Hyun Song Shin on the New Financial Stability Risks

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1:22Hello and welcome to another episode of the AllBots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, we are still here at Jackson Hole. We are coming to the end of our sort of discussion series, however. And I think one of the themes that has emerged from a lot of the people that we've been talking to at this event is this idea of living with high levels of public debt and high inflation, all while having basically a global financial system that is built on bonds. things that are supposed to be boring. They're not supposed to see their yields swing wildly. And yet that's been what's happening.

2:01Two things. One is, to your point on yields, it's the story of the last year, but it's really also the story of the last month, which is that you think things have mellowed out and suddenly you get a new spike. Mortgage rates at the highest since 2000, 10-year or 30-year yields, highest at least since 2007. The other thing is, can I just say one fun thing about Jackson Hole is running into possible odd lots guests on a hiking trail. Yes. Which is a really fun aspect of here. You know, it's like when we're back in New York, we have to do all this work to try to find guests, you know? Here, you're just like, oh, hey, it's you.

2:35You just pick them off in the wilderness. Yeah. Like predators. You want to come on the show? Yeah. All right. Well, one person we did actually run into while hiking is one of our favorite odd lots guests. We're going to be speaking to Hyun Sung Shin. He is, of course, economic advisor and head of research at the Bank for International Settlements. And we're going to try to synthesize a lot of the discussion points we've been having for the past day or so. Right. And to your point, you know, I do think that and this was sort of part of the interesting thing we talked about with Daryl Duffy, which is that we came out of 2008 very focused or 2008, 2009, like very focused on credit risk, right?

3:12Like downside risk, et cetera. And I think by and large, policymakers, we probably did a good job of de-risking the system from the perspective of credit. Then we got this rate spike. We got the highest inflation in at least four decades. We got Silicon Valley Bank. And suddenly they're like, oh, there's other risks. It's not just credit risk. Well, we reduced credit risk at the expense of interest rate risk, it feels like. And we sort of, by design, made bonds really fundamental to the way that, again, the financial system works. So we need to dig into these financial stability risks as they are now.

3:48So without further ado, let's bring in Hyun. Hyun, thank you so much for coming back on. I think this must be your fourth or fifth All Thoughts and Hearings. Something like that. But our first in person, which is really exciting. I was going to say, it's such a pleasure to do this in person, Tracy. And it's a great topic, of course. And I think you've had other people on during the day that have explored bits of this. But maybe the point to start with is just to take a step back and have an overview of the way that the structure of intermediation has changed since the GFC. As you say, Joe, the GFC very much was around the banking sector and in particular credit risk.

4:28The idea is that you need capital there to absorb losses on the assets because they're risky assets. And that's the way that you protect the depositors and other claim holders. I think what we saw in March 2020 with the stress episode in the Treasury market is that even safe securities can be at the center of a financial stress event. I think the UK guilt episode last year. Again, these are safe assets, but they were very much at the center of financial stress. And I think what that does point to is the shifting nature of risks, the different propagation mechanisms, and the different set of players out there.

5:09So we're going from banks to non-bank players. In the jargon, they're called MBFI, it's non-bank financial intermediaries. But it's not just the intermediaries. I mean, it's also the way that infrastructures, you know, CCP's, exchanges, they've also become very important as well. So this is, I think, a very, very important topic for us to touch on. Well, talk to us more about who those non-bank financial intermediaries are, because I think people often hear the term, the more colloquial term, shadow banking. And it sounds kind of nefarious, but there are all these different flavors of non-bank investors.

5:46So talk to us about who they are and what's happened to them in the years since 2008. Well, you can draw a kind of flow chart here. You've seen those New York Fed charts where you have ultimate creditors on one side and ultimate borrowers on the other side and money flows from right to left following the balance sheet direction. We can think of something like that in this case as well. We have fewer of these bank-based intermediaries, although we, of course, still have them, but they've shrunk in size and heft, if you like, within the system. Instead, what we have are many non-leveraged players, asset managers of various stripes, life insurance companies, pension funds.

6:26And I think a very, very important class of players are the other hedge funds as well. There are non-regulated market intermediaries there. And a very important part of the here would be the new central counterparties, other exchanges, where rather than having intermediation go through a dealer balance sheet, you have clearing, you have the central counterparties that actually act as creditors and debtors to a wide range of participants. So you mentioned March 2020. You mentioned the guilt episode. There's also, of course, March 2023 with Silicon Valley Bank. I guess we have had this run up in yields over the last month again, but I don't think, you know, nothing has floated to the surface.

7:13Nothing's broken yet. Nothing's broken just yet. But it feels like we might be in for multiple years of a very different direction. Whereas the 2010s were all about, you think rates are going to go up, but they go back down. You think finally you're breaking out, they go back down. Maybe we'll be in the other direction where we think rates and inflation are settling down, but it turns out they gather steam. We don't know, but maybe that is. How do you think about that in terms of like systemic risk, financial risk? How is it different than a period of like credit risk and slow growth? It's worth thinking about the journey that we've been on for the last 10 years or so, well, maybe 10, 12 years.

7:48You know, we've had a very long period of low for long interest rates. And of course, central bank asset purchases that has really compressed the yield curve. And what that's meant is that borrowers have taken advantage of that and they've termed out their borrowing. And we see it in the corporate sector. They've really termed out their bond issuance. We see it in the household sector as well. But I think especially important would be the government bond market. There's been an increased duration of the bonds outstanding. Not surprising, really, because government debt managers would also be taking advantage of the low long-term rate.

8:29So just to give you a number, in the BIS annual economic report this summer, we had a small discussion on this. If you look at the duration in aggregate of advanced economy government bonds, it was around seven years at the end of 2010. That's now nine plus years. So we've had a tremendous lengthening of duration. And so as central banks have raised rates in response to inflation, what that's meant is that the price impact has been that much larger. So if you're not marking to market, if you're using ultra-maturity accounting, we call that interest rate risk on the banking book. And this is what happened with SVB.

9:10You don't mark to market until you have to. If you're marking to market, then it's duration risk. So as long-term rates go up, the price of your assets will go down accordingly. And the longer the duration, the bigger the impact. And I think in that sense, there is a broad continuum here between what we saw in SVB, the UK guilt episode, but also I think just in terms of emerging market bonds that I think we'll also talk about during the course of this conference. So I think that's, if you like, looking through the sector to the underlying exposures. And if we do that, I mean, that's what's out there.

9:50What's different, of course, is that inflation is high. And so monetary policy has to respond. And after a very, very long period of low for long, we are seeing, if you like, the consequences of raising rates once the exposure has lengthened. So I mentioned this in the intro, and you just gave a very good outline of duration risk and this idea of additional sensitivity to interest rate moves. But I mentioned in the intro that a lot of this is by design. We have actively encouraged a lot of investors to buy more bonds. And maybe that wasn't an issue in the lower for longer era, as you just pointed out.

10:29But it seems to be problematic in an era of high inflation. If not bonds, what do you use as the sort of safety net for a lot of these entities? Well, I think, you know, before we go there, Tracy, I think we have to point out that lengthening duration has also a lot of advantages. One thing that is very good with very long duration exposures is that with very long duration liabilities is that you're not facing the rollover risk that you used to if you were borrowing short. So, you know, for example, if you go back to the Asian financial crisis, there you have the combination of currency mismatch as well as a maturity mismatch.

11:14And if your liability is very short term and your creditors want their money back, then that's actually going to lead to a much sharper episode of stress. So lengthening duration has also a lot of advantages for mitigating financial stability risks. This would be one reason why we perhaps haven't seen as many bankruptcies as were expected as the Fed raises rates, because everyone spent the past two years terming out their debt. Absolutely. And that's especially true for those homeowners who actually refinance their mortgage. I think that's a very, very good example. And what we also see is that in the household sector, mortgage duration has also lengthened as well, not just in the U.S.

11:56I mean, U.S. is special because of its institution of a 30-year fixed rate. But it's also true in other economies that there's been this shifting out. I think on balance, I would say that the lengthening of the liabilities is a good thing on balance. But every silver lining has a cloud. And here we have exactly this problem that it's not a free lunch. You have to pay for the additional risk that comes from greater duration. And what about the if not bonds, what question? Because this is what I struggle with. what is the next safe asset, basically? Well, I think the safest asset is just money. And I think this is where the money in the sense of the high-powered money that is issued by the central bank.

12:41So when a central bank conducts QE, what happens is the central bank takes out duration by purchasing the bonds, but then pays for it by creating reserves that are held by the sellers of those bonds, typically commercial banks, who then would pass that on to the sellers. you know, their customers. What that means, though, is that as interest rates rise, the assets that the central banks hold will also be subject to losses. And this is why we're seeing the spate of losses on central bank balance sheet. The important thing about central bank liabilities, though, is that they're not subject to redemption.

13:18The central bank doesn't have to repay the dollar with another dollar, because that is the ultimate liability. And as we argued in a BIS bulletin recently, we should not be so concerned about central bank losses in the same way that we are concerned about losses suffered by a private sector entity who are subject to those redemptions. But it doesn't mean that there are no limits. I mean, clearly there are limits. And we see those limits, especially in very fragile emerging and developing economies that don't have the same credibility in the value of money as with the Fed or with an advanced economy, with other advanced economy central times silicon valley is selling you a future where you're obsolete or worse identical at palantir they're witnessing something different and revolutionary from From re-industrializing the nation's defense base to shipyard workers building faster and frontline workers boosting productivity, AI is transforming work across the nation.

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15:57See, this is a good time to ask you a question. And I also pose this to Barry Eichengreen in an earlier conversation. Balance sheet policy, I mean, I think we typically associate Fed, QE, etc. EM central banks are building out that capacity. And it seems like in the post, in the sort of COVID era, we are seeing more central. EM central banks having some credibility or capacity enough to be a buyer of last resort for their own government bond markets in a way that we didn't have in the past. Is that fair? Is that an accurate characterization? I think, Joe, what I would say is if we look at the events of last year, if anything, it's been the emerging markets that have done better in some respects than the advanced economies.

16:39And let me explain what I mean by that. So a good comparison is between the events of last year with the earlier stress episode for emerging markets in 2015, 2016. So back then, what we saw was a very strong dollar coupled with very low commodity prices, capital outflows for emerging markets. We saw a sharp steepening of yield curves. That combination of stresses are very typical of emerging market stress episodes that we're familiar from the textbooks. What we saw last year was actually quite different. What we saw was the nature of the shocks were different. We had a war and a pandemic. And what that meant was when commodity prices rose, emerging markets that were commodity exporters actually did very well relative to historical experience.

17:31If you look at the Mexican peso or the Brazilian real. It actually appreciated last year. And that's very different from, let's say, the euro, the yen, even all the other advanced economy currencies. We see quite a resilient picture. And so they didn't even need to enter the market like that. Now, Joe, your question raises a very important issue, which is when can a central bank come into the market, intervene and play the role of a buyer of last resort. I think this is a very, very important policy issue. Maybe we can get back to some of the discussions that's happening in the official world.

18:10But when we look at emerging markets in particular, emerging market central banks, policymakers generally are very reluctant to wade into markets in those stressed circumstances. And for good reason, because when you go into the market, you have to buy the bonds, and you're creating reserves as the byproduct of that. That's going to be held by some of the domestic participants. You're creating money. So liquidity injection, that has many, many good aspects. But what it means is you're also going to put pressure on the exchange rate. So if you're pushing a lot of liquidity into the system and you're a central bank that doesn't have the credibility of a central bank like the Fed, then that's going to lead to a very sharp depreciation of the exchange rate.

18:56And that could, in fact, do more harm than good. So I think the short answer to your question, Joe, is that last year we saw a very different set of circumstances. Emerging markets actually did pretty well. I would say the major emerging markets did very, very well. I mean, there are clearly more stressed developing economies that still have to borrow in dollars and so on. But emerging markets did particularly well. But I think there is a very important lesson here on what are the circumstances that mean that you can enter the market with impunity? And when can you enter the market and get away with it?

19:32Well, why don't we go back to central banks that can create reserves without putting necessarily downward pressure on their own currencies. I wanted to talk to you about leverage and bonds because I think we're used to talking about leverage in the context of credit. And everyone remembers credit derivatives from their starring role in the 2008 financial crisis. But I guess what's perhaps underappreciated, although it feels like more people are becoming aware of it now, is that there's also a lot of leverage attached to the bond market. And we've seen sort of flashes of it emerge, most notably in the March 2020 Treasury event.

20:10But how are you thinking about that issue? And how do you see leverage emerging in the world of bonds? I think that's a very important question, Tracy. And I think it goes to the point made at the outset. I mean, how is it possible that a safe asset can still be at the center of a stress event? And I think here we have to think about the possible reasons for perverse demand responses. And I will sort of make it more concrete shortly. By a perverse demand response, what I mean is when a price falls, we typically would think, well, that means that it's more attractive to buy. And so people would come into the market.

20:48So when the price falls, you expect people to come in and pick up the cheap asset. But in these stress episodes, what you typically find is that a price decline actually generates more sales. And that actually, of course, leads to further price declines and you can have this loop. Now, why would you have this perverse demand response? Well, leverage is one way that you can have that. So if you're leveraged, if you're levered and the price of your assets fall, well, your creditors want their money back. You need to meet margin calls and you have to sell. Right. This is something we spoke with Daryl Duffy about, that typically the thing you sell first is your safest, most liquid asset, which would usually be a bond, probably a U.S.

21:31Treasury of sorts. Absolutely. And so this is how a safe asset can still be at the center of a stress event. But it doesn't have to be leverage as such. It could be leverage-like behavior. And what I mean by that is, what other ways can you have where a price decline would beget more sales? I think a typical and a very, very classical example, and it's in the mortgage market, actually. A well-known historical episode is what happened in 1994 when you had this rapid steepening of the yield curve. The way that the embedded option in the mortgage market in mortgages means that when you hedge, so when rates go up, the duration increases, actually, because people stop refinancing.

22:11This was the big convexity event. This was the convexity issue. Now, there's something similar also in, I mean, something similar can happen even in very boring sectors like pension funds or life insurance. So if you're trying to match duration and you have liabilities to your policyholders, which are, let's say, 30 years, but you have assets that are 10 years, liabilities are much longer duration than your assets. Now, when rates rise, the duration comes in both on your assets and your liabilities. But because your liabilities are much longer duration than your assets, liability duration comes in much faster.

22:50So what ends up happening is that you find that you've got too much duration on the asset side. So you have to sell. So what's just happened? You know, rates rose, but you're ending up selling. That's another example of leverage. This is the UK story, right? I mean, this is similar. This is what happened. I think the UK, it's a combination of both leverage and their story because there was the LDI fund aspect, which actually gave it a further amplification boost. But the underlying exposures, I think, are really all the same, depending on exactly how it will play out, depends on who are the main players.

23:25But the principles are very similar. So even very conventional, very supposedly boring sectors can still be the source of these kinds of perverse dynamics. That's a fun thought. Well, forgive me if this is too big picture or too meta of a question, but for a sort of market capitalist system, someone's got to hold the risk. People need income. You know, it seems to me, I don't know, maybe there's not even a question here, but it seems to me it's like, you know, 2008, okay, there's too much credit risk and too much bad lending to households and German banks somehow financed, you know, construction in the Sun Belt in some way.

24:00And then now we're talking about like pretty boring, boring bonds, treasuries going up, boring sort of simple life insurance companies, pension companies, not particularly exotic. Is this our fate that for the rest of our careers is just every 10 years we have to like pinpoint a new area? I mean, because it's not like risk can never go away. Someone's got to hold the assets. Someone's got to make the income to pay the savers. I think the key here is that we have a diversity of investors. Okay. So whatever we do, we have to make sure that when someone is selling, someone is actually willing to come in and buy.

24:33And the diversity of the market participants is absolutely key for this. And this is all about finding the right price. And finding the right price means that we have buyers as well as sellers. The reason why these financial stability channels of propagation can be so corrosive is because sometimes one part of the market just becomes too big. They grew without our knowing it, without our really noticing it. And then when something happens, this is when all these dynamics take hold. I don't think we need to worry, you know, every 10 years that something big will happen. It's just a case of making sure that we have a diversity of buyers and sellers, of participants in the market.

25:17And there are some rules of thumb that we should use both in the regulation, but also for the private sector institutions themselves in the risk management. So what are some of the potential kind of decision rules that might be baked in, given the kinds of leverage and other exposures out there? Relative value hedge funds, I think, were very important in March 2020. That was very much about leverage, using futures and the cash bonds, futures implied yields a little bit lower because it doesn't take up balance sheet. And so you're selling the futures and buying the bonds. But then if margins go up, you have to either come up with additional equity from somewhere.

25:59That's a very difficult and stressed episode. So you typically end up selling. And so this is another case where safe asset can still be at the center of this kind of episode. So as market observers, as observers from the official sector, we just have to be very careful to be on the lookout for where these stress episodes might arise. I mean, there are some rules of thumb we can use. And I think one of the interesting things is that for the relative value hedge funds, we're seeing again the short positions in futures growing. Not in the 30-year horizon that we saw in 2020, but more in the five-year horizon, more in the belly of the curve this time.

26:39But it seems that that's something that has come back. It's much smaller than it was before the March 2020 episode. But these are the things that, you know, it's not a precise science, but these are the things that we can look out for.