During his address at the 2014 European Investment Conference, Paul Mills, senior London representative at the International Monetary Fund (IMF), shared his outlook on the likelihood of a near-term shift away from an accommodative central bank policy. Mills is in the “low interest rates for long” camp, judging prospects for the withdrawal of monetary stimulus to be remote because of prevailing low nominal economic growth rates.
Aside from that brief crystal-ball-gazing outlook, the bulk of Mills’s address headlined key findings from the IMF’s October 2014 Global Financial Stability Report (PDF), shedding light on the latest multifaceted features within the global financial system, including the contrast between the buoyant performance by financial markets and the slow growth of the real economy. He stated that easy and cheap money from loose monetary policy continues to push investors to search for higher yield. This has led to rising asset prices, tighter spreads across fixed-income securities (including sovereign bonds), stronger correlation, and low volatility across asset classes over the six months preceding the IMF report.
Concurrently, Mills believes there has been a reduction in overall credit risk within the system because of favourable funding conditions and improved asset quality, as banks continue to repair their balance sheets. That being said, he argued that there are strong indicators of credit risk mispricing. This is evident for US high-yield bonds, where bond spreads do not compensate for the likelihood of corporate defaults. Mills added that there is evidence of declining loan underwriting standards, with an increase in the volume of riskier covenant-lite loans.
Structurally, there continues to be an increased capital allocation and migration of risk toward the nonbanking sector, including into mutual funds and exchange-traded funds (ETFs) that invest in high-yield corporate bonds. The increased inflows to these funds have been driven by a search for enhanced yield by investors. Mills argued that, on one hand, the increased inflows are contributing to the economic recovery by alleviating the impact of decreased lending by banks facing deleveraging pressures. On the other hand, there is increased market risk (e.g., asset price bubbles) and liquidity risk because of asset managers entering into credit intermediation space (as they lend directly to companies).
Mills said bank capital increases have resulted in safer banks, but the sector is fundamentally challenged by the low profitability trends. He believes that since the beginning of the crisis, there has been a sustained “profitability gap” within the banking industry (i.e., cost of equity has consistently exceeded the return on equity), which can be explained by cyclical factors — such as the rise in loan impairments, low interest margins, and conduct risk charges. The sustained profitability gap signifies that beyond the safe remedial measures, such as bolstering regulatory capital, there is a need for the bank business model to adjust to the new reality of constrained profitability.
Turning the spotlight to EU banks, Mills did not predict the likely overall findings and capital shortfalls from the European Central Bank (ECB) comprehensive assessment asset quality review (AQR) of approximately 130 banks. Results from this review are expected at the end of October 2014. He explained that the AQR, conducted over the last 12 months, is in preparation for the ECB supervisory mandate within the newly formed EU banking union. While acknowledging ongoing balance sheet repair, such as €80 billion of capital issued, Mills pointed out that the AQR is likely to fall short of the core objective of restoring confidence in the sector. A more potent “game changer,” in his view, would have been strengthening the EU-wide deposit guarantee schemes.
Overall, Mills conveyed that accommodative monetary policy has had both direct and second-order effects across financial markets and that these effects increase risks to overall financial stability.
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