for smaller banks in the UK provide an example of a true Brexit opportunity, and would align the UK more closely with the US approach.
Nonetheless, we anticipate that regulators and central banks are likely to see their independence increasingly subject to challenge in the coming year or two. In the UK, the government mooted, then withdrew, plans to legislate for an Intervention Power to enable the executive to direct a regulator to make, amend or revoke rules where there are matters of significant public interest. The European Central Bank noted that, notwithstanding the rapid and unprecedented monetary policy response around the world to the pandemic, government pressures on central banks were increasing. As debt levels – both private and public – rise, conflicts between fiscal authorities and central banks and regulators are likely to require careful navigation.
1 The changing global economic and geopolitical environment is also giving rise to an increasing regulatory focus on conduct and social issues, and to changes in regulatory approaches, which are considered in other articles in this Global FSR Outlook 2023.