The word “resilient” is often heard these days in international financial institutions. Nevertheless, the global economy’s capacity to endure significant shocks is not unlimited. Klaas Knot, Chair of the Financial Stability Board (FSB), conveyed this message in a letter to G20 leaders, who are scheduled to meet in New Delhi on September 9 and 10. “The global economic recovery is losing momentum, and the effects of the rise in interest rates in major economies are increasingly being felt,” warned Knot. The head of the FSB, an international body that monitors and makes recommendations about the global financial system, is urging countries to acknowledge the vulnerabilities in the global financial system, which were exposed earlier this year by the Silicon Valley Bank (SVB) and Credit Suisse crises. Going forward, Knot says it will be important for authorities to closely monitor asset quality in those sectors most sensitive to interest rate increases, such as real estate.
Just a year ago, Europe was on the verge of a recession amid concerns about potential natural gas rationing due to the war in Ukraine and a sudden interest rate spike. However, the feared recession never materialized. While Germany did experience a downturn, it did not spread to the entire Eurozone. Nevertheless, the FSB and other international organizations are starting to see signs of economic headwinds. “[Rising interest rates] alongside a slowing growth outlook, could impair the capacity of borrowers to service the historically high stock of outstanding global debt and create challenges for both bank and non-bank lenders,” Knot warned in his letter.
Knot, who is also President of De Nederlandsche Bank (the central bank of the Netherlands), reminded world leaders of the events last spring that kept world leaders and central banks on edge. “Earlier this year, amid shifting financial conditions, we witnessed the first failure of a global systemically important bank since the 2008 global financial crisis (GFC), as well as a few medium-sized bank failures.” While contagion from these individual bank failures was limited, thanks to swift action by authorities on both sides of the Atlantic, “... further strains in financial markets cannot be ruled out in the months ahead as higher debt servicing costs continue to permeate the economy.”
The SVB crisis originated from its sovereign debt portfolio. The bank, which had a strong focus on startups, experienced a significant devaluation in its extensive portfolio due to increased profitability. According to the FSB, this crisis revealed the weaknesses in certain banks’ ability to handle and manage interest rate-related risks. And that, Knot concludes in the letter, highlights “... the importance of fully and consistently implementing the Basel III framework, thereby further enhancing banking sector resilience as soon as possible.” Knot also proposes monitoring the quality of portfolios in the “sectors most sensitive to rate increases,” such as real estate.
With a sharp increase in interest rates (from 0% to 4.25% in the Eurozone within a year), international financial institutions have expressed concern over the sources of the mounting global debt, rather than its sheer volume. “A key trend in recent years has been the increased importance of non-bank finance,” writes Knot. The Bank for International Settlements (BIS), which is a bank for central banks, previously warned about this shadow debt in the hands of investment banks and technology platforms, estimated at over $80 billion (€75 billion). “If not properly managed, leverage can amplify stress in the event of a shock and lead to systemic disruption, as demonstrated by recent strains in commodities and bond markets,” wrote Knot in an clear reference to the crisis unleashed by the British government under short-lived Prime Minister Liz Truss.
Knot informed the G20 leaders that one of the FSB’s key focuses next year will be addressing the risks associated with non-financial debt such as cryptocurrencies, including stablecoins tied to currencies such as the dollar and euro. “A number of incidents over the past year have highlighted the vulnerabilities in the crypto-asset ecosystem, which warrant close monitoring given the growing linkages with the traditional financial system... The risks of crypto-assets are not confined to financial stability, but can also include macroeconomic risks relating to monetary sovereignty, capital flow volatility and fiscal policy.”
In the concluding paragraph of his letter, Knot writes, “There will certainly be further challenges and shocks facing the global financial system in the months and years to come. But it is possible, through concerted policy action by authorities, for the financial system to absorb rather than amplify these shocks.” The FSB promotes international financial stability by coordinating national financial authorities and international standard-setting bodies, and its members include the world’s major economies (Russian authorities have agreed not to participate in FSB meetings at present), as well as the BIS, the Organization for Economic Cooperation and Development (OECD), the International Monetary Fund (IMF), the European Central Bank (ECB) and the World Bank, among other international institutions.
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