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“We are not totally off the hook”

Interview with Klaas Knot, Chair of the Financial Stability Board and President of De Nederlandsche Bank, Supervision Newsletter

18 May 2022

The global financial system weathered the pandemic fairly well, but now there is another unforeseen event: war in Europe, with financial and economic sanctions, restrictions on trade. How will this impact financial stability?

Russia’s invasion of Ukraine has profoundly changed the global economic and financial market backdrop. Uncertainty around the outlook for a sustained and broad-based recovery from the COVID-19 pandemic has grown and inflationary pressures have risen. So far, global financial markets have been functioning in an orderly manner and no major financial institution has shown signs of distress, notwithstanding bouts of high volatility and large price swings in commodity markets.

Yet global financial stability cannot be taken for granted going forward. Currently, the most important direct impact on the global economy is the sharp rise and large fluctuations in commodity prices. This not only affects oil and gas, but also many metals and agricultural products. A related issue is the unexpectedly large margin calls for commodity derivatives, which can put strain on the market and cause spillover effects. In addition, the current leverage in the non-bank financial sector could amplify adverse developments and lead to periods of stress, such as the one we experienced during March 2020. Finally, cyber risks remain a key area of concern.

The Financial Stability Board (FSB) is responding to the current financial stability challenges in two main ways. One is intensified monitoring of current market developments and emerging vulnerabilities, with a focus on the resilience of critical nodes in the global financial system. The other is in-depth analysis and assessment of specific potential vulnerabilities, with a particular focus on commodity markets, margining and leverage.

The FSB is at the centre of a multilateral approach to financial stability. Some say the current events could fundamentally change the geopolitical landscape. Could this also have a lasting effect on the global financial system?

There is clearly a great deal of uncertainty about the future geopolitical landscape and whether this will change fundamentally or not. It is difficult to speculate on developments in this crisis and the long-term effects on the global financial system.

However, what this crisis does highlight is the importance of global cooperation. The international reforms that were initiated by the G20 after the global financial crisis of 2008, and coordinated by the FSB in subsequent years, have been crucial in strengthening our global financial system. In particular, banks and financial market infrastructures have been more resilient in recent years and were better able to absorb rather than amplify the different macroeconomic shocks, including the onset of the COVID-19 pandemic. Any new challenges that may arise will also require a joint international response. Moreover, some key structural challenges within the financial sector, like digitalisation, climate change and crypto-assets, are inherently cross-jurisdictional by nature.

The FSB will, therefore, continue to fulfil a coordinating role to promote financial stability, avoiding any sudden change in the integration of the global economy and financial system.

Banks were able to absorb the March 2020 turmoil caused by the pandemic, but non-bank financial institutions amplified the stress. What needs to be done to make the NBFI sector more resilient?

The March 2020 episode provided important lessons for the resilience of the global financial system. In particular, the financial market turmoil showed that our NBFI-specific reform efforts following the 2008 global financial crisis were not sufficient. The episode demonstrated how systemic risks within the NBFI sector can evolve and how liquidity risks in different markets can be amplified by interactions within the NBFI ecosystem and interconnectedness with banks.

Our NBFI work programme to date has focused on assessing and addressing vulnerabilities in specific areas that may contribute to the build-up of liquidity imbalances and their amplification. These include money market and open-ended funds, margining, bond market structure and liquidity, and cross-border dollar funding.

We will use the insights from these areas to develop a systemic approach to assessing and addressing risks in NBFI and a policy toolkit that is effective from a system-wide perspective. Our upcoming conference, in June, is an important input into this work.

But we are not totally off the hook in terms of the banking sector either. Our lessons learned report noted that the functioning of bank capital and liquidity buffers may warrant further consideration. Some concerns about excessive financial system procyclicality also remain. Recent experience has underscored the need to ensure that the core banking system remains resilient to stress and is able to support financing to the real economy as we progressively unwind support measures – so implementing the final Basel III reforms in a full, timely and consistent manner is a key priority.

The use of digital financial services has increased since the onset of the COVID-19 pandemic. What are the challenges in ensuring we harness the benefits of digital innovation, particularly in payments?

Digital innovation offers opportunities for more efficient and inclusive finance, but also presents new risks to financial stability. The use of new technology is one important element of the ongoing work to enhance cross-border payments. The aim of this initiative is to bring about cheaper, faster and more transparent and inclusive cross-border payment services, including remittances, for the benefit of citizens and businesses worldwide.

A key area of our work is focused on the importance of a level playing field between banks and non-banks to ensure entities involved in the same business activities and offering the same payment services are subject to the same or similar rules and supervision (“same activities, same risks, same rules”). There is a concern that non-bank entities involved in cross-border payments may be less likely (or be seen to be less likely) to have appropriate controls in place, for example for AML/CFT checks, leading to blind spots about potential risks within the financial system. An example would be concerns about consistent supervision of non-bank remittance service providers.

The FSB will be looking at this level playing field and aligning standards proportionally to the risks posed, while at the same time ensuring that application of regulation and supervision to non-banks takes account of the risk they pose versus banks, as they aren’t the same.

How much of a risk is cyberwarfare for the financial system?

Cyberwarfare is certainly a risk and the adoption of new technologies and accelerated digitalisation during the pandemic have made cyber risk, more broadly, a priority. While no major cyber incidents have so far been reported in the financial system, the number of cyber attacks has increased.

There is much international work on enhancing cyber and operational resilience by both authorities and financial institutions. These efforts were fuelled by the COVID-19 pandemic, which underscored the need to have effective response and recovery plans as well as business continuity plans in place before an incident occurs. In October 2020, the FSB published a toolkit of effective practices for organisations to draw on in responding to and recovering from a cyber incident, which some jurisdictions have reflected in their supervisory guidance. Recognising that information on cyber incidents is crucial for effective actions and promoting financial stability, we are working on achieving greater convergence in cyber incident reporting. The goal is to have a common set of information related to cyber incidents that authorities could share across borders and sectors.

We are closely collaborating to develop a better understanding of interconnections in the financial system, including dependencies on third-party providers and supply chain risk. In this regard, the FSB is currently working on developing supervisory expectations for financial institutions’ dependence on critical service providers.

The FSB released its “Roadmap for addressing climate-related financial risks” last year, and climate risks are now being incorporated into prudential regulation and stress testing. What are the major challenges for implementation?

Climate-related financial risks remain a priority for the FSB, because of its global nature and direct and indirect effects on financial stability. The recent invasion by Russia in Ukraine and its subsequent impact on commodity prices underline the importance of transitioning away from fossil fuels. We are making progress this year on the four building blocks of our roadmap: i) disclosure, ii) data, iii) vulnerabilities analysis and iv) regulatory and supervisory practices and tools.

On disclosure, we welcome the recent publication of the new draft reporting standards on sustainability by the International Sustainability Standards Board. In addition, we are continuing our work on data, by closing previously identified data gaps in a consistent manner. This includes data on exposures of financial institutions and forward-looking metrics of climate risk, translated into quantifiable, financial impact. A new working group within the FSB will start developing methods to enhance our vulnerabilities assessment to better understand the financial vulnerabilities from climate change. We will develop analytical methods to assess transmission channels and feedback loops of climate-related shocks through the financial system. Finally, we will present a report to the G20 on current practices and experiences with the design of robust supervisory tools.

Indeed, the design of robust supervisory tools, such as climate stress tests and scenario analysis, is key. To this end, we have recently issued a consultation on regulatory and supervisory practices and tools, with a final report due in October. We will also publish, by the end of the year, a report synthesising outputs of scenario analyses done by jurisdictions so far.

On these issues, we are working closely with other international organisations and standard-setting bodies and coordinating our work with the G20 Sustainable Finance Working Group. For example, we will develop scenario analysis together with the Network for Greening the Financial System (NGFS). Engagement with the private sector, for example through the Glasgow Financial Alliance for Net Zero (GFANZ), will also be critical.

What can be done to prevent so-called greenwashing?

Reliable corporate disclosures are important. Disclosures on climate-related risks provide transparency to financial markets on how the risks arising from climate change are identified, assessed and managed by financial firms. They are a critical tool in the fight against greenwashing.

The FSB published a report on promoting climate-related disclosures in July 2021. It calls for an acceleration of progress in the implementation of climate-related disclosures based on the Task Force on Climate-related Financial Disclosures (TCFD) framework. Our aim is to promote comparable and consistent financial information on the impact of climate change that can be taken into account for investment, lending and insuring decisions. In this context, the International Sustainability Standards Board (ISSB), has just published two draft reporting standards for consultation, building on the TCFD recommendations. These ISSB standards on general sustainability-related reporting and on climate-related reporting will provide a global baseline. The FSB will be developing a further report later this year which will provide updates on the progress made by the ISSB and International Organization of Securities Commissions (IOSCO), as well as jurisdictions, in the implementation of climate-related disclosures.

Our July 2021 report also sets out recommendations, such as for authorities to consider third-party verification mechanisms on climate disclosures. External assurance would further contribute to reliability of information over climate-related disclosures.

The FSB has warned that globally used crypto-assets could pose a risk to financial stability and is working on a global standard for digital assets. Will this eventually lead to regulation and supervision of crypto-assets?

Crypto-assets are a priority on the FSB agenda. The recent fast pace of growth, underlying structural vulnerabilities and increasing interconnectedness with the traditional financial system, have increased financial stability risks as reflected in our recent report on the assessment of risks to financial stability from crypto-assets.

Against this background, we are working on the regulatory and supervisory implications of unbacked crypto-assets, including the actions FSB member jurisdictions have taken, or plan to take, to address any associated financial stability threats. Examining the regulatory gaps and challenges that may exist, including those that arise from the cross-border nature of crypto-assets, will be a key element of this work. We also issued recommendations, in October 2020, for the regulation and supervision of so-called “global stablecoins”. Building on these recommendations, we are working, in close cooperation with standard-setting bodies, to identify and close any regulatory gaps. And we are deepening our analysis of the financial stability implications of decentralised finance – DeFi – which is rapidly evolving and not well understood.

Our ambition is to achieve global convergence to avoid regulatory arbitrage and fragmentation. We are already seeing divergence across jurisdictions as individual countries develop their own approaches. But this is not unhelpful. Identifying best practices will help us improve the quality of regulation.

So, while it is challenging to keep pace with the rapidly evolving crypto-asset ecosystem, there is a clear recognition amongst our members that we need to move even faster. The FSB has the agility and the holistic perspective to address financial stability risks from crypto-assets.


European Central Bank

Directorate General Communications

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