The Strategist

OECD defines new financial risks

09/05/2018 - 12:11

Large central banks will need several years to normalize their monetary policies. Inevitably, it will lead to increased volatility in the financial markets, the Organisation for Economic Co-operation and Development (OECD) warned. OECD notes that low rates have already resulted in overestimation of the value of bonds and now the likely adjustments may negatively affect the stock market. Another significant financial risk is an extremely high level of off-balance-sheet debts in the banking system of China.

An incomplete decade of low interest rates has led to an excess of liquidity. However, such favorable conditions are unlikely to last for long as normalization of financial conditions and the growing level of debt burden may challenge the effectiveness of financial reforms undertaken after the 2008-09 crisis, according to the new OECD report financial risks.

The report’s authors indicate that low rates of central banks led to an overestimate of the bonds value (it is directly opposite the required yield on securities). Besides, the adjustment will also be fueled by an increase in issuance of US government securities following the growing budget deficit in the US, as well as a reduction in the Fed’s balance (recall, the regulator is selling securities after completing the quantitative easing program). The increase may also lead to a correction in the stock market, although the latter does not look too overpriced by historical standards taking into account growth of corporate profits amid tax reform in the United States, the OECD notes. The organization points out that the main risk may be a slowdown in the economy and a subsequent drop in business revenues. However, so far the recovery of the economy has been quite strong in the US only, and only American banking system is profitable enough to begin the monetary policy normalization. The total assets of central banks are still increasing mainly because of the continuation of the ECB's purchases (they have grown from $ 3.2 trillion to $ 15 trillion since 2007).

Among other risks, the OECD also calls incomplete implementation of reforms announced after the crisis of 2008-2009. New Basel directives are meant to tighten capital requirements for systemically important banks, but they still do not imply full separation of investment banking and deposit operations, say the experts. They note that size of the derivatives market in the second half of 2017 was only slightly below the pre-crisis level ($ 532 trillion vs. $ 586 trillion, while share of credit swaps that defaulted on the crisis fell from 10.5% to 1.8%). At the same time, investing with algorithms, as well as growing popularity of index funds, increase the volatility of trades." Risk of interdependence of financial institutions has decreased but is still present," experts conclude.

The global financial system will also depend on the ability of the Chinese authorities to deal with the risks of off-balance-sheet debts (the official assets of Chinese banks in 2017 rose to $ 39 trillion, or up to 310% of GDP against about 200% in 2007). Chinese state-owned banks sharply increased lending to prevent the economic downturn in 2009, but it was not so easy to further reduce the burden - interest rates, reserve requirements and other traditional instruments of regulators cannot affect off-balance loans.