Volatile markets from lack of confidence over growth-BIS

    The current volatility in financial markets may be linked to a lack of confidence among investors about the long-term sustainable growth rate in the wake of the global financial crises along with uncertainty over what may be a reasonable rate of return on safe assets and a sensible method for pricing assets and risk taking, according to the deputy general manager of the Bank for International Settlements (BIS).
    In the absence of such anchors for financial markets, the differences between plausible narratives about the future is simply too big to form a definite view and investors are thus held hostage to even the smallest rumors, leading to the current bout of volatility in asset prices.
    In a speech at the Professor Lamfalussy Commemorative Conference in Budapest, Luis Awazu Pereira da Silva of the BIS questioned how investors' faith in the future could be re-anchored now that a 21st century version of the Great Depression has been avoided but yet the world economy appears to be stuck in a "new mediocre" of low growth amidst a gloomy and volatile environment.
    "As we are beginning to see, one answer could be to signal a roadmap towards a gradual normalization of monetary and financial conditions," da Silva said, a reference to the U.S. Federal Reserve's move in December to raise rates above the near-zero level held for the last seven years.
    But normalizing monetary policy is far from enough and has to be accompanied by reforms in the real economy that address disagreements in society over how to allocate resources now and among future generations in a move to establish new social contracts.
    The global financial crises has given economists and policymakers new insights into financial cycles, systemic risk and financial exuberance, and how vulnerabilities can build-up through debt flows in international currencies.
    But the global economic recovery remains weaker than expected given the massive stimuli used, and still being used, and the current state of financial markets may tempt policymakers to increase stimulus and expand asset purchase programs, da Silva said.
    "But are we going to continue recreating large financial cycles, just another boom with an over-priced asset of some sort?," he asked.
    Instead, policymakers should focus on fostering more sustainable growth through productivity, with technology components of a new business cycle already apparent in daily life, such as faster communications, new internet-based services, new exchange rules and new technologies for lower carbon-based growth.
    It is clearly not the role of central banks to foster such structural changes in society, but "neither should be their role to sustain credit boom-and-bust cycles that always end badly even if now we know much better how to manage them," da Silva said.
    Economists and central banks may be able to help encourage such reforms by re-anchoring financial markets' view of the future through narratives that help reduce uncertainty by supporting more pro-active policies towards growth and structural reform.
    That said, financial markets require more than just a vision, da Silva said, adding that tangible action is needed. Some of this is happening with the U.S. monetary policy normalization and in other countries where growth models are being redefined along with social contracts.
    "At the end, confidence will return in a durable way only when agents perceive that we have passed the "bottom" of the GFC" (global financial crises) and investors start to feel that the upside in asset prices is more than just the result of ad hoc temporary exceptional stimuli for exceptional times.

    To read da Silva's speech, click here.

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BIS spotlights home prices as early warning indicator

   House prices in Australia, Belgium and France have declined recently while the rise in Canadian, Norwegian and Swedish home prices has moderated, according to data from the Bank for International Settlements (BIS) that can be used as an early warning indicator for financial instability.
    Encouraged by the Group of 20 finance ministers and central bank governors, BIS has expanded its collection of data on comparable monthly residential property prices to span 55 countries to help policymakers and economists identify whether house prices are sustainable or whether they are exceeding historical averages.
    "Leverage-fuelled housing booms that turn into busts have often been at the very heart of episodes of systemic stress," BIS wrote in its latest quarterly review that includes an article on how the residential price data are collected and can be used.
   "Historical experience has demonstrated that the interactions between rapidly growing house prices and excessive credit expansion are a tell-tale sign of the build-up of vulnerabilities in the household sector and the source of future losses for banks," adds BIS in a reference to earlier work partly by Claudio Borio, the head of its monetary and economic department.

Fed determines global financial cycle - Jackson Hole paper

    (Following is the fourth and final report based on papers presented at the 2013 Jackson Hole Economic Policy Symposium, hosted by the Federal Reserve Bank of Kansas City. The reports have been published as soon as the authors presented their papers to the symposium.)

    A global financial cycle, mainly determined by U.S. monetary policy, constrains national monetary policies when capital is freely mobile regardless of the exchange rate regime, according to a paper presented at the Jackson Hole symposium by Helene Rey of the London Business School.
    In her paper, “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence,” Rey shows how global capital flows, asset prices, credit growth and financial leverage tend to move in sync with the VIX, the ticker symbol for the Chicago-traded index that measures uncertainty and risk aversion in financial markets.
   The VIX thus becomes a proxy for a global financial cycle that is independent of countries’ specific economic conditions. The symptoms of the cycle can be benign or large asset price bubbles and excess credit growth, one of the best predictors of financial crises.
    “Low value of the VIX, in particular for long periods of time, are associated with a build up of the global financial cycle: more capital inflows and outflows, more credit creation, more leverage and higher asset price inflation,” Rey says, adding that asset markets with more credit inflows tend to be more sensitive to this global cycle.

Global supervisors aim to limit risks from shadow banking

    Shadow banking, the huge but unregulated frontier of the financial world, will soon be subject to bank-like supervision as global policymakers start to hammer out rules that reduce the chances of future crises yet still allow new creative financing models to emerge.
    The Financial Stability Board (FSB), which monitors and coordinates global financial regulation, has proposed an ambitious policy framework and recommendations that it believes are needed to “mitigate the potential systemic risks associated with shadow banking,” and expects to issue final proposals in September 2013 following industry comment.
    The term shadow banking describes the murky world of hedge funds, money market funds and investment vehicles that are often used by major banks to carry out sophisticated financial transactions.
    As these shadow legal entities do not take customer deposits, they don’t need banking licenses and are not subject to supervision.
    The 2008 global financial crises exposed the threat from shadow banking to financial stability, not just because of its vast size but because it was completely interwoven with the supervised banking system; a regulated banking system relied on unregulated entities with a razor-thin capital base.
    Global political leaders, meeting as the Group of 20, decided that the risks from shadow banking – about half the size of the normal banking system - posed too great a threat and asked the FSB to come up with policy recommendations.

UK banks should boost capital during EU crises - BOE

    UK banks should continue to limit dividends and executive compensation and instead use the funds to boost their capital cushion to absorb any possible losses during the current risk to financial stability from the crises in the euro area, the governor of the Bank of England said.

    In his prepared remarks for a press conference, Mervyn King said the cushion that banks should build up may even be larger than the current planned increase toward meeting the tougher Basel III capital requirements.

    “The Committee continues to believe that there is a need for banks temporarily to raise their levels of capital, in view of the exceptional threats they currently face,” King said presenting the bank’s Financial Stability Report.

Top OTC derivative markets set to meet deadline - FSB

    United States, Europe and Japan are on track to have all standardized over-the-counter (OTC) derivative contracts traded on exchanges and cleared through central counter parties by end-2012, meeting a deadline set by Group of 20 leaders, the Financial Stability Board said.
    The global financial crises revealed that OTC derivatives had contributed to a build-up of systemic risk, triggering fears of contagion due to the close ties between market participants and a lack of transparency of their relationships.

BOJ says will do utmost to ensure financial stability

    The Bank of Japan said there is a high degree of uncertainty surrounding the global economy, both in Europe, the United States and in emerging markets, but it would do its utmost to ensure stability in Japan's financial system.
     Speaking after the BoJ held interest rates unchanged at around 0 to 0.1 percent, the monetary board said in a statement:
    "There remains a high degree of uncertainty about the global economy, including the prospects for the European debt problem, the momentum toward recovery for the U.S. economy, and the likelihood of emerging and commodity-exporting economies simultaneously achieving price stability and economic growth."
      "The Bank will also do its utmost to ensure the stability of Japan's financial system, while giving particular attention to developments in global financial markets," the BoJ said.


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ECB says ready to provide liquidity if needed

    The European Central Bank will continue to provide funds to healthy banks during the current turmoil in the euro area, ECB President Mario Draghi said.
    "As you are all aware, the ECB has the crucial role of providing liquidity to sound bank counterparties in return for adequate collateral. This is what we have done throughout the crisis, faithful to our mandate of maintaining price stability over the medium term – and this is what we will continue to do. The Eurosystem will continue to supply liquidity to solvent banks where needed," Draghi said in a speech in Frankfurt.
    Draghi's remarks come ahead of this weekend's election in Greece that could decide whether the country remains in the 17-nation euro area, a decision that has financial markets on tenterhooks.
    Click here for Draghi's speech.


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Financial cycle peaks coincide with crises - BIS paper

    Peaks in financial cycles of 16 years and longer tend to coincide very closely with crises that cause serious economic damage and the virulence of these cycles has increased since the mid-1980s, according to a working paper by economists at the Bank for International Settlements.

    Prior to the global financial crises, economists typically focused on business cycles and believed that interest rates captured the interplay between the financial and real sides of an country's economy. But the crises showed the failure of this understanding and the paper by the BIS economists is part of a wholesale rethink of the discipline of macroeconomics.

    The paper concludes that financial crises, or systemic banking crises, are linked to a policy regime of liberalizing the financial sector in an environment of monetary policy that is focused on price stability -- a finding that has major policy implications.

    "And we note that the authorities should watch out for what we call the “unfinished recession” phenomenon. Policy responses that fail to take (medium-term) financial cycles into account can help contain recessions in the short run but at the expense of larger recessions down the road," the paper said.

    For details, see the BIS working paper: "Characterising the financial cycle: don’t lose sight of the medium term! "

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FSB:progress in making executive pay aligned with risk

    Countries with major financial institutions are making gradual progress toward ensuring that compensation for top executives reflects the real risks that the firms are taking on, the Financial Stability Board said in a progress report.