Gabriel Makhlouf: Publication of the Financial Stability Review 2022:2
Remarks by Mr Gabriel Makhlouf, Governor of the Central Bank of Ireland, on the
publication of the Financial Stability Review 2022:2, Dublin, 24 November 2022.
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Thank you for joining us today for the release of the second Financial Stability Review
(FSR) of 2022.
Since the release of our first Review in June, it is far clearer now that we have entered
a period of macro-financial adjustment. At that point, we were experiencing sharp
increases in inflation owing to the initial energy market effects of Russia's invasion of
Ukraine, which were exacerbating pandemic-related supply-demand imbalances. A
process of monetary policy normalisation was beginning across the world, and our
expectations were for weaker growth and elevated risks facing the financial system.
Since June, the true extent of that inflation, both in its broad-based nature, its intensity
and its persistence, has become more apparent. Monetary policy across the world has
responded more rapidly and with greater force than was expected at that point. At the
ECB, we have raised policy rates by a cumulative 200 basis points since June - and
will be going further - with many other central banks further advanced in the process.
Over the past decade, in a prolonged period of extremely low global interest rates, we
have been highlighting a wide variety of vulnerabilities that have been building in
pockets of the global financial system as diverse as non-bank financial intermediation,
leveraged lending, high-yield corporate bond markets, and more familiar overvaluations
in segments of equity markets. The extraordinary growth in crypto markets was perhaps
the most striking representation of the unsustainability of the risk-taking
environment. And as I (and others) have said before, people should only put their
money into crypto if they are prepared to lose all of it.
The past twelve months have seen an abrupt adjustment in the macro-financial
environment. Many asset prices have fallen sharply since the last Review, yields have
risen, and market volatility has increased substantially in the period. The fragility of
certain markets and its participants - particularly in the non-bank financial sector - was
made all too apparent by the gilt market disruption in the UK in September. Housing
markets across the world are now responding to rising interest rates, with early
indications of reductions in demand as potential borrowers face affordability challenges
due to higher borrowing costs.
As we and other central banks take the necessary steps to bring inflation back to target,
there are undoubtedly risks of further asset price falls and, more significantly, potential
episodes of disruption in segments of global financial markets. We must remain vigilant.
The vulnerabilities accumulated during the period of low interest rates, along with the
increasing interconnectedness of the modern financial system, means the full impact of
shocks in this period of high volatility is hard to foresee with certainty.
While global financial markets are fraught with risk, the inflationary challenges are being
experienced most acutely as shocks to people's real incomes, an erosion of their living
standards, and in difficulties servicing debts. The profit margins of businesses,
particularly the smaller businesses with less scope to pass on cost increases to
customers, will suffer due to the size of their energy bills and other costs as well as
falling revenues as customers reduce discretionary spending. Taken together, these
pressures are leading to significant downgrades in growth forecasts across the
globe. Domestically, we are no different, although for the moment our central
expectation continues to be for positive if lower growth and a robust labour market
through 2023.
Downside risks to the Irish macro-financial system, which we focus on in this Review,
have clearly risen since June. However, there are a number of reasons to believe there
is resilience in the system to meet these risks. While some mortgage customers are
experiencing directly the effects of our interest rate decisions, there is substantial
resilience across the mortgage market. Lower levels of indebtedness, a gradual shift
towards fixed rate borrowing, pandemic savings and substantial housing equity, are all
ensuring that the mortgage market as a whole has significant capacity to absorb
shocks. Even in the SME sector, where cost increases will severely tighten profit
margins for many, indebtedness has fallen continually for a decade, reducing the risk of
macroeconomic spillovers between the financial sector and the real economy.
The domestic retail banking sector will not be immune from the financial hardship
experienced by household and business borrowers. However, banks are a very
particular case during an episode such as this, seeing as their primary source of
profitability is the net interest margin, which typically rises with increases in interest
rates. Of course, a darker economic outlook - especially if associated with shocks to
the labour market or further shocks to real incomes - would change this, as the balance
would shift from the positives of greater interest earnings toward the negatives
associated with greater loan losses and provisions. Banks are also entering this crisis
with a strong capital position, providing significant capacity to absorb shocks.
For these reasons, we are proceeding as stated in June to increase the countercyclical
capital buffer from 0.5 to 1 per cent. The primary aim of our CCyB strategy is to build
resilience to allow the banking system to absorb future shocks. While downside risks
have clearly increased, we judge that continuing to build capital resilience at this time,
in the absence of these downside risks crystallising, remains the appropriate course of
action. Due to capital headroom levels and the profitability outlook, we believe that the
increase to 1 per cent can be absorbed without curtailing banks' ability to supply credit
to the real economy. This marks another step in our progress towards a target CCyB
rate of 1.5 per cent. Our guidance is that we expect to announce a move to the target
rate by mid-2023, in the absence of a material change in the outlook for the banking
sector.
I turn now to the third pillar of the Central Bank's macroprudential policy framework, the
non-bank sector. Today marks an important milestone, as we are announcing for the
first time macroprudential measures for non-banks. Non-bank financial intermediation
has experienced strong growth globally over the past decade, as highlighted by
previous Central Bank work in this area, as well as by other national and international
financial stability authorities. Ireland is host to the third largest fund sector in the world;
by the end of 2021, there were nearly 10,000 such entities, up from about 6,000 in
2016. And in the same period, asset values of these entities increased from
approximately €3 trillion to €5.6 trillion. In Ireland, a key link to the domestic economy is
through investment funds that invest in commercial property.
The Central Bank has outlined that macroprudential policies for these entities are
warranted as they are now significant investors in the commercial real estate
sector. The resilience of this form of financial intermediation matters more now for the
overall functioning of the Irish commercial property market than it did a decade ago.
Last November we consulted on a set of proposals to enhance the resilience of the
property fund sector in Ireland. Following this consultation process, today we are
announcing the final package of measures, namely the introduction of leverage limits
and liquidity management Guidance for Irish funds investing in Irish property. The core
of these measures remains intact from the consultation but we have considered
carefully the feedback we received and, in light of the current macroeconomic
environment, we have made appropriate adjustments. As I have said before, these
measures are being applied to ensure that investment funds are better able to absorb,
rather than amplify, downturns in the property market. This will, in turn, better-equip the
sector to continue to serve as a sustainable source of financial intermediation.
We believe that, globally, the non-bank financial sector should continue to be a top
priority for financial stability policy makers, with a broader set of macroprudential tools
required to manage the risks emanating from the sector appropriately. Global and
European coordination is critical and, with international efforts underway to develop the
policy framework, it is important to maintain momentum to strengthen the resilience of
the investment fund sector, mitigating the risks to investors, consumers and the wider
economy. At the Central Bank we are taking a two-pronged approach: implementing
macroprudential tools to safeguard resilience of the segment of the sector most closely
linked to the domestic economy, while at the same time engaging with our international
colleagues to develop and implement a macroprudential framework for non-banks
internationally.
We are ready to take your questions.