BIS Quarterly Review, March 2019 - media briefing

Claudio Borio's remarks | Hyun Song Shin's remarks

Claudio Borio

It was a tale of two phases.

The period under review started just the way the last one ended. In the second half of December, the risk-off phase persisted. Led by the US markets, stock prices worldwide continued to decline, volatility to rise, credit spreads to widen, sovereign bond yields to soften, term premia to fall and market-implied inflation expectations to dip. Volumes in the leveraged loan market and issuance of high-yield bonds slowed to a trickle; and withdrawals from mutual funds added to the surge in corporate spreads (see also Box).

In the background, concerns about a slowdown in the global economy continued to weigh on sentiment. And rather surprisingly perhaps, markets focused on the Federal Reserve's highly predictable, passive unwinding of its balance sheet. The process was supposed to be uneventful; it turned out to be anything but. When on 19 December the US central bank hinted at slowing the pace of its very gradual tightening through the policy rate, market participants duly adjusted their expectations of the rate's future path. But they were seemingly disappointed because the Fed did not suggest a more flexible interpretation of the unwinding of its balance sheet. As a result, asset prices quickened their descent.

Beginning in January, markets rebounded and recouped the losses incurred since early December. Reinforced by some improvement in the economic outlook, once again they largely took their cue from central banks. When on 4 January the Federal Reserve Chairman indicated that not just the policy rate but also the balance sheet could respond flexibly to economic weakness, financial markets cheered. Moreover, market participants found further comfort in statements by the ECB and the Bank of Japan which signalled accommodation and a willingness to adjust course in light of evolving circumstances. As risky asset prices rallied, bond yields dipped further, with German bunds plumbing depths not seen in a very long time.

All along, just as they had in the previous quarter, emerging market economies (EMEs) held up remarkably well. This was so despite the slowdown in China, which once again induced monetary and fiscal easing there. More than the uncertainty and reality of trade tension, it was the headwinds from the Chinese economy's necessary deleveraging that seemingly weighed down on activity. If anything, China's condition appeared to exert more of an influence on economic developments in advanced economies (AEs), notably in the euro area, than in EMEs. Quite apart from the strides that EMEs have made to strengthen their economies and financial systems, a quiescent US dollar provided welcome support. And when monetary policy in AEs became more accommodating than expected, the risk-on phase propelled fund inflows into EME asset classes, lifting their prices.

Developments in the period under review highlighted two enduring features of the economic and financial landscape. One, in the background and little noticed except by practitioners, is the sea change in the day-to-day functioning of financial markets since the Great Financial Crisis (GFC). The other, in the foreground and commanding widespread attention, is the close interaction between central banks and markets.

Since the GFC, markets have exhibited a number of price patterns that, by pre-crisis standards, would be regarded as "anomalies". These include: apparent violations of covered interest parity, as embodied in the evolution of the cross-currency basis; much larger spikes in interest rates and spreads at quarter- and year-end (see Box); and uncollateralised rates for overnight transactions among private sector parties hovering below the risk-free ones on central bank deposit facilities. More generally, the dispersion of money market interest rates has greatly increased.

At first sight, these so-called anomalies may seem to be a cause for concern. After all, do they not point to less day-to-day market liquidity and make markets more vulnerable to sudden price jolts? To some extent they do. Still, the spikes mainly reflect financial institutions' retrenching and contracting of their balance sheets around reporting dates: while this indicates some unwelcome window-dressing, the price moves are purely technical.

More importantly, these apparent anomalies reflect institutions' better recognition of the risks linked to the use of their balance sheets, hard-wired by regulation. Financial institutions no longer treat their balance sheet as a free resource. They see that it has a price. They can no longer extend it with the previous insouciance. This development is healthy. It means that the aggressive risk-taking and overextension that tend to precede the sudden drying-up of liquidity, while a permanent danger, are somewhat less likely or at least less intense than they would otherwise be. And it means that, when market liquidity does come under strain, financial institutions should be better placed to absorb the blow.

Turning now to the second new feature of the landscape, asset price swings in the period under review highlighted once more the extraordinarily tight relationship between central banks and financial markets. Financial markets scrutinise central banks' every word and deed, taking them as the cue for their ups and downs and seeking perennial comfort. Central banks, in turn, scrutinise financial markets to better understand what the future holds for the economy, as markets both reflect and influence activity - a complex and delicate task. Together with the "hard" data, this interaction helps explain the Federal Reserve's recent patience along its normalisation path. As central banks and financial markets dance locked in this embrace, it is sometimes hard to tell their steps apart.

Be that as it may, developments over the last couple of months conveyed a simple message. The very gradual and predicable monetary tightening process is on pause and has become less predictable, as inflation in AEs has shown little sign of flaring up, the prospects for economic activity have become more uncertain, and financial markets have turned out to be especially jittery. The narrow normalisation path is proving to be a winding one.

Hyun Song Shin

LIBOR - or, to give it its full name, the London interbank offered rate - was once a widely used but not much discussed interest rate in an unglamorous corner of the money market. The financial crisis and the LIBOR manipulation scandal changed all this; LIBOR was catapulted to the top of the news headlines. Since then, intense work has been under way to find a successor to LIBOR that can simultaneously serve as a reliable benchmark drawing from actual market transactions, and allow market participants to hedge risks on trillions of dollars' worth of financial contracts.

In "Beyond LIBOR: a primer on the new reference rates", Andreas Schrimpf and Vladyslav Sushko describe the current state of play and the conceptual and practical challenges involved in "going beyond LIBOR".

At their root, the challenges stem from the fact that a reference rate has to satisfy several criteria that may sometimes pull in different directions. Foremost is the requirement that the reference rate should not be susceptible to manipulation - ie that it be based on actual market transactions in liquid markets. Overnight risk-free rates (RFRs), either unsecured or secured on collateral, suit this purpose well. However, for banks and other intermediaries that borrow in order to lend, hedging the cost of borrowing is key to their risk management. A sudden spike in their short-term borrowing rates can pull the rug from under their feet during episodes of financial stringency, squeeze their margins, and subject the system as a whole to broader stress. Banks could be exposed to basis risk in periods when their marginal funding costs diverge from interest rates earned on those of their assets benchmarked to the new RFRs, resulting in a margin squeeze. For hedging purposes, the benchmark rate should hence ideally reflect the cost at which intermediaries can raise that funding in term money markets at the margin. There is also the issue of how medium- to long-term interest rate benchmarks can be constructed from the overnight benchmarks.

Authorities have identified a number of RFRs that can serve as robust and credible overnight reference rates. Cash and derivatives markets are expected to migrate to the new RFRs. However, there may be a continuing need in the market for a set of benchmarks that provide a close match to intermediaries' funding cost. This may call for a pragmatic and tailored approach. For instance, RFRs could be complemented with some forms of credit-sensitive benchmark, an approach undertaken in some jurisdictions. The eventual outcome could well feature the coexistence of multiple benchmarks. A toolbox with a separate screwdriver and saw could be better suited to serve the financial system than a Swiss army knife.

This issue of the BIS Quarterly Review is also notable for unveiling a major initiative on assessment of the impact of financial and regulatory reform. In "Impact of financial regulations: insights from an online repository of studies", by Frederic BoissayCarlos Cantú, Stijn Claessens and Alan Villegas, the authors unveil FRAME (Financial Regulation Assessment: Meta Exercise), an online interactive repository of regulatory impact estimates maintained at the BIS. Its purpose is to keep track of, organise, standardise and disseminate the latest findings. FRAME currently covers 83 studies and 139 quantitative impact estimates from 15 countries and regions. It classifies each of these along 18 dimensions, ranging from the specific countries analysed and the size of the banks studied to the specific sample period. The repository is structured according to selected bank balance sheet measures and their effects on more than 10 variables. The ratios currently being considered relate to those Basel Committee on Banking Supervision capital and liquidity standards which are balance sheet-based.

A comparison of the effects of the various regulatory ratios in normal and crisis times suggests that the Net Stable Funding Ratio has a much stronger countercyclical effect on bank lending than bank capital or liquidity. The authors document significant heterogeneity across quantitative impact estimates, notably regarding the effects of capital (regulation) on loan growth. On average, the effect is found to be positive, but there are large differences, in part due to whether the underlying study incorporates general equilibrium (second-round) effects.

In "The zero lower bound, forward guidance and how markets respond to news", Richhild Moessner and Phurichai Rungcharoenkitkul examine the ways both forward guidance and a binding zero lower bound (ZLB) can influence how markets incorporate economic news into asset prices.

While the ZLB was binding, variations in the probability of hitting the ZLB can account for the decline in the sensitivity to news of short-maturity interest rates. Markets did not react as strongly to new data because rates could not fall further and were seen as likely to stay very low for some time. The role of forward guidance in this period remains difficult to assess. After policy normalisation started in the United States, significantly reducing the ZLB's probability, the response to news of short-maturity yields and some risky asset prices remained attenuated. This suggests that forward guidance had some effect during this phase - markets remained relatively insensitive to news, because the Federal Reserve's communication narrowed the possible range of future rates.

Two special features take the reader through the changing shape of the financial system.

In "Emerging markets' reliance on foreign bank credit", Bryan Hardy shows that emerging market borrowers' reliance on foreign bank credit has been decreasing since the GFC. The decline stems in part from stagnation in foreign bank credit and expansion of credit from domestic banks and non-bank creditors. Emerging market borrowers obtain 15-20% of their credit from foreign banks on average, as of the second quarter of 2018, with over half of that in the form of local currency lending from subsidiaries. Such subsidiaries are, to all intents and purposes, local banks, and give rise to fewer concerns in terms of financial stability. Nevertheless, concentration among foreign creditor banking systems is high and rising in EMEs. Part of the story is the withdrawal of some large European banks from EME activities, thanks to deleveraging and the euro sovereign crisis. But there are substantial differences across emerging market economies and sectors in terms of both foreign bank reliance and concentration of foreign creditor banking systems.

The pattern of financial intermediation has also been shaped by policies introduced after the GFC. In "Following the imprint of the ECB's asset purchase programme on global bond and deposit flows", Stefan Avdjiev, Mary Everett and I draw on several data sources to track the imprint left by the ECB's unconventional monetary policy on the international banking system and global bond markets. We find that non-bank financial institutions (NBFIs) located outside the euro area were active as sellers of euro area bonds during the ECB's expanded asset purchase programme (APP). And we find evidence suggesting that, perhaps surprisingly, non-euro area NBFIs retained a substantial fraction of their bond sale proceeds as euro-denominated deposits in banks outside the euro area. Banks located in the United Kingdom and their euro area affiliates were the main facilitators of the APP bond sales by non-euro area investors, demonstrating the key role of the United Kingdom as the gateway to the euro area financial system for investors outside the euro area.

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