Tuesday, June 18, 2019

Risks and vulnerabilities in a post financial crisis world

Concerns continue to be raised about the robustness of the global financial system

Risks and vulnerabilities in the global financial system have been key topics of interest in the aftermath of the 2008 financial crisis, and there have been a number of developments over the last couple of months.

The Financial Stability Board (FSB) is an international body that monitors and makes recommendations about the global financial system, co-ordinating national financial authorities and international stands-setting bodies. FSB chair Randal K Quarles met with G20 finance ministers and central bank governors in April to update them on the FSB’s work and discuss current vulnerabilities in the financial system.

In June, the FSB published a report entitled Decentralised Financial Technologies, looking at the financial stability, regulatory and governance implications of the use of decentralised financial technologies such as those involving distributed ledgers (eg blockchain) and online peer-to-peer platforms.

Meanwhile, UK Bank of England governor Mark Carney highlighted the risk to the wider financial system from open-ended investment funds (often structured as companies and hence known as OEICs). Many of these funds hold a relatively high proportion in illiquid assets, which can create a liquidity problem if investors want to withdraw their funds faster than the fund can sell the underlying assets.

His remarks come as trading was suspended in Woodford Equity Income, one such fund run by UK star investment manager Neil Woodford, which succumbed to precisely this problem. The Woodford fund only held around 10% in unlisted, privately held businesses (the maximum permitted under EU rules), but even that was too high to avoid a suspension.

Carney commented that over half of investment funds have a structural mismatch between the liquidity of the underlying assets and the frequency with which they offer investors redemptions. Such funds are an increasingly popular way to invest, and so the risk the liquidity mismatch poses to the financial system has also grown in recent years, somewhat under the radar until now.

Around the same time, the International Monetary Fund (IMF) raised concerns that weak spots in the global financial system could have the effect of amplifying a financial shock. Its regular blog identified a number of vulnerabilities:

  • Record levels of corporate debt compared to GDP in the USA
  • Levels of government bonds held by European banks.
  • Declining bank profitability and low capitalisation levels in Chinese banks.

The blog highlights the dilemma faced by governments and central banks, in that whilst acting now may manage the risks in the short term, if such vulnerabilities continue to grow the likelihood of a sharper downturn in the future will be higher.

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