The crisis of 2007 – 2009 saw the financial sector infect society: the US subprime crisis hit financial institutions around the world and provoked banks failures, this triggered in turn public-funded banks bail-outs, impacted public budgets, spread to the real economy and created massive unemployment.
The current pandemic-linked financial turmoil is an entirely different story. As a matter of fact, its chain of causes and consequences is exactly the opposite: we are facing a health crisis that has brought the world economy to a standstill, or at least to a very significant slowdown, which in turn has created havoc on financial markets.
This should not be a surprise: price formation on financial markets is, by construction and regardless of its flaws, about transforming economic expectations into asset prices. When economic expectations become sharply negative, markets collapse; and when economic forecasts become impossible to make, markets become very volatile. We are facing today a situation that combines negative economic expectations and a great difficulty to make reasonably founded economic forecasts, hence the collapse of financial markets combined with a volatility peak.
In a very unusual pattern, the first days of market turmoil saw equity, bond (including sovereign bond), and gold prices drop together. We did not see the “flight to safety” usually encountered during market crashes where equity and possibly corporate bonds prices drop but sovereign bonds and gold prices go up. This time, investors were just looking to exit all financial assets and keep their money in cash, a phenomenon that can be explained by the unusual transmission mechanism of the crisis (health=>economy=>finance), but also by the fact that the yield provided by sovereign bonds is close to zero, when it is not negative, very much as is the case for the remuneration provided by cash (no cost of opportunity).
With 3 billion human beings (i.e., economically, 3 billion consumers and workers) under lockdown around the world, the global economy is seeing a considerable decline of activity. This, predictably, is going to create enormous difficulties for enterprises, large and small, as well as citizens who are going to be caught without revenues or resources very quickly. The key to navigating this situation is going to be the provision of cash to economic actors, whether enterprises or private individuals, with particularly close attention to be paid that we do not see families with modest income and over-indebted individuals walk out of this crisis with even mode debt.
Banks have an essential but challenging role to play in this situation: they must extend the credit necessary for enterprises to survive this particularly difficult moment and, at the same time, they must not endanger their own resilience as a bank crisis would make the economic situation even worse. This is where the role of governments and financial supervisors is essential. Governments can and must guarantee the credit extended by banks to enterprises because of the crisis, as it is the most efficient way to combine the otherwise contradictory objectives for banks to support the economy without incurring a growing amount of non-performing loans that would put their stability at risk. This is what many European governments are doing and it is to be welcome.
Meanwhile, financial supervisors have the delicate task of combining the monitoring of financial institutions to ensure that their resilience is not affected by the turmoil on financial markets, and releasing the regulatory pressure on the same institutions in order to account for the exceptional circumstances (the financial system was not designed to cope with an economy slowing down on such a large scale, and financial institutions face very significant operational difficulties due to the lockdown of their staff). Supervisors are obviously treading a fine line to find the right balance between the two objectives.
Importantly, supervisors are able today to release some regulatory pressure in the midst of crisis while feeling confident that they are not endangering financial stability because a certain level of regulatory constraint was put in place over the past ten years. If anything, this is the best possible testimony to the fact that sufficient financial regulation must be enacted and enforced if society wants to keep control of its financial system, and if it wants supervisors to have the necessary leeway to react to crises as they happen. This is something that Finance Watch has been advocating for over the years and that it will continue doing once the crisis is over. For instance, if it can be argued that regulators have good arguments to delay the finalisation of the Basel III framework by one year in the current context, it will be essential that this delay does not become a renouncement if society wants to be ready to absorb the following shock that will come inevitably one day. Conversely, the fact that regulators and policy-makers decided not to tackle the bank-sovereign doom loop outside of crisis time has the consequence that this doom loop is today one of the major weaknesses of the European banking system and constitutes potentially an existential threat. The same could be said of too-big-to-fail: even if it is not at the origin of the current financial problems, it constitutes a threat for society as the default of a too-big-to-fail institution (for instance triggered by the bank-sovereign doom loop) would necessitate mobilising public budgets to save the system.
Last but not least, regulators and supervisors have to ensure that the necessary support they bring to financial institutions to face the crisis (releasing the pressure on capital requirements, bringing state guarantees to credit extended to cash strapped enterprises…) benefits society and not private interests. This is why the pressure exerted by financial supervisors on financial institutions not to distribute dividends and to show “extreme moderation” on bonus payments is indispensable: it is in nobody’s interest to see the social contract between a population severely affected by the current health and economic situation and financial institutions break down completely.
Thierry Philipponnat
