Potential storms ahead in the banking sector
Panelists discuss the possible impact of corporate bankruptcies on European banks emerging from the pandemic and note that central banks are juggling digital currencies; unable to stop their arrival but must still organize progress and ensure that technology does not weaken financial stability. The session examined structural trends in the financial sector that have been fully amplified or altered by the COVID crisis.
The pandemic has triggered a re-indebtedness event among governments, businesses and households with significant implications for two-way risk, said Jeremy Lawson, chief economist, Aberdeen Standard Investments. Speaking at FIS Digital 2021, he said current debt levels are a gateway to higher inflation or a entrenched decline for a longer interest rate regime. He also described the current financial environment as volatile with thicker tails around inflation.
“It complicates our perception of the environment,” he said.
Lawson stressed the importance of monetary and fiscal coordination, stressing the importance of fiscal policy shifting from support to long-term stimulus. Outside the United States where major public investment projects are underway, he said he was skeptical about the possibility of this rotation. He added that it was not clear whether the political mistakes of the past would not be repeated.
Lawson told delegates to expect a structurally low inflation environment going forward, with European economies, Japan, Australia, Korea and China struggling to meet long-term inflation targets. term. He argued that current factors driving up inflation, such as bottlenecks in the supply of goods, will ease when demand moderates and supply catches up, but he noted the challenge for investors to disentangle cyclical and structural forces impacting inflation.
Stefan Dunatov, executive vice president of strategy and risk at British Columbia Investment Management Corporation, suggested that service sector inflation may be constrained by long-term trends in technology disrupting global services. In response, Lawson noted that while remote working in the service sector can drive down prices, the pandemic has also raised pay levels for low-skilled workers.
Another panelist, Professor Thorsten Beck, professor of banking and finance at Cass Business School and researcher at the Center for Economic Policy Research, pointed out the likelihood of discrepancies between different regions. He said he expects interest rates to stay low for longer in Europe, but sees inflation risk in the US and UK. However, he clarified that these two inflationary shocks could be transitory. Beck said today’s corporate debt overhang is linked to optimism about the vaccine and the recovery.
Beck pointed out the main risks associated with the ability of banks to overcome business failures. People are confident in the banking industry, he said, but warned of potential storms ahead. While some companies can manage their level of debt, others may need to restructure and others may not be able to do it at all.
Corporate insolvency laws vary across Europe with different levels of restructuring effectiveness. This means that corporate debt could end up on banks’ balance sheets. He said this combination of corporate and bank fragility could be limited to certain geographies and will depend on regulatory and policy response. There is a lot of room for mistakes, he said, but added that policymakers in Europe have a new level of coordination after the GFC, and said decisions will ultimately be made at the political level.
David Veal, director of investments for the City of Austin’s Employee Retirement System, asked panelists if they expect structural changes in the financial system and whether central banks will introduce new policy tools to navigate the new environment. He turned the conversation to cryptocurrency, where panelists responded that while central banks have opened the door to changes in payment systems, they are reluctant to cede control or decentralize finance due to concerns about financial stability. Central banks take a close look at digital assets and participate in their evolution to avoid disruption due to the emergence of private digital currencies.
Any transition from a heavily banked system or the signal of a shifting dynamic will see investors reassess how they value the banking industry. Any transition is a very complex exercise for central banks which cannot stop the arrival of new technologies, but must orchestrate their progress and ensure that they do not weaken financial stability.
Beck also noted how the growth in corporate financing by non-banks can make monetary policy less effective. Returning to previous points on bank fragility, he said it was important to create cross-border banks rather than silos. Regarding digital currencies, he said central banks were responding with a defensive regulatory response that allows fintechs to play a role in the payments system, but also protects traditional finance. Noting how China has gone further in limiting the size of large tech companies, he said the regulatory response (in the West) will be cautious and cautious: expect change but not revolution, he said. he concluded.