At its meeting at the end of 2019 the European Systemic Risk Board (ESRB) considered a number of vulnerabilities in the EU financial system, including the indebtedness of non-financial corporations, the liquidity of assets in investment funds, the misconduct costs facing financial institutions and abiding concerns related to low interest rates.
Richard Portes, Professor of Economics at London Business School, has built a distinguished career studying the causes and consequences of financial crises and currently identifies a potential failure within financial systems, a crisis which may become deeper through a ‘doom loop’ mechanism, as a major cause of concern.
Low interest rates is in one such doom loop, leading to a build-up of debt because it is cheap to borrow. The IMF identifies persistently low interest rates as an inducement for investors to take dangerous risks in a quest to maintain their financial returns, thereby raising further concerns about the stability of the global economy may not be sustainable. Low interest rates are supporting growth for the time being, but are putting growth at risk in the medium term, says Portes.
“We have had an extraordinary financial environment since the global financial crisis, with interest rates at or close to zero for a decade – great for those of us with variable-rate mortgages, but not great for financial stability,” he adds.
This low interest rate (LIR) era has led to an unprecedented build-up of debt in the corporate sector, among households (especially in the UK), and of sovereign debt, coupled in Europe with a sovereign-bank nexus, leading to a potential ‘doom-loop’ scenario. If the creditworthiness of sovereign debt holdings of the banks comes into question and their prices fall, this hits bank balance sheets and may lead them to fail, with the government having to pick up the tab and a consequent deterioration in its fiscal position, which pushes its bond prices down still further. This can become a vicious circle, ending in bank and sovereign defaults.
LIR leads to a search for yield, whereby asset managers look for higher-yielding assets. But higher yield comes with greater risk, so the search for yield leads to more risk-taking. This could see rising defaults on loans and the return of complex securities like those that were so dangerous in 2008.
Other vulnerabilities stem from some equity markets and EU commercial real-estate markets reaching historic highs; the largely unregulated shadow-banking sector; liquidity risk and risks associated with leverage among some types of investment funds; and exists greater interconnectedness, creating risk of contagion across sectors and within the non-bank financial system, both domestic and through cross-border linkages.
A sudden, major collapse of asset values that generates a credit cycle could lead to a ‘Minsky moment’, whereby a period of stability encourages risk-taking, leading in turn to a period of instability when risks are realised as losses, leading in turn to risk-averse trading or deleveraging, restoring stability, and setting up the next cycle.
The task force should principally consider whether and how the aforementioned vulnerabilities such as the indebtedness of non-financial corporations, the liquidity of assets in investment funds, and the misconduct costs facing financial institutions, might be affected by the implications of the current low or even negative yield curve, proposing macro prudential policy responses where appropriate.
The ESRB will receive an update in this regard at its next meeting in June 2020. The work will be chaired by Mr John Fell (ECB), Mr Tuomas Peltonen (ESRB Secretariat) and Professor Portes.