Klaas Knot: Main risks to the financial system
Introductory statement by Mr Klaas Knot, President of the Netherlands Bank, prior to
the session with the Standing Parliamentary Committee for Finance, The Hague, 18
June 2024.
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I would like to thank the Chair and the members of the House of Representatives for
their invitation. Together with my colleagues from CPB and the AFM, I would like to
discuss with you the main risks to the financial system. I will do so on the basis of the
DNB's Financial Stability Report, which has been sent to you.
I will start by outlining the overall macroeconomic picture before specifically addressing
the risks of geopolitical tensions and the formation of blocs around the world
(geoeconomic fragmentation), as well as the resilience of Dutch financial institutions. On
both subjects I will highlight a number of recommendations for areas where national
governments and parliamentarians, such as yourselves, have scope to further improve
the financial system. Before moving on to these risks and recommendations, I will first
look back briefly at the past year, because it has been an eventful year for the global
financial system.
In the spring of 2023, the rapid transition from low to higher interest rates - in response
rising inflation - exposed vulnerabilities in the financial sector. In the midst of this
transition, a number of US regional banks and the systemic Swiss bank Credit Suisse
encountered severe difficulties for different, unrelated reasons, leading to resolution,
merger or acquisition. On my previous visit, I therefore drew a number of lessons from
the failure of these banks.
Fortunately, a year on, the situation seems to have improved. Inflation has fallen
substantially in both the Netherlands and the euro area. Dutch inflation, for example, fell
to 2.7% in May 2024. This substantial fall in inflation and the improved inflation outlook
in the euro area prompted the ECB to cut interest rates for the first time in early June.
At the same time, Dutch economic growth is expected to pick up in the year ahead,
spurring confidence in a "soft landing" for our economy. The Dutch financial sector has
also proved resilient, partly due to the reforms following the financial crisis. Confidence
in a soft landing for the economy is reflected among other things in historically high
share prices and less tight financial conditions. As a result, the soft landing is initially
good news for financial stability.
Looking ahead, however, there are risks to the economy and our financial system, with
uncertainty being a central concern. First, inflation might start rising again, for example
due to continued strong wage growth. It is therefore important to base further monetary
decisions on incoming data rather than pre-empting future developments. At the same
time, various factors, such as rising geopolitical tensions, are generating greater
uncertainty, which could lead to financial market corrections and higher risks for
financial institutions. High share prices make financial markets vulnerable to corrections
and a downturn in sentiment. For instance, political uncertainty in France last week
caused a correction in French government bonds, which also spread to bank shares in
France. These corrections are taking place against the backdrop of geopolitical
tensions and geo-economic fragmentation. Price falls prompted by geopolitical tensions
have so far been short-lived, but I do wonder whether investors are fully pricing in the
risks of geopolitical tensions.
This is one of the reasons why I would like to focus particular attention on the risks of
heightened tensions and geo-economic fragmentation. Geo-economic fragmentation is
not new but is part of a gradual global shift. The fragmentation of the global economy
into blocs has increased in recent years, leading to more trade restrictions and
sanctions. At the same time, geopolitical tensions have increased. At first sight, Dutch
financial institutions appear to have only limited sensitivity to geopolitical tensions given
their small corporate loan and investment portfolios exposed to countries that are
geopolitically remote from the Netherlands. Geo-economic fragmentation may
nevertheless have an indirect impact on these portfolios, because Dutch firms also use
imported goods in their production processes and trade restrictions disrupt these value
chains. Geopolitical tensions also increase cyber risks worldwide and reduce the
effectiveness of multilateral fora. For example, blocking and tensions hampers effective
crisis response as during the COVID-19 pandemic, but also effectively tackling global
challenges such as the energy transition.
As well as the need for greater awareness and analysis of these risks by financial
institutions and policymakers, I also see scope for action by national governments. At a
time when there is high external pressure from other regions of the world, a
wellfunctioning European single market reduces Dutch dependence on other regions. As an
open economy, the Netherlands has benefited from this more than other countries.
After all, the European internal market acts as a cushion for shocks originating from
outside Europe, thus providing economic security. In my view, this requires a European
market that is as open as possible to market forces and competition. Further
development both of the internal market and of the capital markets union and the
banking union is necessary to achieve this. The European market offers scope for
further integration, especially in the services sector. National governments have a vital
role to play in driving progress and can draw on lessons from European banking
supervision.
Given the heightened uncertainty, which is partly due to fragmentation, it is important
that Dutch financial institutions remain resilient. Dutch banks, pension funds and
insurers are in a good position, partly thanks to reforms following the financial crisis. In
all sectors, the transition to higher interest rates has had a positive effect and prudential
ratios are above the required levels. Although the transition to higher interest rates
enabled banks to generate high profits in 2023, the higher rates may also negatively
impact the quality of outstanding loans and investments. Higher interest rates and lower
economic activity increase the probability of default among firms and households. So
far, we have not seen this affecting banks, although the first signs of deterioration are
visible. The credit quality of corporate loans secured on commercial real estate has
deteriorated, partly because this market is under pressure. One solution to this is for
banks to use part of their high earnings to set aside additional provisions. Insurers and
pension funds are also now investing more in firms. Specifically, there has been growth
in private equity investments and loans to high-risk firms, in other words private credit.
Private credit broadens the range of credit available to firms and reduces their
dependence on banks, which may contribute positively to the stability of the system.
Private credit is attractive to investors because of the higher returns. But higher returns
are accompanied by risks, and the same applies to this shift in lending. Specifically in
the case of private credit firms, risks additionally ensue from their inherently low
transparency, given that they typically lack external credit ratings. Financial institutions
must therefore maintain sound risk management and monitor potential
interdependencies.
Given the heightened uncertainty, it is important to have an appropriate
macroprudential toolkit for financial institutions in Europe. During the COVID-19
pandemic, we saw the value of banks having releasable capital buffers. At DNB, we
have now introduced these additional capital buffers, but these lessons could be even
more firmly embedded in the European toolkit, as recommended in the Ministry's study
on the resilience of banks. More consistent use of instruments is also desirable for a
more level playing field among European banks. In the case of non-banks, this
macroprudential toolkit is still in its infancy, but pension funds, insurers and investment
funds are now playing a greater role in the financial system. Improvements to the
framework are therefore desirable, particularly for investment funds. This concludes my
introduction.