How far has the financial system advanced since the crisis of 2008, and what potential sources of instability lay ahead?
This many-faceted question deserves a multi-layered and wide-ranging response. At the Tuesday morning Big Issue Debate on financial stability at Geneva’s Palexpo, the conversation touched on Brexit, blockchain, machine learning and financial inclusion and reflected on the consequences – intended or not – of post-crisis reform for banks, market infrastructures and their users. It soon became clear that the financial system might look very different in the future.
Moderator Merryn Somerset Webb, editor-in-chief of MoneyWeek and Financial Times columnist, set the tone for the debate by reminding delegates of the core service provided by the finance sector to the wider economy, i.e. to transfer money from those that have it and would like a return to those that want it and would like to deliver a return. “Everything in between is just back office work,” she said. The sector had lost sight of this core purpose prior to the financial crisis, asserted Somerset Webb, but had attempted to re-establish its focus since 2008, prompted in part by regulatory reform. “This has led to burdens that the sector could have carried quite well, without all the other challenges that have arrived over the last few years,” she said, referring to the increased pace of technology innovation and competition from FinTech firms.
Panellists acknowledged that impact of regulatory reform would continue to be felt by banks for some time. “There will be significant restructuring in the financial system,” said David Wright, partner at business advisory firm Flint Global and president of financial services think-tank Eurofi. “The banks are under a lot of pressure – return-on-equity is poor, capital requirements are going up, negative or low interest rates are shaving margins, and there is tremendous pressure coming from the so-called disruptors.”
Wright, who worked for 34 years at the European Commission, largely on finance sector policy, and subsequently served as secretary general of the International Organization of Securities Commissions, predicted that the number of banks in Europe will almost certainly shrink over the next 20 years; only the efficient, reputable, well-managed ones will survive and prosper.
Tightened capital and liquidity requirements, as well as new governance and behavioural standards, should help to protect the banking sector from future shocks, but there remains a fundamental lack of trust in the banks that drive global finance. Somerset Webb asked whether and when could banks regain that trust. Panellists said proof of systemic stability, governance and ethics would all contribute, but suggested the road would be long.
“The main problem today is the lack of confidence in the banking business and the weakness of commercial banks to attract capital for internal development,” said Sergey Shvetsov, first deputy governor at the Bank of Russia.
The lack of confidence is a reflection not only of the economic impact of the financial crisis, but also of the lack of ethics and governance within the banking sector that have been laid bare by successive market scandals, including Libor and FX.
Predicting the source and form of any future financial crisis is difficult, but while debate participants agreed that there has been significant de-risking since 2008, bubbles remain that will need to be closely monitored. As most crises in history have been associated with property markets and more recent crises derived from excessive leverage, Wright recommended watching both areas.
Nevertheless, Trevor Spanner, chief operating officer and group risk officer at Hong Kong Exchanges and Clearing, believed greater credit should be given to the progress that has been made in understanding and managing risk and financial infrastructure among both regulators and industry participants. While risk models previously discounted remote but highly damaging ‘black swan’ events, this was no longer the case.
“The concept of financial market infrastructure and systemic risk is now a board-room issue and there is a lot of credibility established from that. People have a much better understanding of what extreme but plausible events may occur and how they would respond to them,” said Spanner.
A key conclusion of regulators has been that the implications of complex relationships were not fully understood pre-crisis, nor the risks they posed to financial stability. In response, they raised the cost of riskier activities and reduced the likelihood of taxpayer bail-outs. But the banking industry is barely less interconnected, and new ways of monitoring systemic risk have been compromised by implementation. New solutions may yield better outcomes, suggested Wright, positing that distributed ledger technology could have a key role to play in tackling the challenges associated with global reporting and regulatory oversight of complex financial systems.
“From a regulatory point of view, what an opportunity we now have to build a real-time information system to really understand global finance for the first time. I can tell you, nobody really understands the interconnectivities and contagion. But with these new technologies there are huge potential improvements,” said Wright.
It is also the responsibility of national and regional supervisory authorities, Wright added, to make sure global regulations are consistently implemented and properly enforced. He applauded the work of the European supervisory authorities and the European Central Bank to improve convergence in the regulation of Europe’s financial markets, but remained concerned by the uncertainty caused by the UK referendum decision in June 2016 in favour of leaving the European Union.
Asked by Somerset Webb whether London could remain a leading global financial centre, Wright said there were currently too many uncertainties to be sure. “We don’t yet know what the market access arrangements will be after Brexit and the situation is going to be uncertain for some time. There are nine steps in Dante’s hell and I’m afraid we’re still at step one, which is limbo,” he said.
If Brexit does eventually lead global financial institutions to move some or all of their operations out of London, there could be benefits to other aspiring financial centres in continental Europe. But both Wright and Shvetsov agreed that business would be likely to spread around multiple cities rather than London’s dominance being assumed by Frankfurt, Paris or another European centre.
In terms of the future shape of the global financial system, a further potential game changer is the Capital Markets Union (CMU), a European Commission strategy to fuel growth and employment by pursuing more integrated and efficient capital markets. The Commission has acknowledged that investment in Europe is heavily reliant on banks, and access to financing varies from one member state to the next, with many small- and medium-sized enterprises still struggling to tap the capital markets.
But there is uncertainty over exactly how CMU will unlock capital and lower the cost of funding, particularly with Brexit threatening to fragment European capital markets. CMU was the focus of a Monday afternoon panel discussion – moderated by Wright – in which Kay Swinburne, Conservative MEP for Wales, asserted that the City of London would still play a key role in CMU irrespective of the terms of Brexit.
“London is the biggest single capital market we have in Europe and it’s not going away. It’s a global financial centre and will maintain that capital markets expertise, investor base and capital base that the rest of Europe will need to tap into,” said Swinburne, also a member of the European Parliament’s Economic and Monetary Affairs Committee.
Although CMU’s broad remit gives it scope to review existing rules that impair access to finance, Swinburne suggested the initiative would achieve its objectives as much through a cultural shift as by specific legislative means.
“I want to get to the stage where a small but highly innovative company in a small member state doesn’t have to relocate its headquarters to a larger member state or another part of the world to access capital and investor flow. Such companies need access to a much broader range of good-quality products and investors than they have today,” she said.