Klaas Knot: Rebuilding resilience - the financial system after the
Covid crisis
Keynote address by Mr Klaas Knot, President of the Netherlands Bank, before the International
Symposium of the National Association for Business Economics, 11 May 2021.
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It's an honor to speak at this International Symposium of the National Association for Business
Economics. I think we all share a fascination for economics here. Having worked in academia,
the IMF, the Dutch finance ministry and the central bank, I live and breathe economics. So I feel
very much at home here.
"My friends, I want to talk for a few minutes with the people of the United States about banking."
So began, on March 12, 1933, the first of about thirty fireside chats that president Roosevelt
delivered over the radio. It was eight days after his inauguration. He had spent his first week
coping with an epidemic of bank closures that affected households in every state. Three days
after closing down the entire American banking system, Congress passed the Emergency
Banking Act. Roosevelt used it to create federal deposit insurance when the banks reopened.
That Sunday night, on the eve of the end of the bank holiday, Roosevelt spoke to a radio
audience of more than 60 million people. He told them in clear language "what has been done in
the last few days, why it was done, and what the next steps are going to be." The result was a
remarkable turnaround in the public's confidence.
Since this, almost iconic, banking crisis of 1933, we have seen financial crises in all shapes and
sizes throughout the world. And now, the Covid crisis poses yet a new challenge to the financial
system. How has the financial system stood up to this latest test? And what can we learn from it
for the future? These are the questions I want to address with you today. First, I will reintroduce
you to the concept of systemic risk. I will argue that this has been the primary ingredient in
financial crises throughout history, from 1933 to the 2008 global financial crisis. I will then
discuss what governments and regulators have done to strengthen the financial system. I will
explain how the financial reforms of the past ten years helped to cushion the impact of the Covid
crisis, especially in the banking sector, but that systemic risk revealed itself in other parts of the
financial system. I will end by discussing how we can address these new vulnerabilities in the
financial system and strengthen its overall resilience.
Let us start with systemic risk. Systemic risk can be described as the risk that an initial shock
may spread through the system to such an extent, that otherwise healthy and solvent financial
firms and markets are severely affected. It can even lead to the breakdown of the entire financial
system, severe economic disruption, and great economic hardship for companies and
households.
The financial system is more vulnerable to systemic risk than other sectors of the economy.
Academic literature gives three main reasons for this.
First, many financial institutions are characterized by a liquidity mismatch between assets and
liabilities. For example, banks traditionally take deposits that can be withdrawn at very short
notice, and they provide long term loans to companies. If, for some reason, depositors want to
withdraw their money all at the same time, the bank does not have sufficient reserves to pay out
everyone. So the stability of the financial system is highly dependent on confidence. In the case
of banks, it is the confidence of depositors in the value of the loan book and confidence that other
depositors will not withdraw their money. Importantly, this type of dynamic is not exclusive to
banks, as we will see later on.
Secondly, participants in financial markets are interconnected by a complex network of
dependencies and exposures. Interconnectedness is inherent in any mature financial system. It
allows financing to flow, and provides for diversification and risk-sharing. Yet, imbalances or
shocks in one sector can quickly pass through to the rest of the financial system.
The third factor that makes the financial sector particularly susceptible to systemic risk, is the
intertemporal nature of financial contracts. For example, if you invest in a company's stock, you
have expectations about the cash flows that stock will generate in the future. Expectations that
may or may not materialize. Changes in expectations about future cash flows can lead to sudden
asset price fluctuations, like stock market crashes, resulting in financial losses. If you combine
that with leverage, the consequences may be unpleasant.
Liquidity mismatch. Interconnectedness. The intertemporal nature of financial contracts. These
three elements make the financial system more vulnerable to systemic risk than other sectors of
the economy.
We saw the first element at work during the 1933 banking crisis. A collapse in confidence in the
banks, and expectations about the behavior of other depositors led to a run on the banking
system. The image of people queuing up in front of their banks hoping to collect their savings
lives on forever, even in movies. Who can forget the American Christmas classic It's a
Wonderful Life, when Jimmy Stewart and Donna Reed used their honeymoon savings to keep
the bank open.
We have seen the three elements of systemic risk at work many times since then. For example,
during the Asian crisis of 1997, the Russian default crisis of 1998, and of course the global
financial crisis of 2008. Having been a witness to all these three crises in the course of my
professional career, I must say each one of them was a fresh eye-opener.
Throughout history, financial policies have aimed to contain systemic risk and build resilience in
the financial system. For example, after the financial crisis of 1907, the Federal Reserve was
established to act as a lender of last resort. And after the banking crises of the 1930s, we saw
the birth of capital requirements and deposit insurance, in the US and elsewhere.
The reforms after the 2008 Global Financial Crisis can be seen in that historic context. Capital
and liquidity requirements for banks were raised to increase their loss-absorbing capacity and to
withstand an outflow of funds. Capital requirements were raised even further for highly
interconnected global banks. And counterparty credit risk was reduced by increasing margin and
collateral requirements and by establishing central clearing counterparties.
Despite this historic tradition, there was also something new about the post-2008 reforms. This
time the reforms were a truly international effort. The G20 nations established a Financial Stability
Board that coordinated the development of new policies. The FSB also encouraged these
policies to be implemented in a coherent manner across sectors and countries. The FSB was
also given the task of monitoring the global financial system for new weaknesses and springing
into action at short notice once a new crisis hit. Since modern financial markets do not stop at
national borders, that was a very important step. We still reap the benefits from this today, and I
will discuss this aspect later on.
So we have identified the elements of systemic risk and how this has shaped financial crises and
policy responses. Let us now look at how the financial system has weathered the Covid storm.
First and foremost, the bold policy response by governments, central banks and supervisors,
helped maintain global financial stability and sustain the supply of credit to the economy. Also, the
global financial system, at least its core parts, is more resilient than it was ten years ago. This is
largely due to the financial reforms in the wake of the 2008 global financial crisis. Thanks to these
reforms, banks have been able to absorb the Covid shock. They have continued to provide credit
to the economy at a time when it is most desperately needed. Although Covid-related corporate
insolvencies will no doubt hit their loan books pretty hard, it seems banks will also be able to
continue supplying credit in the near future.
I really want to emphasize this, because it offers a valuable lesson. Many of you probably recall
the tough discussions we had only a few years ago about the cost of the rising capital
requirements for banks, and the possible negative impact on credit supply. But if we had not
done this, governments would now have to deal with a crippled banking sector in full deleveraging
mode, on top of an economy starved of credit. We would have had a crisis within a crisis. In
other words: building resilience into the financial system in good times may seem expensive, but
over the long run it is the most cost effective thing to do.
So the banking sector has withstood the Covid stress test pretty well. However, you and I know
that not everything went smoothly in the financial system, as events in March last year showed.
Let us go over some of the key developments that happened.
As countries went into their first lockdown, and the scale of the Covid impact became apparent,
investors and corporates fled for safety and liquidity. You probably remember how firms
everywhere tried to tap the capital markets. Money market funds experienced significant
outflows. And some open-ended funds faced large redemptions. Initially, yields on risk-free
assets fell rapidly at the end of February and early March due to the flight to safety. However, this
became an abrupt and disruptive 'dash for cash' in mid-March, as investors demand for cash
and near-cash assets rose sharply. This resulted in selling pressure on usually safe and liquid
assets such as government bonds. Risk-free yields began to rise sharply and the financial
conditions facing major economies tightened. Looking at a Bloomberg screen during that period
sometimes felt like being back in September 2008.
Central banks had to take extraordinary measures to stabilize markets: asset purchases, liquidity
operations, and backstop facilities for specific financial entities. While in 2008 central banks had
to bail out the banks, this time they had to bail out a number of financial markets.
Some of this may have been inevitable given the enormity of the economic shock. But
weaknesses in the non-banking part of the financial system made matters worse. The FSB
carried out a thorough review of the March market turmoil. It was published last November and I
recommend you read it. As the review showed, liquidity mismatch, interconnectedness, and
sudden changes in expectations, those systemic risk factors that I mentioned earlier, again
played a key role in propagating the initial shock.
It seems that over time, investments in money market funds and open-ended funds came to be
seen by investors as just as liquid and safe as cash. As doubts started to grow about the ability
of these funds to liquidate their assets on demand, investors wanted to be at the front of the
redemption queue. In other words: as it emerged that these funds had a liquidity mismatch
without the buffers to sustain it, a stampede was triggered that was in essence not so different
from the classic bank runs we saw in the 1930s.
Next, the March events highlighted the dependence of the system on readily available liquidity. If
liquidity strains emerge, in money market funds and open-ended funds, through margin calls and
in core bond markets, vulnerabilities spread quickly through the financial system.
One of the important post-crisis reforms I mentioned earlier, was the greater use of margining
and central clearing through the CCPs. Thanks to this, the market stress did not result in
widespread concerns about counterparty risk - as we saw in 2008. But violent price swings in
financial markets translated into margin calls that may have been larger than expected. This put
sharp liquidity pressure on those on the wrong side of derivatives exposures, adding to demand
for liquidity in the system.
All this should not surprise us. Money market funds already played a crucial role in propagating
the initial shock of Lehman's collapse in 2008. Maybe you remember the speech that Paul
Volcker gave at a NABE conference in 2013, when accepting the Lifetime Achievement Award for
Economic Policy. On that occasion he expressed his concern about the weaknesses in the
regulation of money market funds.
With the financial reform agenda after 2008 being heavily focused on banks, and much less so
on non-banks, vulnerabilities in the financial system moved from the banking sector to the
nonbank financial sector. This is what I call the 'waterbed effect'. Pressing down on one end of the
financial system will cause risks to pop up elsewhere. And, indeed, since 2008 non-bank
financial intermediation, or NBFI, has grown much faster than bank intermediation. It now
accounts for about half of all financial assets worldwide.
So, whereas in the aftermath of the previous crisis the emphasis was very much on the banks,
we now have some catching up to do when it comes to reducing systemic risk in non-bank
financial markets. Where there is a liquidity mismatch, a complex network of exposures, and
potentially sudden price swings, it is key we have buffers, flexibility in regulation and safety valves
in the system, to contain systemic risk. Financial institutions need buffers to absorb losses and
liquidity shocks. Regulation needs flexibility in order to allow institutions to use these buffers. And
the system needs safety valves, like margining, to prevent too much risk pressure being built up.
In July, the Financial Stability Board will publish a consultation report with proposals to improve
the resilience of money market funds. This work will also consider the relationship between these
funds and short-term funding markets. We need to look in particular at whether investors
conceive money market funds as equivalent to deposit accounts. And if so, whether money
market funds have the resilience to meet the consequent liquidity demands in the event of severe
stress. This work will soon be followed by ongoing efforts focused on other open-end funds,
margining and bond market structure, and liquidity. The FSB also continues to advance work to
improve CCP resilience and resolvability.
Maintaining a strong global financial system requires a global approach. Here, we have one big
advantage. We can fall back on a framework of international cooperation that has been tested
and proven to work. The Financial Stability Board has coordinated important financial reforms in
the past and will continue to do so in the future. Indeed, coordinating the post-Covid reform
agenda to rebuild financial resilience will be central to its work well into next year.
Almost ninety years have passed since that American president with Dutch ancestral roots first
took to the airwaves to reassure the public. Yet today the challenge to contain systemic risk and
keep the financial system resilient is as important as ever. The policy tools we have at our
disposal are now much more powerful. But the complexity and dynamism of the financial sector
are also far greater. It's a job that's never done. So let's make use of the architecture for
international cooperation that we have built up. And ensure the post-pandemic financial system is
resilient, and stays strong enough to meet future challenges.
Thank you.