Mains Paper: 1 | Economic development
Prelims level: Global financial crisis
Mains level: Explain the resurgence of global risk.
• The global financial crisis (GFC) led to a major strengthening of international financial regulations.
• Supervisors in the advanced economies had become too laissez-faire about financial innovation.
• Lax credit-rating agencies were complicit. Basel II naïvely accepted risk weights from banks’ own internal models and stress test results provided by the industry.
• It allowed very light capital requirements both for securitized products held on bank balance sheets and for credit commitments given to off-balance sheet vehicles holding such products.
• Regulators in India were tougher: if the Reserve Bank of India (RBI) found the benefits of an innovation were not convincing enough, it would be subject to restrictions.
Important highlights of GFC
• The GFC gave central banks new macroprudential policy instruments that could be adjusted as changes in macroeconomic or financial market conditions warranted.
• Financial risk is not black and white. It is rather various shades of grey that depend a lot on macroeconomic conditions.
• Adventurous risk-taking when the economy is depressed is less dangerous than when the economy is close to full employment and asset prices are booming.
• By mid-2005, worries about the financial risks of the house price bubble in the US and about the dubious mortgage-based financial products dominated central bank meetings.
• Yet, little thought was given in advanced economies to raising the risk weights on such assets or to developing suitable macroprudential policies.
• Also the RBI did impose macroprudential restrictions which made the banking system more resilient.
• As a result of stronger financial regulation and macroprudential policies, the financial system in most advanced economies is now safer.
• In addition, very expansionary monetary policies have succeeded in countering persistent deflationary forces.
Basel III limitations
• Basel III is the lack of a global Pillar 1 capital charge on interest rate risk on bonds held in the banking book.
• The Basel Committee has struggled with this since the 1990s. No capital charge was incorporated in Basel II although the committee was convinced that this is a significant risk which “merits capital”. In Basel III,
• The sharp divergence in the views of national supervisors once again prevented agreement on a capital charge.
Market risk factor
• To generate adequate returns as they reduce credit-risk exposures, banks and financial firms have tended to increase the duration of their government bond portfolios.
• Such regulation-induced substitution of interest rate risk for credit risk on their financial assets can lead to destabilizing market dynamics.
• There is evidence that institutional investors have recently increased in a pro-cyclical way the duration of their assets in response to a fall in long-term rates.
• Accounting conventions have not adapted well to a situation of the benchmark long-term interest being depressed by monetary and regulatory policy.
• International Accounting Standard 19 requires the calculation of the present value of defined-benefit pension liabilities, typically using a discount factor linked to a bond yield.
• The increase in the present discounted value of liabilities as bond yields fall encourages firms to increase the maturity of their assets.
• If pension funds all react by buying more longer-dated bonds, they could collectively magnify the initial interest rate shock.
• Given the rise in public debt since the GFC, governments need cheap finance.
• Through new rules, governments have in effect induced regulated lenders to limit credit risk from lending to the private sector but have acquiesced in their increased interest rate risk exposure from larger holdings of longer-maturity government bonds.
Macroeconomic development effect
• Macroeconomic developments in the advanced economies are also likely to push long-term rates higher.
• Growth forecasts in the US and a number of advanced economies are strong.
• With unemployment falling and financial markets buoyant, inflation may begin to surprise on the upside.
• The added stimulus from tax cuts could require higher short-term rates to counter overheating.
• Macroprudential policies need to address new interest rate risks more effectively.
• The reforms since the GFC have made the financial system stronger.
• But guard against the financial stability risks of a sharp rise in long-term rates.
• Policy influences on demand which have pushed bond yields in core markets lower are now fading.
• Banks will not further increase their stock of government bonds once they have met their liquidity regulation requirements.
• The adjustment to new accounting rules will run its course.
• Bond purchases under quantitative easing programmes are ending.