Transcript of a Press Conference on the Analytic Chapters of the Global Financial Stability Report

October 2, 2013

October 2, 2013

Jan Brockmeijer, Deputy Director, Monetary and Capital Markets Department
Laura Kodres, Assistant Director, Monetary and Capital Markets Department
Erik Oppers, Lead Author of Chapter 2, "Assessing Policies to Revive Credit Markets," Monetary and Capital Markets Department
Brenda Gonzalez-Hermosillo, Lead Author of Chapter 3, "Changes in Bank Funding Patterns and Financial Stability Risks," Monetary and Capital Markets Department
Olga Stankova, Moderator, Communications Department
Webcast of the press conference Webcast

MS. STANKOVA: Good morning, everybody and welcome to the press conference on the release of the Analytical Chapters of the Global Financial Stability Report, prepared by the Monetary and Capital Markets Department of the IMF. Let me introduce the speakers at today’s press conference. To my far right is Jan Brockmeijer, Deputy Director of the Monetary and Capital Markets Department. To my immediate right is Laura Kodres, who oversees the work on Analytical Chapters of the GFSR in the Department. And to Laura’s right is Erik Oppers, the lead author of Chapter 2. And to his right is Brenda Gonzalez-Hermosillo, the lead author of Chapter 3.

Jan and Laura will make introductory remarks and then we’ll take your questions. I’d like to remind you also that this is a release of the Analytical Chapters of the Report that will also include as always the main chapter that will be released next week on Wednesday, October 9 and certainly some issues will be addressed in the context of that release. With that I will pass the floor over to Jan for his remarks.

MR. BROCKMEIJER: Thank you Olga and good morning. As usual, we provide a separate press briefing on the Analytical Chapters of the GFSR ahead of our annual meetings. These chapters distinguish themselves because they are meant to take a step back and provide a slightly longer term view of global financial stability risks, often examining how reform efforts and other policies interact with the more structural elements of financial systems. And indeed, under the present circumstances as we slowly inch our way out of the financial crisis and get economic growth back on track, it’s important to see whether the plethora of policies that are being applied are as effective as can be, and if not, whether some mid-course adjustments might be called for. This time around, the two chapters focus on two crucial types of policies: those aimed at reinvigorating credit growth and those that affect bank funding structures, both of which may have long term implications for financial stability. In Chapter 2 we take a close look at the policies in place to restart credit markets. To do this we tried to get under the surface and identify the factors influencing the constraints on bank credit growth. Understanding these underlying causes that constrain credit demand and supply is essential to effectively target policies. This is not only an important but also a very complicated task. The chapter explores techniques on how to tackle this challenge and applies them to a few countries. Beyond the actual results that the analysis provides the main contribution of the chapter is to provide a framework for thinking about the issues that can be used and a framework that can be used by country authorities to further development of the analysis in this field. And this is important because such further analysis will allow them to better target their policies.

And the other chapter, in Chapter 3, we examine how bank funding structures are changing and whether the set of regulatory reforms affecting them are making banks, or more generally the financial system, more stable. This is not so obvious even though all the policies are individually aimed at making banks safer and their funding structures more resilient, collectively the policies could work at cross purposes. The chapter points to the tension that might arise between the tendency towards more secured funding on the one hand and the introduction of bail-in as part of resolution schemes on the other. The less unsecured debt outstanding, the higher the chance that it will be bailed in, the more likely it is that the cost of unsecured lending will rise. While not manifest at the moment, policymakers should pay attention to such potential interactions. And the chapter importantly points out that strengthening capital positions reduces the risk of such adverse outcomes considerably.

Before I now pass on the microphone to Laura Kodres to present the work on the chapters that she has led I’d like to just note that this will be the last time that she actually does so in this context. Laura is moving on to our Institute for Capacity Development and this is pretty much an end of an era in which she has contributed very much to the strong reputation of the analytical chapters. We’ll, of course, be hearing more from her as she continues to work on financial stability in her new position. We have an excellent successor in our midst in the person of Gaston Gelos but for now I would like to introduce with particular pleasure Laura Kodres to introduce the work this time around. Thank you.

MS. KODRES: Thank you, Jan, for those kind words and thank you all for attending. Before I open up to questions, I’d like to spend just a few minutes with an overview of the two analytical chapters and starting with chapter 2. Many of our member countries are puzzled by the slow economic recovery and the very weak credit growth that they are experiencing. They want to know how to restart their dormant credit markets and why what they have done so far has not lead to the hoped for results. There are of course, many possible reasons for this, and instead of giving a country by country run down of all the potential issues, we try to provide a framework for going about a thorough analysis and point to what policies would fallout in such analysis.

Before getting into the framework we put forth, it’s worth recognizing that in general, policies should only be employed if they addressed a problem that the private sector cannot address on their own. That is, generally, governments should attempt to do no harm, and see if there is anything that constrains credit beyond the private sector’s control, so-called market failures or externalities. We identify the typical ones that economists worry about, but also note that this downturn has been especially deep, with various elements that have amplified the response of credit. This is leading us, and others, to rethink the role of government policies both now, when credit growth is weak, but also during upswings.

The chapter takes a stepwise approach to the moribund growth in credit. First, it uses lending surveys to disentangle the constraints to credit that it might be due to firms or households’ reluctance to borrow, the demand side, or due to banks unwillingness to lend on the supply side. After narrowing down this distinction, the chapter attempts a much harder step, identifying the specific factors that may play a role on either side of the market. For instance, firms and households may have built up excessive debt and may need to de-leverage before taking on more loans, By contrast, banks may be undercapitalized, or have too many non-performing loans and may need to rebuild capital before lending more. The second step is very difficult, since often such factors like economic growth influence both sides of the market. But if policy makers can accurately identify the factors, then policies can better target the underlying cause of the weakness.

The chapter then applies its framework to several countries where credit growth is low or negative and sufficient data is available. The analysis finds that the constraints vary across countries, across time, and across types of credit. For instance, demand factors had a negative affect on corporate credit growth late in 2009 in France, Italy and Spain, and many countries have seen a deterioration in demand conditions in the most recent period.

In the United States, corporate credit was constrained early in the crisis by a substantial tightening of lending standards in banks, but these constraints have since dissipated. Supply constraints have more recently surfaced in some Euro area countries including France and Italy. In some cases, both factors have been identified as holding back credit. In these cases, sometimes we can use the analysis to see whether the quantity or price of credit is likely to expand more if a certain factor is addressed. For instance, it may be that supplying banks with more liquidity lowers lending rates, but does not affect the quantity of credit much.

The chapter is careful to caution policy makers that doing too much to help credit rebound now may come back as a costly mistake later. For instance, in an effort to expand lending to small and medium sized enterprises, by lowering the amount of capital that banks need to hold against these loans, lending standards may deteriorate, and at some point in the future, a crop of bad loans may show up on banks balance sheets with attendant risks to financial stability. To the extent risk taking by banks is encouraged through these various policies, it will be important to consider this as a medium term cost of the policies and weigh it against the near term benefits of boosting credit.

Moving to chapter three of the Global Stability Financial Report, here we take a deeper look at how banks are funding their assets and what that might mean for financial stability. It was clear that the crisis was in part, exacerbated by some advanced economy banks’ over reliance on short term wholesale funding. The chapter’s empirical results support that observation and point to the useful role that equity capital and deposits play to reduce a bank’s vulnerability to distress. Higher amounts of equity capital and more deposits in the funding structure are features in many emerging market economies and one reason that they have suffered less during the crisis.

The chapter documents that most country banking systems are altering their funding structures to include longer term debt, mostly debt secured by assets on the balance sheet and more equity capital, factors that are positively related to financial stability. In some countries, mainly in the Euro area, where some banks are still distressed and having difficulty raising new funds, they are relying relatively more on secured debt, much of it by writing covered bonds using their existing assets on their balance sheet, which can serve as collateral at the European Central Bank.

The chapter goes on to discuss how several regulatory reforms will affect bank funding structures and notes, that while they are all meant to make banking systems stronger, they may work at counter purposes to one another. Here we note that the increased encumbrance of assets from secured debt issuance, and the discussion about depositor preference, where some depositors will stand in line ahead of other unsecured debt holders in case of a bank liquidation, may reduce the bank’s assets that would otherwise be left for the unsecured creditors. This is relevant because there has been a movement by some countries to avoid taxpayer funds to support banks in distress, that is, to avoid government bailouts. To accomplish this laudable goal, there should be more unsecured debt available to be bailed in before a government is to step into the void. That is, after shareholders lose their potential returns, some debt holders should also bear the burden of a bank’s difficulties, after all, they did not purchase risk free debt.

If the new regulations (including the Basel III to liquidity risk reforms and the ones to OTC derivatives that will also require assets to be held to cover liquidity and counterparty risks) mean that there is less room for unsecured debt within a bank’s funding structure, then it is likely that this form of debt becomes more expensive for banks to issue. Whether this raises the total funding costs of a bank is hard to determine, since there are many types of liabilities, each with their own costs and amounts. We attempt to gauge the impact on the unsecured debt using a numerical exercise with options pricing formulas and we find that under current conditions, the cost increase is probably small. It is likely that the largest impact would be for too-big-to-fail banks that have benefited from their status by being able to issue unsecured debt at lower costs relative to their competitor banks. This would, of course, be a welcome effect. The exercise also demonstrates that if banks raise capital, all costs of debt decline, which is why the quantity and quality of capital is so important for the regulatory agenda.

Having pointed out the tensions among the regulatory reforms, it is important to re-iterate that each of these policies individually are moving in the right direction to lessen financial stability risks and make bank funding structures more stable, more diversified, and more resilient. They can still accomplish these goals if policymakers carefully implement the reforms so as to assure that if these do tradeoffs arise they are taken into account. We recommend that policymakers monitor the increased demand for collateral, including from the new Basel III liquidity standards and OTC derivatives reforms, to ensure that there are enough unencumbered assets to meaningfully attract unsecured creditors. We suggest, going forward, if encumbrance looks to be too high, that limits on encumbrance be considered.

Alternatively, policymakers can request that a minimum amount of unsecured debt relative to assets be maintained to make sure that it will be enough to absorb losses and protect against future use of taxpayer funds. These discussions are already underway and a number of countries are collecting information about the degree of encumbrance and some have set limits. A minimum amount of unsecured debt available for bail in is also under discussion in countries where resolution reforms are being implemented. Such new rules will, of course, need to take account of very specific situations in countries and their banks’ activities and be introduced during times in which banks are mostly free of funding difficulties and a smooth path for the funding structure can be ensured.

Overall, then, the chapter points out that, for the most part, bank funding structures are improving and the reforms to address bank soundness and financial stability are moving in the correct direction. As usual, the details matter and the interactions among the reforms will need to be anticipated and accommodated to get the end point -- a safer and more stable financial system. With that, I open it up to questions.

MS. STANKOVA: Thank you very much Jan and Laura. We will take now questions from the audience and online. Please introduce yourself and your affiliation.

SPEAKER: I have three questions. The first is about the fiduciary (inaudible) plan and many people have the speculation that the U.S. Federal Reserve (inaudible) but the Fed didn’t do it, so do you think it’s the Federal Reserve’s communication problem, or it’s the market participant’s mission problem? And do you think these miscommunications could become a risk for the global financial stability -- because we have seen the emerging market, financial markets, have targeted this in the last three months. And the second question is about the U.S. Federal government shut down. Do you worry that if the U.S. Congress completes an agreement to raise the public debt ceiling on October the 17th, what is the impact on the financial markets? And the third question is for the two big to fail problem. It has been five years since the 2008 financial crisis. Can we say that we have solved the problem of too big to fail? If not, what more can we do? Thank you.

MR. BROCKMEIJER: Let me just remind you that next week we will have the press conference on chapter 1 of the GFSR and that chapter will deal with many of the conjunctural issues that you have raised in your question. For instance, the recent developments in financial markets and the impact we have seen on emerging market economies. So we will refer the answer to those types of questions to the press conference that will take place next week. What we can discuss I think, is the impact on the cost of credit that might result from certain events, as you mentioned. For instance, the discussion now about the shut down of the U.S. Government is in the press, and perhaps Laura can explore more of that question somewhat.

MS. KODRES: Thank you. I think one thing to stress is that the shut down so far has been fairly benign. The effects on markets have been relatively low. It’s very unpredictable to determine what will happen next, and so I won’t speculate on that. Let me just note that in terms of our credit market chapter that any time that we have an increase in uncertainty, that can have an effect on demand, and potentially the supply of credit. And so, to the extent that this is an event of uncertainty, which can happen due to government actions in various countries, we should see some decline in demand as households and corporations face a more uncertain future and then are unsure whether they would like to demand loans or not. Also, on the bank side too, they would also find the uncertainty potentially unsettling and then they too could have difficulty supplying loans at the same time. So to the extent that uncertainty is raised, that is a factor which might constrict credit.

In terms of your concerns about the too big to fail issue, I think you are correct in suggesting that we have not completely nailed that problem yet, but I think our chapter on funding structures points to an area that has been an attempt to address this issue, and that’s through the resolution process. So the notion that there would be bail in-able debt in the capital structure, and that resolution regimes would now require this as part of a resolution will most likely hit those types of institutions harder than other banking institutions. And to the extent that their implicit government subsidy, in terms of a lower funding cost, is eliminated or at least mitigated to some degree, we should see that those banks are now on more equal footing with their competitors. And therefore that problem will at least dissipate to some degree.

MS. STANKOVA: Thank you Laura. We have a question online. There are some banks and systems that are healthy and without financial problems as the Mexican one, but they don’t have a bigger credit offer. How would you explain it?

MS. KODRES: Not exactly sure what we mean by bigger credit offer -- bigger credit supply. So in the case of Mexico, and emerging market economies, I think it would be important to point to the factors that we have cited that underlie the supply and demand equations and take a careful look to see if there are any constraints in those underlying factors. One of the factors we identify is in terms of households and corporates, is their own indebtedness, so taking a close look at the indebtedness of corporations or households, that would be important. Another factor would be whether or not banks are well capitalized and whether or not they can offer loans, I don’t think that’s a particular issue in the case of Mexican banks, but there are a number of these underpinning issues having to do with the supply and demand that we identify in the chapter, and that each country should take a very careful look to see if there are any constraints that they can identify having to do with those, and in that way, the policies can be very well structured to exactly the type of constraint that that particular country faces. And so that’s the main message of our chapter. We did not go through country by country examples, but that’s the main framework which we’d like authorities to use in order to get to appropriate and effective policies.

MS. STANKOVA: Do you have more questions? We don’t have more questions and will conclude the press conference. Let me remind you that the release of main chapter, chapter 1 of the Global Financial Stability Report will take place next week on Wednesday, October 9th. You are very welcome to attend the press conference as well. Thank you.


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