Keynote speech by Dimitris Malliaropulos, Chief Economist and Director of Economic Analysis and Research of the Bank of Greece, at the World Banking Forum, titled: “Banking Around the World Today”
21/09/2023 - Speeches
It is a great pleasure to participate in this year’s summer event by the World Banking Forum, hosted in a city with a long history in trade and financial activities. Throughout the decades, banks around the world have experienced major transformations to keep pace with changing economic needs, often the result of various crises. Today is no different, although several forces including globalisation and digitalisation, have increased the complexity of the challenges, as well as the uncertainty about the outcomes.
Today the banking industry is facing challenging macroeconomic conditions, following multiple supply (and demand) shocks that hit the global economy, combined with profound structural shifts relating to the green and digital transitions. In what follows, I will discuss in more detail the implications of the global macro-financial environment for banks, touching upon the lessons learnt from the recent bank episode in the US, before I move to the state and prospects of European banking amid the new geo-political realities. Finally, I will share with you my take on the most pertinent structural issues banks are likely to confront in the next five years.
The current macro-financial environment faced by banks can be summarised in three elements: economic slowdown, persistent inflation and, probably, high interest rates for longer. Over the past three years, our economies have been hit by a back-to-back triple shock: the pandemic, the war in Ukraine and an energy/cost-of-living crisis. The compounded effect of these shocks has been significant, pushing economic activity down and prices up. To support incomes, governments increased spending, which together with excess post-pandemic private savings and a resilient labour market, have sustained aggregate demand. To tame very high inflation, central banks globally embarked on an unprecedented, synchronised and aggressive tightening of monetary policy. Since the start of the recent tightening cycle and in about one and a half years, the fed funds rate has increased by 525 basis points, the Bank of England’s official rate by 515 and the ECB’s deposit facility rate by 450 basis points. As a result of monetary policy tightening, lower energy prices and a normalisation of supply chains, headline inflation has abated, but underlying inflationary pressures remain elevated and persistent. Meanwhile, activity has softened, but a hard landing has been avoided, at least for now.
Looking ahead, global GDP growth is forecast by the IMF to weaken to 3% in 2023 and 2024, under the weight of still high inflation and tighter monetary and financial conditions. This growth is well below the historical average of 3.8% in 2000-2019. It also masks significant regional divergences, with a pronounced deceleration in advanced economies, but brighter spots in emerging markets. China’s more-subdued-than-expected recovery poses a downside risk to global growth. Global headline inflation is set to fall to 6.8% in 2023 and 5.2% in 2024, while core inflation is expected to decline more gradually. Its persistence reflects the lagged pass-through of past shocks, high corporate profit margins, and strong nominal wage increases, which combined with weak productivity growth lifts unit labour costs. Services are labour-intensive but also less sensitive to interest rates, increasing the lag and decreasing the efficiency of monetary policy transmission. However, to date, wage-price spirals do not appear to have materialised in the average advanced economy, while longer-term inflation expectations remain anchored.
If there is one thing characterising the current macroeconomic environment, that is uncertainty around the global growth prospects and the disinflation process, even in the absence of additional shocks. Elevated and multi-layered uncertainty complicates the task of central banks. For example, there is still debate on the drivers of inflation, whether these are dominated by supply or demand factors, their dynamics and cross-sectional price spillovers. Another area of uncertainty relates to wage developments and second-round effects on inflation. Is the tightness in the labour market cyclical, due to supply and demand dislocations caused by the pandemic, or more structural due to demographics and skill mismatches? How strong will nominal wage demands be to compensate for real wage losses and to what extent will high profit margins absorb wage increases? Can we engineer a soft landing, where labour market rebalances through a decline in excess labour demand rather than a large increase in unemployment? Do we account for non-linearities in the relationship between inflation and labour market slack and how important are they in explaining the recent surge in inflation? And to complicate policy further, let us not forget that the levels of neutral interest rates and the lags of monetary policy transmission to the real economy are difficult to estimate with confidence. Thus, there is always uncertainty about the precise level of the required monetary policy tightening, in real time, and how it affects economic activity and inflation.
To mitigate the uncertainty surrounding the medium-term outlook, the ECB has made future decisions contingent on three criteria: the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. In the current environment, this means, quoting ECB President Christine Lagarde at the 2023 Jackson Hole meeting “setting interest rates at sufficiently restrictive levels for as long as necessary to achieve a timely return of inflation to our 2% medium-term target”. In the same vein, Fed Chair Jay Powell noted that “we are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective”. In other words, interest rates are likely to be higher on average through the course of the cycle.
Higher interest rates are affecting banks’ balance sheets. On the asset side, credit expansion to households and corporates has slowed sharply amid tighter lending standards and reduced loan demand. Bank lending surveys in the US and Europe suggest that credit growth will remain sluggish in coming months. Banks’ higher risk perceptions and lower risk tolerance continued to be the most significant factors contributing to the tightening. Asset quality has also deteriorated amid higher debt servicing burdens and rising debt distress and defaults among borrowers, adding pressure on banks’ earnings and impairment costs. The fact that the bulk of new term loans to non-financial corporations are at a variable rate in many advanced economies, including the euro area, increases credit risk at this juncture. In the EU, as loans under the various national COVID-19 guarantee schemes mature over the coming months/years, bankruptcy declarations may increase further. On the liability side, banks’ cost of financing, including through bond issuance, has gone up and we might not get back to the low levels of yields that preceded the pandemic for some time to come. Deposits have also shifted from current accounts into higher-yielding time deposits, at a record rate in the euro area. Yet, as the interest rate pass-through on loans still significantly exceeds the pass-through on deposits in the EU and the US, net interest income continues to support bank profitability. This trend could reverse as excess liquidity, relating to past QE and low-cost re-financing operations, dries up and bank competition for deposits increases.
The bank failures in the US and Switzerland in the first half of the year reminded us that shocks in the banking system can emerge at any time, the root cause being poorly managed leverage. They also highlighted the role of interest rate risk in the financial system. Banks hold large quantities of sovereign debt, with exposures increasing after the pandemic along with the risk of bank-sovereign “doom loops”. Losses on government bond holdings and other interest rate sensitive exposures could sap banks’ capital and trigger bank runs, as the SVB failure illustrated. Problems could be compounded if sovereign’s creditworthiness was downgraded.
From a policy perspective, the banking turmoil highlighted the importance of post-GFC financial sector reforms for the resilience of EU banks to shocks and contagion. The US regional banking distress has not materially spilt over to euro area banks despite an incomplete banking union and lower deposit insurance levels. This reflects stickier deposits, more limited scope for unrecognised mark-to-market losses, less acute commercial real estate concerns, and “less significant” banks being a smaller universe. More generally, euro area banks score better on several measures of solvency, liquidity and funding stability compared to the US ones.
Yet, there remains room for improvement and harmonisation to build a crisis management framework suited for all types of banks operating in the EU, including for small and medium-sized banks. The latest proposals by the European Commission for a consistent and effective framework for managing banks in distress is a critical part of the Banking Union. However, the onus for building resilience and liquidity preparedness sits first and foremost with the financial institutions; for example, improve stress testing and risk management practices to include correlated risk, and increase transparency and information-sharing on exposures. The event has also illustrated that banks need to be mindful of the role of technology and social media in deposit runs and the dangers from exposure to crypto-assets, and protect themselves accordingly.
Overall, the EU banking sector remains robust, based on the results of the 2023 stress tests published by the European Banking Authority (EBA) and the ECB in July. Resilience reflects banks’ robust capital position, and the positive impact of significantly higher net interest margins on bank profits so far. However, the EBA stressed the importance of remaining vigilant and called for both supervisors and banks to be prepared for a possible worsening of economic conditions.
It is clear that financial stability risks from asset repricing are growing. In this context, I would like to highlight the importance of geopolitical tensions. The unprecedented shocks that hit recently the global economy following Russia’s war in Ukraine have exacerbated geoeconomic rivalries and prompted governments to impose trade restrictions and adopt policies that reduce their countries’ external trade dependence, especially in sectors of strategic importance. In addition, multinational firms are increasingly adopting risk diversification policies, such as near/ friend/re-shoring, to increase their resilience of their global supply chains to shocks. In this “new global map”, the future of global trade integration looks increasingly uncertain. Trade fragmentation may have (potentially important) implications for the global economy in terms of volatility, economic growth and inflation, but it will also affect financial markets and cross-border banking. As the ECB recently noted, a potential intensification of geopolitical tensions may further increase repricing risks in financial markets. As the world becomes more geo-economically fragmented, cross-border banking would become more difficult, more local and more costly. For example, the war in Ukraine or the US-China conflict (although they have a limited direct impact on European banks) are adding pressures that are speeding up financial fragmentation regionally and globally. The implications for financial stability could be significant. These include potential capital flow reversals, disruptions of cross-border payments, impact on banks’ funding costs, profitability, and credit provision, and more limited opportunities for global risk diversification. In the EU the answer is to complete the Banking Union. Without this, times of stress will always raise fragmentation risks.
In the next five years, what are the challenges that banks in the world will be facing? I would like to focus on three challenges: the increasing role of non-bank financial intermediaries, climate-related financial issues and digital transformation.
The structure of the global financial system has changed in the last decade. Low interest rates, easy liquidity and lighter regulation compared to banks, have supported a rapid expansion of non-bank financial intermediaries (NBFIs), which now hold almost 50% of global financial assets, a larger share compared to that of banks. It is unclear how higher policy rates will be transmitted through the NBFIs, since many have not been stress-tested for an interest-rate or a cash-flow (recession) shock. There is also lack of granular and reliable data to monitor the sector as a whole. A major concern of policymakers and investors is the rising interconnectedness of NBFIs with banks, both as lenders and borrowers. The Fed in its latest Financial Stability Report shows that US banks have $2 trillion of credit commitments outstanding to global NBFIs, while the ECB and the Bank of England highlight the systemic risks from NFBIs providing funding to the banks. The ECB also highlights in its Financial Stability Report, May 2023, that “any turmoil in the NBFI sector is likely to disproportionately affect large, complex, systemically important banks”. For example, bond market turbulence could trigger liquidity stress in some NBFIs like hedge funds and then spill over to the whole ecosystem as they sell off their assets, reducing their prices, and withdraw funding from one another. Aside financial stability risks, banks could also face more competition from non-banks in attracting savings and providing credit, necessitating tighter regulation of non-banks to ensure a level-playing field. That said, the collaboration with FinTech startups and other technology providers poses an opportunity for banks to tap specialised expertise, access innovative products and realise efficiency gains.
The second set of challenges banks will face relates to climate change. This expands from proper measurement and hedging against climate-related financial risks on banks’ balance sheets to financing the vast investments required for climate mitigation and adaptation. There is a need for sustainable finance products, such as green loans and bonds, and funds with environmental, social and governance standards. The latest ECB’s climate stress tests show that an accelerated green transition significantly reduces credit risk for banks.
Finally, let me touch upon the multi-dimensional challenge of digital transformation. Banks are called to adjust their business models, operations, products and services to the new digital realities. Physical networks are scaled back in favour of e-banking and e-branches, which in turn increases cyber-threats. Large parts of the front-end of banking are now self-driven via apps, while large parts of the back-end are now composed of third-party providers of cloud computing. Digital neo-banks, such as N26 and Revolut, and big tech companies challenge incumbents. Blockchain technologies enable the introduction of digital currencies, including those by central banks, making payments faster and cheaper. Also, data is turning into a product that has the potential to transform the foundations of banking.
The world is changing and along with it banking. The challenges and risks faced by banks today are multiple and complex, stemming from a geo-economic environment in transition, technological disruptions and regulatory reform. The banking sector must cope with lower growth, persistent inflation, higher interest rates and growing fragmentation. These are great challenges. Banks would need to adapt strategically by enhancing their financial, technical and business capabilities to navigate through heightened uncertainty, compete, grow and remain profitable and relevant in the new global landscape. Thank you!
 The relationship between labour market slack and inflation is likely nonlinear, steepening in a tight labour market. This means that a small change in labour market tightness could result in a more substantial change in inflation. It is difficult to know with precision how steep that relationship is in real time or how it might evolve as labour market tightness changes. For more information on nonlinearities in this relationship, see Boehm, C.E. and N. Pandalai-Nayar (2022), "Convex Supply Curves," American Economic Review, vol. 112 (December), pp. 3941–69; Benigno, P. and G.B. Eggertsson (2023), "It's Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve", NBER Working Paper Series 31197; and Petrosky-Nadeau, N., Zhang, L. and L.-A. Kuehn (2018), "Endogenous Disasters," American Economic Review, vol. 108 (August), pp. 2212–45.
Speech by C. Lagarde, President of the ECB, at the annual Economic Policy Symposium by Federal Reserve Bank of Kansas City in Jackson Hole, 25 August 2023.
 IMF, Global Financial Stability Report April 2023, Chapter 3.
 Around 14% of euro area bank funding is provided by NBFIs, while in the UK banks hold £1.5 trillion of credit lines to NBFIs, but as of end-2021 sourced around £850 billion of repo and deposit funding from NBFIs. See, ECB Financial Stability Review May 2023 and BoE Financial Stability Report December 2022.