Alina Barnett, Sinem Hacioglu Hoke and Simon Lloyd
Since 2007, macroprudential policymakers have grappled with a broad set of vulnerabilities. While regulators cannot be sure what risks the next decade will feature, they can be sure that the set of issues will continuously evolve. In this post, we explore three timely challenges that financial stability policymakers are likely to face in the coming years, including risks associated with: non-bank financial intermediation, cryptoassets and decentralised finance (DeFi), and climate change. These challenges have been noted by many, and are already stimulating development of macroprudential frameworks. But while some of this development can build on well-grounded principles for financial stability policy, other aspects are likely to come up against three timeless challenges, requiring novel and innovative thinking to overcome.
Figure 1 summarises the most common issues considered by the Financial Policy Committee in the last decade.
Figure 1: Key words from the first decade of Bank of England ‘Financial Stability Reports‘
Three timely challenges for financial stability
1. ‘The place beyond the banks’: market-based finance and non-bank financial institutions
Market-based finance refers to the system of markets, non-bank financial institutions (including investment, hedge and pension funds) and infrastructure (eg payment providers) which, alongside banks, provide financial services to support the wider economy. Non-bank financial institutions have grown substantially since the global financial crisis and currently represent around 50% of global (and UK) financial-sector assets. Consequently, they are increasingly a source of finance for UK businesses.
The resilience of market-based finance is determined by the extent to which the overall system, rather than individual institutions, can absorb shocks and thus support the real economy. Non-bank financial institutions are highly interconnected, across markets and across countries, and their comparative infancy means that the availability of data to monitor risks emanating from them is currently limited.
These challenges were particularly apparent during the March 2020 ‘dash for cash’, when there was a rapid deterioration in the functioning of advanced-economies’ government bond markets. This created market dynamics significant enough to raise the cost of lending, and threatened to spill over to the wider economy and amplify the impact of the Covid shock. As international policymakers have since noted, the episode clearly demonstrated the need to build resilience in market-based finance.
Given the global nature of market-based finance, the effectiveness of UK policies will depend in part on those implemented in other major jurisdictions. Currently, there is a less comprehensive and less detailed body of international agreements and standards for market-based finance relative to the banking sector. Policymakers globally are therefore working together to take co‑ordinated action to address these issues – including on open-ended funds, margins, leverage/liquidity structure, and the resilience of core markets. In the meantime, policymakers need to continue monitoring them, starting by ensuring there is reliable data to do so.
2. ‘Rise of the machines’: the growth of cryptoassets and decentralised finance
Another important challenge is seen in cryptoassets and DeFi. Although not currently large enough to generate systemic risk by themselves, in recent years they have rapidly grown to represent around 1% of global financial assets and are becoming more connected to the traditional financial sector. If this pace of growth and increasing interconnectedness continues, risks emanating from these activities and institutions are likely to become increasingly relevant.
Cryptoasset technology is creating new financial assets, and new means of intermediation. Many services now facilitated by this technology mirror those available in the traditional financial sector, including lending, trading and exchange, investment management and insurance. This also has the potential to reshape activities currently taking place in the traditional financial sector. These changes could deliver significant benefits, for example by reducing the cost and increasing the speed of cross-border transactions and encouraging competition in the financial system.
However, those benefits can only be realised, and innovation can only be sustainable, if accompanied by effective public policy frameworks that mitigate risks and maintain broader trust and integrity in the financial system. In designing such frameworks, regulators must continue to adapt to tackle challenges, including resolving limited data availability to better monitor risks and identify systemic interconnections. Given that many cryptoasset activities span economic borders, international fora will likely be of particular importance for building resilience.
3. ‘The day after tomorrow’: climate change and the transition to net-zero carbon emissions
Climate change poses challenges for scientists and economists alike, creating risks for financial stability through two channels: physical and transition. Physical risks can damage property and infrastructure, disrupt business supply chains and food systems, and influence productivity and health. These can reduce asset values, result in lower corporate profitability, damage public finances, and increase the cost of settling insurers’ underwriting losses. Transition risks, arising through changes in climate policy, technology and shifting consumer preferences could prompt a reassessment of the value of a large range of carbon-intensive assets, in turn creating credit risks for lenders and market risks for insurers and investors.
But these risks may not yet be fully reflected in the market prices. Structural barriers such as the lack of climate disclosure, the lack of clear sector-level climate policies, firms not internalising the cost of emissions, and the short time horizon of some investors, can all contribute to market failures. A sharp shift towards a new equilibrium as a result of recognising the full extent of this market failure could create significant financial losses in a ‘climate Minsky moment’.
Maintaining financial stability in light of these risks demands timely and co-ordinated action from authorities, supported by private and public sector institutions. The financial system will play a key role in financing the significant structural economic changes needed to deliver the transition to a net-zero economy. The role of financial stability policy here is focused on tackling the consequences (not the causes) of climate change, and more work is needed to build the green-market infrastructure that will support an orderly transition to net zero.
‘Nothing new under the sun?’ Three timeless challenges for financial stability
These timely risks also represent manifestations of more timeless challenges for policymakers. While the past may not always be a perfect guide for the future, it is helpful to consider the lessons learned in order to build a macroprudential framework that is fit for the future: robust and adaptable in the face of evolving sources of risk.
1. Ensuring the toolkit is dynamic and defining optimality
The three timely risks all have an important feature in common: none are entirely covered by existing macroprudential policy instruments. While policymakers continue to monitor these risks, they currently have limited tools available to address the underlying vulnerabilities. So, it is important that policymakers ensure their toolkit is dynamic.
Policymakers should continue to identify a range of indicators to regularly monitor in order to assess underlying vulnerabilities and develop new tools and regulatory initiatives. However, to calibrate potential new tools, further work is needed to define the optimal level of resilience – akin to the cost-benefit analyses that contributed to the bank-capital framework.
2. Regulating an internationally interconnected system
Many of these timely vulnerabilities are as much global as they are domestic too. As a result, the risks arising in UK’s financial system can very well have their roots in activities of non-UK regulated financial market participants, which the policymakers can only monitor at best.
Therefore, the effectiveness of domestic actions depends in part on policies implemented in other major jurisdictions. Policymakers have already recognised the need for international co‑ordination in the face of new and emerging risks, but more work is needed at a global level to build safe and open policy frameworks.
3. Collating data in the face of new and emerging risks
To face up to these challenges, we also need timely and granular data to operate with precision. Such data can help to monitor vulnerabilities, and identify new ones that might not otherwise be apparent. It can also support the calibration of the costs and benefits of resilience, and in so doing help to pin down the ‘optimal’ degree of resilience. And improved international coverage can also help to identify common global issues, in order to encourage and facilitate greater cross-border co‑operation.
By increasing transparency around how financial market players operate, major regulations (eg EMIR and MiFID) and new data collection initiatives represent import steps towards filling data gaps. The data gathered from these initiatives can help to establish how different players in the system behave and if their interconnectedness to other players constitute particular financial stability risks. Beyond collecting more granular data, we also need to develop methods to build our understanding of it, which requires substantial effort from regulatory parties and financial market participants alike.
Conclusion
The risks emanating from non-banks, crypto and climate have posed, and will continue to pose, challenges for financial stability policymakers. Although there is no one-size-fits-all policy response, all these risks have features in common, which are not new for financial stability policymakers: they are likely to be best resolved with timely and granular data, international co-ordination, and a clear definition of the optimal level of resilience.
Alina Barnett and Sinem Hacioglu Hoke work in the Bank’s Financial Stability Strategy and Projects Division, Simon Lloyd works in the Bank’s Global Analysis Division and Macroprudential Strategy and Support Division.
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