Klaas Knot: Financial stability risks and the FSB's work program
Speech by Mr Klaas Knot, Chair of the Financial Stability Board and President of De
Nederlandsche Bank, at the CFA Institute Systemic Risk Council, Washington DC, 26
April 2024.
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Thank you for inviting me once again. It's truly a pleasure to address such a
distinguished audience in this virtual gathering today. The similarities of goals between
the Systemic Risk Council and the Financial Stability Board are evident, and I look
forward to your insights and questions later.
What was on our minds when we last met in December 2022? At that time, we had just
seen the sharpest tightening of financial conditions since the 2008 global financial
crisis. We had concerns about elevated debt levels and interconnectedness between
banks and non-bank financial intermediaries amid high inflation and a deteriorating
growth outlook. In this context, I emphasized that financial stability could not be taken
for granted.
So where are we today? Well, these concerns have not vanished; they continue to
shape large parts of the FSB's work.
While inflation has somewhat eased, there is still some uncertainty about the
persistence of inflation.
What's more, market valuations remain elevated. The tight spreads and low volatility in
corporate bond markets are hard to square with rising defaults and upcoming higher
refinancing costs. Similarly, equity valuations appear stretched.
So, why is the market so upbeat?
Investors prepare for a soft landing, hoping to evade serious challenges in refinancing a
wall of maturing debt. Caution is warranted though. Delays in disinflation or negative
surprises in the future path of monetary policy may cause sudden repricing.
Moreover, geopolitical tensions add to the already uncertain environment and do not
seem to be properly reflected in asset prices. Perhaps because geopolitics is regarded
as an 'unpriceable' risk; it is zero or one, with an unpredictable probability distribution.
But be it unpredictable or not, the world has been far from dull: surprises may occur.
Market shocks could propagate. Volatility in the markets could trigger vulnerabilities in
some non-bank investors that are highly leveraged and face liquidity mismatches.
We also remain concerned about indebtedness.
Households, companies and sovereigns too show high debt levels at a time of declining
growth rates and high interest rates. Past interest rate hikes are still passing through to
borrowers and debt service challenges could still arise. Meanwhile, property prices
remain under pressure. For now, the vulnerability is mostly located in a subsector of
commercial real estate: downtown office space. We must watch closely if spillovers to
different subsectors emerge.
These debt servicing pressures could spill over to banks, leading to a worsening in
asset quality. While aggregate banking sector capitalization has been steady for several
years, low equity market valuations for some banks make it costly to raise capital. And
we still are vividly reminded that the March 2023 market turmoil suggests that deposit
runs can be faster than previously thought.
This is the backdrop that we are facing today. All in all, the outlook is improving but we
clearly have no space for complacency.
Lessons from the March 2023 banking turmoil
Just after my last visit, we had a sharp reminder of this. Let us zoom in on the series of
events of March 2023, as the lessons drawn continue to shape large parts of the FSB's
work.
The banking turmoil was the most significant system-wide banking stress since the
2008 Global Financial Crisis. The bank failures had largely distinct causes but triggered
a broader crisis of confidence in the resilience of banks, banking systems and financial
markets across multiple jurisdictions. The turmoil exposed fundamental shortcomings in
these banks' basic risk management of interest and liquidity risk. Unprecedented
factors played an important role too: the speed of deposit outflows was striking.
The FSB's review of lessons learned from the 2023 bank failures confirmed the
soundness of the international resolution framework. But areas deserving further
attention in the implementation of that framework were highlighted too: we need to
maintain momentum and advance the work on bank resolvability. We will focus on
public-sector backstop funding mechanisms, on better operationalizing a range of
resolution options, and on the impact of social media and digital innovation on
resolution and depositor runs. We are also doing analytical work to examine interest
rate and liquidity risk in the financial system.
Following the takeover of Credit Suisse by UBS, there remains just one G-SIB in
Switzerland so it is more important than ever that relevant options can be implemented
in a timely and credible manner. The Swiss government's recent steps to further
strengthen their TBTF framework echo the recommendations in our recent Switzerland
peer review, and if adopted would make the framework stronger. But additional steps
can be taken to further strengthen the TBTF framework in Switzerland.
Non-bank financial intermediation
We are also maintaining momentum in our work to address other vulnerabilities in the
financial system.
During my last visit we talked extensively about the NBFI sector. The growing
importance of NBFI for the financing of the real economy - including for capital flows to
emerging market and developing economies - underscores the need to effectively
assess and address vulnerabilities in this sector.
Enhancing NBFI resilience should ensure a more stable provision of financing to the
economy and reduce the need for extraordinary central bank interventions.
To do so requires that we contain liquidity imbalances. That means we should address
sources of elevated liquidity demand during stress, such as one-sided selling of assets
by investment funds or unexpectedly large margin calls. We should further keep a close
watch on excessive build-up of leverage, which may amplify adverse dynamics.
The FSB and standard setters have made progress in addressing these vulnerabilities.
We published recommendations for addressing liquidity mismatch in open-ended funds
in December; last week, we published a consultation report on liquidity preparedness
for margin and collateral calls; and we are currently working on policies to address
excessive leverage in NBFI. Furthermore, we work to identify NBFI data gaps and ways
to fill them.
It is now time to move forward and implement the recommendations and tools that are
needed.
Structural vulnerabilities
I do not want to take much more of your time before giving the floor back to you.
But before I do so, let me briefly discuss some other, more structural, vulnerabilities the
FSB is addressing.
All of what I discussed before, is happening in a financial world that is increasingly
interconnected through accelerating digitalisation. This increases the contagion
potential of a cyber or operational incident at a financial institution. Timely and accurate
information on cyber incidents is crucial for effective incident response and recovery
and to mitigate adverse impacts on financial stability. Building on our work to promote
convergence in cyber incident reporting, this year, the FSB is developing a common
format for exchanging incident reports. The wide adoption of AI presents opportunities
but is also associated with risks that need to be understood and managed
appropriately. We will deliver a report on the financial stability implications of AI to the
G20 later this year.
In 2023, the FSB reached a major milestone by publishing two reports with a revised
set of recommendations for global stablecoins and a new set of recommendations for
broader crypto-asset activities and markets. The recommendations are guided by the
principle of 'same activity, same risk, same regulation'. That is, crypto activities that
seek to perform equivalent economic functions to ones in traditional finance should be
subject to equivalent regulation, commensurate to the financial risks, including financial
stability risks, that they pose. Our recommendations set a global regulatory baseline
that should be applied to crypto-assets in any jurisdiction. Our focus this year is on
promoting their implementation. To ensure global consistency and minimise regulatory
arbitrage, it is crucial that the work on implementation includes jurisdictions from
beyond the FSB's membership that is based around the G20
Our work to address climate-related financial risks is also important. Not doing enough
to limit global warming or leaving it too late could have destabilizing effects on the
financial system, such as a spike in risk premia for assets exposed to climate risks and
or gaps in the insurance to cover losses caused by natural disasters. According to the
World Meteorological Organisation, 2023 was the warmest year on record that brought
intense heatwaves, floods and droughts. So this is not just a long-term financial risk or
tail event, but a current risk.
Our roadmap for addressing climate-related financial risks coordinates progress by
financial authorities across four pillars: disclosures, data, vulnerabilities analysis, and
regulatory and supervisory approaches. Last June saw a milestone with the finalisation
of the ISSB sustainability and climate disclosure standards. The standards are based
on the recommendations of the FSB's Task Force on Climate-related Financial
Disclosures. We now face the practical challenges of making sure that such disclosures
are comprehensive, reliable and are supported by proportionality and capacity-building
to assist emerging markets and developing economies. We are supporting the efforts of
the ISSBs and others on that.
Within the FSB, we are developing metrics to embed the analysis of climate-related
vulnerabilities into the FSB's overall Surveillance Framework. There is growing attention
on transition plans as a tool to provide a forward-looking view on business strategies to
achieve net-zero. We are assessing the relevance of these plans for financial stability.
Finally, there is also increasing attention among financial authorities to whether
biodiversity loss could also be a relevant financial risk and ways in which climate and
nature risks may reinforce each other. Indeed, the Brazilian G20 Presidency has asked
the FSB to conduct a stocktake of regulatory and supervisory initiatives on
naturerelated financial risks, which we will publish in July.
The FSB will continue work on these vulnerabilities and we will stay alert for new
vulnerabilities that potentially emerge.
Wrapping up
Now, for the sake of time, let me wrap up. One and a half years have passed since my
last visit. The outlook has changed greatly. What will be on our minds, one and a half
year from now, end of 2025? We cannot predict what is coming, but we will enhance
resilience in the financial system by addressing the vulnerabilities discussed today and
those that may emerge. We continue to do so. Now, I hope to hear more about your
views; I give back the floor to you.