Financial sector markers of an uneven global recovery

Dividing fault lines is the financial sector in the US and Europe, and its ability to power the economy, in contrast to the post-Global Financial Crisis (GFC), when it was emerging markets that led to the global recovery.

US: The recent financial stress tests conducted by the Federal Reserve have shown the resilience and resilience of the US banking system after its response to the macro-financial shocks of the COVID pandemic. These tests show that the largest lenders can manage potential further shocks from the return of severe bearish conditions and still meet Tier-1 common equity regulatory requirements. As such, the US banking system is firmly positioned to support its ongoing recovery.

The key lesson is that US banks entered the current crisis with massive capital and liquidity buffers – rebuilt after the GFC – and that non-banks and capital markets were able to absorb the portfolio changes that have occurred since then. . These help the system deal with the significant liquidity problems experienced in the early days of the COVID crisis, also helped by the Fed’s actions to provide adequate liquidity. Both were instrumental in ensuring that the US financial system remains resilient in the face of COVID disruptions. However, it also raises issues of further regulatory actions that could be taken to prevent a recurrence of vulnerabilities in systemically important US markets and institutions, and to better assess non-bank vulnerabilities.

Europe: We see this in Europe as well, although its financial system reform was longer after the GFC. The capitalization level of banks is now well above the regulatory minimum requirements. The expansion of comprehensive support measures during COVID has eased the functioning of Europe’s financial system, prevented widespread bank divergence, and maintained favorable credit terms. Eurozone banks significantly increased their liquidity buffers in 2020, and their common equity tier-1 ratio improved to generally above 15%. Thus, market-based financing of the economy remains strong. The EU-wide stress testing exercise on more than 100 financial institutions, which was recently publicized, confirmed that its banking sector will remain resilient under the prolonged Covid crisis.

Emerging Markets: It is difficult to compare financial systems in advanced countries with emerging markets, where they remain relatively underdeveloped and repressed, characterized by public ownership of banks, regulation of interest rates, interference with credit allocation, legacy affecting bank balances reflect the problems. sheets, and control of cross-border capital flows. These prevent them from fully supporting a recovery.

In the case of China, to keep up with demand in the wake of the GFC, China helped the global recovery by making massive investments in infrastructure. An increase in such lending to local governments and state enterprises kept China’s growth high, but its overall indebtedness grew at an alarming rate.

For now, system-wide buffers in China’s financial sector may continue to bear the brunt. However, there are vulnerabilities that can intensify, and regulatory tolerances, high corporate leverage, and inflated asset markets can lead to increased financial stability risks. Overall, the system’s inability to properly recognize deficits, insufficient incentives to avoid bankruptcy, and the resultant all-round growth of loans work against full support to sectors. More fundamentally, in order to rebuild overall productivity and sustain rapid growth, China needs to transform its financial system so that savings and capital can go to rapid growth areas, not to unproductive state-owned enterprises. for.

Many of these considerations apply to India, which is also dealing with high non-performing assets (NPAs) and deleveraging and repair of corporate balance sheets. His persistence has held back credit, investment and growth. The second wave of Covid in India added to the hurdles faced by banks and non-banks, and regulatory relief measures have postponed dealing with asset-quality issues.

Thus, India’s financial sector generates relatively low levels of credit and its credit market remains in an early stage of development. These withhold support for inclusive and sustainable development. To fix this, the loan would have to grow at a much faster pace while avoiding excessive risk.

Allowing greater private sector participation, easing the flow of money into capital markets, and properly regulating public banks and systemically important non-banks—like private banks—will help the financial sector grow in that direction. Which can help India move faster. Broad-based development. The government’s plan to consolidate, privatize and recapitalize public sector banks is a necessary first step to strengthen governance, supervision, efficiency and risk management.

Overall, vulnerabilities in the financial systems of many emerging markets present significant fault-lines in the ongoing global recovery from COVID, jeopardizing their return to sustained and inclusive growth.

Anoop Singh is a Distinguished Fellow at the Center for Social and Economic Progress, New Delhi and a former member of the 15th Finance Commission.