BIS: higher interest rates may stress financial system

    A sharp rise in interest rates from major central banks’ exit from extraordinary accommodative policy could raise the risk of stress in the financial system as banks hold large portfolios of long-dated fixed income assets that will fall in value, warned the Bank for International Settlements (BIS).
    In its annual report, published as financial market shudder from the Federal Reserve’s decision to start cutting back on asset purchases later this year, BIS warned of the challenges facing central banks in striking the right balance between a premature exit and the risks from delaying an exit further.
    “These considerations highlight the possibility that disruptive market dynamics could even materialize as soon as central banks signal that an exit is imminent,” said Swiss-based BIS, as if it had been looking into a crystal ball at last week's plunge in global bond and stock markets.
    The annual report went to the printers on June 14, the week before the Federal Reserve on June 19 laid out its timetable for pulling back from quantitative easing, underlining the uncanny ability of BIS to spot and anticipate financial events.
    In its 2006 annual report – a full 12 months before the first signs of a global liquidity shortages - it warned of “financial market turmoil or a long period of relatively slower global growth” from the unwinding of financial imbalances.  And in 2008, a few months before the bankruptcy of Lehman Bros., BIS predicted a “more protracted global downturn that the consensus view seems to expect.”
     While central banks have more tools at their disposal, are more transparent and experienced in managing expectations that in 1994 - when a tightening of U.S. monetary policy lead to turbulence in global bond markets - BIS said the situation now is much more complex with the exit requiring “a sequencing of both interest rate increases and the unwinding of balance sheet policies.”
    Central banks’ will be exiting at a time of very high levels of debt with much issued at record low levels, raising the risk of public and government anger over higher interest payments and losses.
    A rise in U.S. Treasury yields by 300 basis points, for example, would result in losses to holders of those securities that exceed $1 trillion, or almost 8 percent of U.S. GDP.  While yields are not likely to jump that much overnight, BIS noted that yields in 1994 rose some 200 basis points during one year in a number of countries, illustrating that “a big upward move can happen relatively fast.”
    Central banks’ communications skills will be severely tested during the exits from easy policy, putting a premium on careful, advance preparation at the same time that central banks have to shore up their anti-inflation credentials.
    “Retaining the flexibility and wherewithal to exit is critical to avoid being overtaken by markets,” BIS said.
    Despite progress in slashing deficits, gross government debt in most advanced governments has continued to rise. This year it is projected to reach some 110 percent of Gross Domestic Product in the United States, the United Kingdom and France, some 230 percent in Japan and close to 90 percent in Germany.
    In most large and advanced economies, the total debt of households, non-financial corporations and governments has risen by $33 trillion from 2007 to 2012, with debt ratios in a number of emerging economies rising even faster.
    In addition to slashing policy rates to effectively zero to avoid a total financial collapse, central banks also embarked on large-scale asset purchases to aid the economic recovery.
    Since late 2007 central banks’ total assets worldwide have roughly doubled to over $20.5 trillion, or just over 30 percent of global Gross Domestic Product. Among the emerging Asian countries, central banks’ assets correspond to over 40 percent of GDP as banks boosted their foreign currency reserves.
    “Open questions remain about how well markets will react to a change in course of monetary policy, not least as central banks have taken on such a large role in key  markets,” said BIS.
    In some markets central banks are effectively seen as the marginal buyer of longer-term bonds while in others they have provided a liquidity backstop and “in effect become core intermediaries in interbank markets.”
    Financial institutions will face the challenge of managing this interest rate risk and efforts by regulators’ to stress-test for the impact of higher yields take on added importance along with banks’ and investors’ ability to hedge risks.
    “That said, there may be limits to investors’ ability to hedge effectively if the transition to higher returns turns out to be particularly abrupt and bumpy,” BIS warned.
     Emerging market economies and small advanced economies will also feel the draft from the exiting by major central banks – witness the outflow of capital from emerging markets since early May – possibly leading to volatile capital flows and exchange rates and financial stability.
    Apart from the major financial repercussions of the exit, central bankers will face political pressure as households, companies and governments object to the rise in interest rates, making the exit even harder.
    “For instance, it is easy to imagine tensions arising between central banks trying to exit and debt management offices seeking to keep servicing costs low,” BIS said.
    Central banks’ own finances may also come under strain, “possibly even undermining the institutions’ financial independence. The public’s tolerance for central bank losses may be quite low.”
 
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