THE RISK OBSERVATORY:

HUGUES PIROTTE Solvay BS, ULB FinMetrics

This edition of the Risk Observatory will be clearly faithful to its title, providing a large picture of the hot subjects in the financial industry (be)for(e) the summer, since our readers will share some time probably on the beach, or next to a pool with plenty of time to reflect.

 

On June 1st, the chairman of the Financial Stability Institute of the BIS, Fernando Restoy, summarized the recent trends in banking regulation. In particular, the standardized approach for credit risk is being modernized to be more granular, more representative of the real risk exposure. At the same time, for those who apply the alternative internal ratings-based (IRB) approach, the parameters are tightened by setting floors to them as well as floors on the results to avoid wide gaps between the two approaches. This is part of a big reality check: complexity, also in regulation, deters transparency, expectable behavior and confidence. But, by barring the route with precautionary floors, the cost-benefit relationship of implementing an IRB approach starts to be prohibitive. Some banks are furious, given the sums, efforts and time invested into more quantitative methods. The desire of comprehensiveness, comparability1 , easier validation, healthy competition, and reduction of procyclicality are advocating back for more simpler, readable, rule-based regulations.

 

The renminbi keeps internationalizing, reaching almost two percent of global payments. It was the first most actively traded currency among emerging countries. According to the IMF2 , its share in the World’s total allocated international reserves (1%) starts to approach that of the AUD and is more than six times higher than the CHF. But it is not yet matching the real global economic significance of China, whose output represents around 18% of the total.

 

A recent interview of Peter Praet, member of the Executive Board of the ECB, mentions him acknowledging a synchronized recovery of the world economy. But he notes that the euro area recovery is not yet sustainable without the support of the monetary policy, and confidence indicators, the soft data, are still higher than the hard figures. Private consumption is driving again demand. Inflation has recently been volatile, but it continues on the path outlined in the forecasts of the ECB. They believe that the output gap will be closed by 2019 which will be followed by a price pressure. Therefore there is no fear of a “low inflation trap” but monetary efforts must still be sustained in the meantime. Economic development is still fed by very favourable financial conditions. Banks are not very happy about negative interest rates but it is not the only reason why their profits are under pressure. The ECB was awaiting more consolidation in the sector. But the good news is that this doesn’t prevent banks from providing their clients with cheap long-term financing conditions; SMEs are less worried about access to credit and that can help unleashing growth. Of course, we are in a strange environment says Peter Praet, but without this the recession would have been much deeper. He reminds that the mission of the ECB is price stability and that does not entail influencing redistribution processes over governments’ action.

 

Following the case of Switzerland is interesting since they depend massively on their trading partners. Thomas Jordan, chairman of the Governing Board of the Swiss National Bank confirms the outline of the global environment mentioned by Peter Praet. Core inflation, that excludes oil and food prices, has not increased. US is already in full employment territory; Europe follows behind. The Swiss franc appreciation seems to have been digested and the Swiss GDP is expected to grow at a 1.5% rate in 2017. But production capacity utilization, as in Europe, shows some leeway still. The SNB had to still continue its intervention on the foreign currency markets, purchasing currencies for CHF 67 billion in 2016 (totaling almost CHF 800 billion). The rest of their assets is gold and a small fraction of Swiss assets. Currency reserves allows them to react to smooth out the valuation of the Swiss franc but in the meantime, they need to make sure their reserves keep their value. First, they cannot hedge FX risk against the Swiss franc since this would push it upwards again. Second, by contrast with the monetary policy, the investment policy shouldn’t impact prices and thus the SNB cares a lot about absorption capacity, liquidity thus, security and return.

 

"Complexity, also in regulation, deters transparency, expectable behavior and condence "

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