OECD Business and Finance Outlook 2018

OECD

• Publisher: OECD
• Year: 2018
• eBook ISBN: 9789264306127
• Topic: Social Sciences
• Subtopic: Sociology
• Index: Social Sciences

Chapter 1. The financial system outlook

Three major risks are set to shape the financial outlook:

1. Monetary policy normalisation: with the unwinding of ultra-low interest rates and the large-scale holdings of sovereign and private sector securities on central bank balance sheets, the transition may be volatile.

2. Financial sector vulnerabilities and the extent to which the recent finalisation of G20 reforms, including Basel III, has achieved the goal of a safe and sound financial system in the face of future stresses.

3. High indebtedness and leverage, especially related to China’s bank, shadow bank and wealth management businesses, and how well the Chinese authorities will be able to manage related risk.

All these risks have the potential to disrupt sustainable growth in the global economy. This chapter examines these three topics, concluding that financial system risk will be elevated in the period ahead.

The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

1.1. Introduction

Since the global financial crisis of 2008, monetary policy has been focused on supporting both the financial system (in the early stages) and real economic activity in line with price stability objectives (in the later stages) with ultra-low interest rates and massive buying of debt securities by central banks, mainly in jurisdictions where global systemically important banks (G-SIBs) are located. Fawley and Neely (2013) states: “Initially, the Fed, BOE, BOJ, and ECB policies focused on restoring function to dysfunctional financial markets, but concern soon shifted to stimulating real growth and preventing undesirable disinflation”.1

Over two years ago, the US Federal Reserve (Fed) decided to begin the reversal of its accommodative policy stance via interest rates, given that the economy is operating closer to its capacity, which is when inflation pressures are more likely to arise. More recently, it has announced the reversal of quantitative easing. Inflation pressure has not yet emerged in the euro area and Japan, though the OECD Economic Outlook foresees a moderate pick up in the euro area over the next two years. While there have been signs of more inflation pressure in the United Kingdom, it has not yet begun the reversal of quantitative easing, since this is likely due to past depreciation of sterling.

The timing and scaling of reversals can also be linked to the recovery of the safety and soundness of the institutions that were at the centre of the crisis, and to any changes in the structure of markets that may warrant higher longer-term holdings on central bank balance sheets as a share of GDP compared to that which prevailed prior to the crisis. Banks in the United States have already reached that point which, coinciding with the sound shape of the economy, has supported the case for the Fed to announce a schedule for the gradual unwinding of large holdings of central bank assets. This shift to normalisation has already led to extreme movements in asset prices in the early part of 2018. This may be a foretaste of things to come, underlining the delicate balancing act required of central banks.

The beginning of monetary policy tightening in the United States in the fourth quarter of 2015 preceded the finalisation of the Basel III rules at the beginning of December 2017. The period of monetary support for the banking system would have been a good opportunity to fundamentally change the business models and governance of banks (to not mix commercial banking and investment banking, recommended by the OECD since the crisis). This opportunity was used only partially: capital requirements were raised but G-SIBs’ business models remained more or less the same as they were before the crisis. These banks have strongly defended their business models (limiting separation policies which lie outside the scope of the Basel process) but G20 reforms, including to over-the-counter (OTC) derivatives markets and liquidity requirements, offer mitigants to high degrees of interconnectedness.

The notional value of OTC derivatives, an indicator of the interdependence of G-SIBs,2 stood at USD 532 trillion in the second half of 2017, compared to USD 586 trillion in the second half of 2007, just prior to the crisis. This has fallen as a share of the recovered global economy over that period (by roughly one third). Credit default swaps– the most significant derivative type for interconnectedness – has fallen as a share of the total OTC derivatives market from 10.5% at its 2007 peak to 1.8% at end of 2017. In terms of OTC derivative counterparties, reporting dealers make up 15%, other financial institutions 80%, and non-financial customers 5%.

Clearing and margin rule improvements under Dodd-Frank and European Market Infrastructure Regulation (EMIR) have helped to reduce systemic risk for broker dealers, either by netting through Central Counterparty (CCP) clearers, or through margin requirements for un-cleared derivatives. CCPs cleared 60% of OTC derivatives by the end of 2017.

CCPs represent larger ‘nodes’ of interconnectedness, but initial design and subsequent implementation of work to strengthen CCP recovery and resolvability have helped address concerns on whether CCPs are sufficiently re...

Table of contents

• Title page
• Legal and rights
• Foreword
• Acronyms and abbreviations
• Editorial
• Executive summary
• Chapter 1. The financial system outlook
• Chapter 2. The Belt and Road Initiative in the global trade, investment and finance landscape
• Chapter 3. Reaping the full benefits of large infrastructure projects
• About the OECD