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Financial regulators need to be vigilant as crisis threats reappear

By Anthony Rowley   
September 22, 2023

Things seem to be getting worse on the banking front. Recent days have brought news that global debt is rising again to new highs with banks and non-banks heavily involved, and accusations that financial supervisors, if not exactly asleep at the wheel, are not keeping a proper eye on the road ahead.

The G-20’s Financial Stability Board (FSB) warned in August of the danger of further challenges and shocks “in coming months as high interest rates undermine economic recovery and threaten key sectors, including real estate”.

As the International Monetary Fund observes in a blog post on September 19, "financial stability needs supervisors with the ability and will to act", in order to avoid a repeat of past banking and financial crises, such as in 2008 or even as recently as early this year.

"Keeping banks safe and sound, and anchoring financial stability, hinges as much on good supervision as on effective risk management and governance in banks, robust regulation, and vigilant markets," according to the blog post written by IMF Financial Counsellor Tobias Adrian and others.

Several days before that, the Institute of International Finance (IIF) reported in its latest Global Debt Monitor that the global debt stock rose by US$10 trillion to a new record high of $307 trillion in the first half of 2023, a staggering $100 trillion more than a decade ago.

Over 80% of the debt buildup came from mature markets, with the US, Japan, the UK and France registering the largest increases. In emerging markets, the rise has been more pronounced in China, India and Brazil.

The report says the global debt to gross domestic product ratio has resumed its upward trajectory after declining for seven quarters and has reached 336%, despite the fact that rising prices have allowed debtors to inflate away some of their debt burden.

The IIF notes that high inflation, higher borrowing costs and tighter lending standards have significantly curtailed bank credit creation in recent months. Meanwhile, expansion of private credit markets continues despite increased regulatory scrutiny.

It warns that as higher rates and higher debt levels push government interest expenses higher, domestic debt strains are set to increase. “Yet, the international financial architecture is not adequately equipped to tackle unsustainable domestic debt levels."

The IIF’s warnings echo concerns expressed by the IMF in a separate blog post on September 17, this one written by Vitor Gaspar, director of the Fiscal Affairs Department and others, questioning whether banks' risk management practices are strong enough, and whether prudential regulation are adequate and banking supervision effective.

"While much attention is typically devoted to the needed upgrading of regulations following episodes of bank distress, upgrading of supervisory effectiveness can be left bereft of corresponding attention," they write.

According to the officials, financial sector supervisors "need a clear mandate to ensure they are focused on the right trouble spots” and also “need adequate legal powers to back their actions".

They point out that the 2008 global financial crisis highlighted the importance of supervisors needing to be assertive and intrusive, and note that “light touch supervision, often invoked to encourage economic activity and foster competition, has proved unsuccessful”.

Such sentiments may not go down well in parts of the banking and financial sectors but they will likely resonate within the wider community which suffered under the impact of the global financial crisis.

The next such crises could occur in the non-bank or shadow banking sector. The FSB report singled out – but did not name - a group of hedge funds as a potential source of financial market instability, warning that they had “very high levels of synthetic leverage”. These are debt created by the use of derivatives and other complex financial instruments and which does not appear on balance sheets. They are difficult to measure but the impact can appear suddenly, the FSB says. Shades of the sub-prime mortgage crisis.