Creating Global Financial Stability

By M. Isi Eromosele

Recent important policy steps have brought some much-needed relief to Euro area financial markets. Sovereign spreads have declined, bank funding markets have partly reopened and equity prices have recovered.

Nevertheless, pressures on European banks remain, including from sovereign risks, weak Euro area growth, high rollover requirements and the need to strengthen capital cushions to regain investor trust. Together, these pressures have induced a broader drive to reduce balance sheet size.

Large EU-based banks could shrink their combined balance sheet by as much as $2.6 trillion through end of 2013, or almost 7 percent of total assets. Although subject to considerable uncertainty, about one-fourth of this deleveraging could occur through a reduction in lending, with the remainder coming largely from sales of securities and non-core assets.

Under the baseline, the impact on Euro area credit supply is estimated at about 1.7 percent of present credit outstanding. Some balance sheet reduction by individual banks is necessary because high leverage is no longer supported by either markets or regulators and some activities are no longer viable.

But the potential consequences of a synchronized and large-scale deleveraging warrant supervisory efforts to avoid serious damage to asset prices, credit supply and economic activity in Europe and beyond.

Against this backdrop, European policymakers need to build on recent improvements to implement the agreed reforms swiftly. Avoiding fresh setbacks will be critical, especially on the difficult path ahead, which is fraught with political and implementation risk.

The recent decision to combine the European Stability Mechanism with the European Financial Stability Facility is welcome and, along with other recent European efforts, will strengthen the European crisis mechanism and support the IMF’s efforts to bolster the global firewall.

But to achieve lasting stability and move to a path that inspires confidence, these crisis management policies need to be anchored with a road map of further financial and fiscal integration of the Economic and Monetary Union.

Most emerging markets have policy room to buffer moderate deleveraging forces emanating from the European Union, but their resilience could be tested in a downside scenario, notably in emerging Europe.

Elsewhere, the United States and Japan have yet to forge a political consensus for medium-term deficit reduction, perpetuating latent risks to financial stability. Meanwhile, the global financial regulatory framework is being strengthened, but key agreements still need to be concluded, while the transition to this new setting could add to cyclical challenges facing financial institutions.

The financial crisis and concerns about sovereign debt sustainability in some countries have reminded investors that no asset can be viewed as truly risk free. Future pressure points may arise in the future due to various roles of safe assets and the effects of different regulatory, policy and market distortions.

The combination of heightened uncertainty, regulatory reforms, and crisis-related responses from Central Banks will drive up demand. On the supply side, the number of sovereigns whose debt is considered safe is declining, taking potentially $9 trillion in safe assets out of the market by 2016 (roughly 16 percent of the projected total).

These developments will put upward pricing pressures on the remaining assets considered safe. Regulations should be designed flexibly and should be gradually phased in, according to an internationally agreed schedule, to avoid a choppy or uneven path of adjustment to a new price for safe assets.

More attention to longevity risk is warranted now, given the potential size of these effects on already weakened public and private balance sheets and because the effective mitigation measures take years to bear fruit.

Governments need to acknowledge their exposure to longevity risk; put in place methods for better risk sharing between governments, private sector pension sponsors and individuals and promote the growth of markets for the transfer of longevity risk.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

Pages

Oseme Finance