Category Archives: Financial stability

2020

It’s this time of the year. This post recalls events of 2020. It has been such an unusual year, so different from what we expected. Luckily, there seems to be light at the end of the very long and dark tunnel, and – I hope – that 2021 will be considerably more joyful than 2020.

2020 started out so well. The roaring twenties and all that. Wuhan was a city I had not heard of, corona a beer people tell me is best served ice-cold with a slice of lime (I do not drink beer, tough I do enjoy wine), and social distancing words we would only get to know too well. Today, we know that Wuhan is a Chinese city with more than eleven million inhabitants and a marketplace where it presumably all started, corona also means something terrible, and social interaction is an activity we have come to miss so dearly.

At the time of writing, app. 75 million cases of corona/COVID-19/SARS-CoV-2 have been confirmed globally and app. 1.7 million people have passed away because of corona. Most countries have been in lockdowns, many still are (again), and the social and economic costs of the crisis have been enormous.

I started this blog in April 2020. This had nothing to do with corona. I had wanted to set up a blog for some years (people ask me where I find time for this, and I really do not know, but seemingly I simply like writing economic stories and analyses). Starting the blog in April this year, however, naturally implied that many of the blog posts have dealt with various economic and financial aspects of the pandemic. In this post, I will review some of the learnings from 2020.

The worst recession on record. With the highest growth rate on record

The recession started in February 2020 in, e.g., the US. Initially, it was caused by a supply shock: lockdowns were imposed and firms could not sell their goods and services and households could not go shopping. In April, when the IMF released their Spring Outlook, they labelled it “The Great Lockdown”. This was a suitable label. The IMF also noted that “This is a crisis like no other” and that “many countries now face multiple crises—a health crisis, a financial crisis, and a collapse in commodity prices, which interact in complex ways”. As unemployment and bankruptcies increased, households and firm got nervous, and demand suffered, too.

The path of economic activity has been highly unusual. This graph shows the quarterly percentage changes in US real GDP since 1947:

Quarterly percentage changes in US real Gross Domestic Product. 2020 encircled.
Source: Fed St. Louis Database

2020 is very much an outlier. On average, from 1947 through 2020, real GDP has grown by 0.8% per quarter. Until 2020, quarterly growth had never exceeded 4%. Economic activity had never contracted by more than 2.6%. Then came the Great Lockdown. During the second quarter of this year, economic activity contracted by 9%. This is almost four times more than the otherwise worst contraction on record. In this sense, it was the worst recession ever.

It has also been the weirdest recession ever. During this recession, we have also witnessed the highest growth rate on record: economic activity expanded by 7.4% during Q3. This is twice as much as the otherwise highest growth rate on record.

This puzzling feature of the recession led me wondering what a recession really is (link). I expressed sympathy with members of the NBER Recession Dating Committee. They face a particularly difficult task this year. Should they conclude that we had one V in spring, with the recession ending in late April, and then a new V now, i.e. two separate Vs (VV), or that we have had one long recession with a double dip, i.e. a double-V (W)? Does it make sense to call it a recession when we experienced the fastest rate of growth in economic activity on record? If you conclude that the economy cannot be in recession when it expands at its fastest growth rate ever, then you must conclude that the recession ended during Q2. But, the NBER Recession Dating Committee has not called the end of the recession yet, i.e., officially, the recession is still ongoing.

You may ask why it is important to know whether the recession ended in April or whether it is still ongoing. The development in economic activity is what it is, whether we call it recession or not. It is important because a “recession” is such an important concept in economics. We inform the public, business leaders, students, and others about the characteristics and consequences of recessions. If a recession can contain the by-far strongest expansion of economic activity on record, we need to change our understanding of recessions.

The very unusual behavior of economic activity during Q2 and Q3 caused very unusual, and scary, developments in unemployment and related aspects of economic activity. This graph shows the monthly change in the number of unemployed in the US:

Monthly changes in the number of unemployed in the US. Millions. 2020 encircled.
Source: Fed St. Louis Database

During March, unemployment in the US increased by 16 million. Again, this was beyond comparison. Until March 2020, the number of unemployed had never increased by more than one million over one month. In March 2020, it increased by 16 million.

As the virus contracted during summer, unemployment fell. There has never been as fast a reduction in the number of unemployed as the one occurring during this summer. In May, the number of unemployed dropped by more than three million. Until May 2020, the number of unemployed had never fallen by more than one million over one month. In May 2020, it fell by more than 3 million. So, within a year, we have had the strongest-ever increase in unemployment, but also the largest-ever fall in unemployment. By far.

Such dramatic events happened all around the world. I documented this here (link) and here (link).

Inspired by these events, I did something admittedly nerdy. I calculated the probability that we would experience events such as these, given the historical data (link). I found the unconditional likelihood that we could see the increase in newly registered unemployed that we saw in spring to be 0.97 x 10^(-841). This is a zero followed by 841 zeroes and then 97. For all practical purposes, this is a zero-probability event. But it did happen. It was just very, very unusual.

The stock market

I use some of my time (a significant part, by the way) to try to understand the stock market. This has not been a straightforward task this year.

Today, the global stock market is 13% percent above its January 1 value, the US stock market is 18% higher, and the Danish stock market 29% higher (MSCI country indices). Given that we have been through the worst recession ever, and that the recession is not officially over yet, this is not what one would have expected prior to the events.

Then, on the other hand, in hindsight it is perhaps not so strange. The recession has been the worst on record, yes. But, we have also had the fastest growth in economic activity on record. I argued (link) that if we imagine that the recession ended in late April, when economic activity bottomed out, the behavior of the stock market fits perfectly well with the historical evidence on the behavior of the stock market.

Central banks have certainly played their role, too. When markets melted down in March, central banks intervened heavily. In contrast to the financial crisis of 2008, it was not banks that were in trouble this time, but firms. Firms could not sell their goods and services due to the lockdown. The limitless purchases of government bonds that central banks have become used to during and after crises thus probably did not do much good (evidence came out that central bank purchases of government bonds are less effective than we are often told, link ). What turned things around, instead, was the announcement on March 23 that the Fed would facilitate credit to firms (link). This was a new policy tool. It led to a complete turnaround of events. I produced this graph (I still think it is a supercool graph): 

Difference between yields on ICE BofA AAA US Corporate Index and 3-month Treasuries (Left hand axis) as well as the SP500 inverted (Right hand axis). Both series normalized to one on January 2, 2020. Vertical line indicates March 23.
Source: Fed St. Louis Database

The graph shows how the stock market lined up with credit spreads. Firms were suffering, and their credit spreads started widening, in late February. The stock market suffered. The Fed announced it would provide credit to firms on March 23. Credit spreads tightened. The stock market cheered. The graph summarizes how the Fed saved credit and equity markets. And, strikingly, the Fed did so by merely announcing they would intervene. Up until today, the Fed has not intervened a lot. In this sense, it was a “Whatever it takes moment of the Fed”.

It should be mentioned that the Fed announced other initiatives on March 23, too, such as the Main Street Lending Program (link) and the Term Asset-Backed Securities Loan Facility (link). The Corporate Credit Facilities were the ones that directly targeted corporate bonds, though. Due to the nature of this crisis, the stock market lined up with credit spreads during this crisis, as the above graph reveals, emphasizing the importance of the announcement of the Corporate Credit Facilities.

Eurozone troubles, or rather no Eurozone troubles

The fact that we have not had to talk a lot about the risk of a Eurozone breakup since summer has been a positive surprise. In spring, there was talk about the risk of a Eurozone crisis. Like so often before, Italian sovereign yields rose relative to German sovereign yields. There was reason to be anxious. I argued that “Some kind of political solution at the EU level would be needed” (link).

This we got. The European Union agreed on a “Recovery and Resilience Facility” (link) that includes both loans and grants. EU has moved one inch closer towards a common fiscal policy. Who will pay is not clear, but EU has shown solidarity. I believe this is positive. At the same time, the European Central Bank continued its interventions and bought a lot of Italian debt. This has kept yields on sovereign bonds low. Here is the Italian-German yield spread during 2020:

Italian yield spread towards Germany. Ten-year government bonds. Daily data: January 2, 2020 – December 21, 2020.
Data source: Thomson Reuter Datastream via Eikon.

Italian yields have been falling continuously since summer, when the EU agreed on its recovery plan. It is positive that we have not had to discuss Eurozone troubles. We have had so many other troubles. Whether this means that we do not have to discuss Eurozone troubles again at some point, I am less sure. But, that is for another day.

Banks have been doing OK

The risk of a Eurozone breakup did not materialize. Another risk that did not materialize was the risk of systemic bank failures. This is positive as well, as economic activity suffers so much more when banks run into trouble and credit consequently does not flow to its productive uses.

During the worst days in March, stress in the banking system intensified. For instance, the spread on unsecure interbank lending increased relative to secure lending:

The TED spread. Difference between 3-Month USD LIBOR and 3-Month US Treasury Bills. Daily data: January 2, 2000 – December 14, 2020. 2020 encircled.
Data source: Fed St. Louis Database.

Stresses lasted only a few days, though. During the financial crisis in 2008, on the other hand, spreads remained elevated for much longer. This time, trust in the banking system was quickly reestablished.

I think I am allowed to claim that this was one of the predictions I got reasonably right. In autumn 2019, when nobody knew about the upcoming crisis, I wrote a policy paper on the Nordic financial sector. It was presented in December 2019 and finally published in June this year (link). I argued that banks are safer today, compared to 2008. Some doubted my conclusion and said, “just wait until the next crisis, then you will see that banks are not safer today”. Well, few months later we had the worst recession ever. Luckily, though, we have not had bank-rescue packages and we have not had to bail out banks. Banks have been withering the storm. In some instances, banks have even been part of the solution by showing flexibility towards troubled firms. I am not saying everything is perfect, but I am saying that the situation has been very different from the situation in 2008. On a personal note, this made me happy, too, as it would have been somewhat embarrassing if banks had failed at the same time I published an analysis arguing that the banking sector is safer. This, luckily, did not happen. Instead, the banking system turned out to be far more resilient than in 2008, as I predicted.

You may add that the Fed rescued markets during spring, as mentioned above, and thereby rescued firms and subsequently banks. True, but there was certainly also tons of rescue packages in autumn 2008. Banks nevertheless failed in large numbers in 2008. They did not this time around. Perhaps, thus, we did learn something from the financial crisis of 2008, and have gotten some things right. This would be no small achievement.

US election and Brexit

There have been other events, for instance the US election and Brexit negotiations. In normal years, such events would potentially have been among the most important events for markets and the economy. This year, the pandemic has certainly been more important. I did manage to write a post on the US election and the stock market, though (link). I discussed evidence that stock markets perform better under Democratic presidents. Only time will tell whether the same will happen under Biden.  

I did not manage to find space to discuss Brexit, but we got a trade agreement on Dec. 24 (link). Hopefully, the EU and UK can now move on.

The cost of the crisis

It is impossible to summarize the pandemic in one number or one word. Hence, I will not attempt to do so. But, I did present a calculation of the expected cost of the crisis in Denmark (link). I arrived at DKK 336bn, or app. USD 10,000 per Dane. This calculation generated some attention in Denmark.

One can discuss every single assumption one needs to make when calculating the expected cost of a crisis: What is the value of a statistical life? What is the value of a statistical life of those who pass away due to COVID-19, i.e. who are typically above 80? What is the past loss as well as the expected future loss in economic activity due to the crisis? Does it make sense to present one number when there is so much uncertainty? And so on. These are all fair points, but if we want to have a meaningful discussion of the impact of the crisis, we have to start somewhere.

In my calculation, I closely followed the assumptions of Cutler & Summers, such that US numbers and Danish numbers can be compared. This allowed me, for instance, to conclude that the cost of the crisis in Denmark, most likely, will be much lower than the cost of the crisis in the US.

Conclusion

I must admit I find it difficult to end this last post of 2020 on a happy note. Right now, at the time of writing, the situation is bad in the country I live, Denmark, and in many other countries in Europe and around the world. Numbers of new cases and deaths have been rising recently, or are on the rise again, and more and more restrictions and lockdowns are being imposed. Days are grey and short. The crisis has already been tremendously costly and it is clearly not over yet.

Nevertheless, I will try to end the post on a positive note. It gives me hope that several countries have started vaccinating people, and it seems to be working well. Finally, the EU also starts vaccinating people now. This has taken way too long, however, given the severity of the crisis and the fact that other countries started weeks ago. And, yes, every day counts. If it is correct, though, and I deliberately write if, that the EU has failed when it comes to the approval process and purchase of vaccines, as the normally well-informed and serious magazine Der Spiegel claims (link), it is a scandal. Biden aims to vaccinate 100m Americans within his first 100 days in office (link), close to a third of the US population. As things look now, it seems unlikely that we will be able to achieve the same in Europe. Christmas is all around us, though, so let us hope that somehow things will develop in the right direction.

Therefore, let me focus on the bright side. With the jabs, the situation will most likely start to improve within a not too distant future. I will try to convince myself that I see weak light at the end of the long and dark tunnel, even when we probably have to wait many months before things really calm down. Days are at least getting longer. I will focus on this, then.

With this, which is meant to be a positive message, let me thank you all for reading this blog and for sending me many encouraging mails with feedback. Please keep on doing so – it is highly appreciated.

I conclude by expressing hope that next year will be considerably more joyful than the one we leave behind.

Happy New Year!

How stable is the Nordic financial sector?

In 2008, banks were too fragile given the risks on and off their balance sheets. Many banks failed, others were rescued by governments/taxpayers. The societal costs were enormous. In a new publication, I evaluate the robustness of the Nordic financial sector today. I conclude that the Nordic financial sector is more robust than in 2008. This is important because we are currently going through a severe recession. If banks today were as weak as in 2008, this recession would have been even worse.

Once a year, Nordregio publishes the Nordic Economic Policy Review. The theme of this year’s publication is “Financial Regulation and Macroeconomic Stability in the Nordics”. Because of my experience from analyzing the financial crisis in Denmark in 2008 (I chaired the government-appointed committee that investigated the causes and consequences of the financial crisis in Denmark, the Rangvid-committee, link), I was asked to write the first paper in the publication (link), assessing the robustness of the Nordic financial sector today.

It is a policy paper. No fancy equations and regressions, but straight-to-the-point analyses and conclusions. The Review was published Tuesday, June 16. At its launch, I participated in a panel debate with, among others, two former deputy-governors at Riksbanken (the Swedish central bank), a former governor at Riksbanken, and myself. In this post, I review my main conclusions and relate them to this crisis.

An ironic incident
I start my paper emphasizing that it is difficult too foresee financial crises.

As an example, the first-page headline – typed in large bold letters – in the 2008 Financial Stability Report of Nationalbanken (the Danish central bank) was: ‘Robust Financial Sector in Denmark’. The Financial Stability Report analyzed the robustness of the Danish financial sector. It was published in May 2008, i.e. only a few months prior to the outbreak of the worst financial crisis since the 1930s. Half of Danish banks disappeared following the financial crisis of 2008.

Even if this headline probably still haunts Nationalbanken, Nationalbanken was not alone in not foreseeing the financial crisis. On the contrary. Financial crises are almost per definition unpredictable. If it was generally accepted that a financial crisis was in the making, action would surely be taken to prevent it. In this sense, we tend to become surprised each time.

The first version of my analysis was written in autumn last year. The final version was submitted in January this year. Right before the corona crisis.

I had not seen the corona crisis coming. In particular, I had not seen how severe it would be. Clearly, I was not alone either. Financial markets, for instance, had not seen it, and financial markets summarize the average views of all investors. Stock markets, credit spreads, stress indicators, etc. did not react before the crisis was in fact happening. So, was my assessment of the financial sector in January – that I present below – “robust” in light of the events that have happened? I will return to this in the end.

Why an important question?

If financial crises, and more generally stress in financial systems, are so hard to predict, why do we bother? There is one main reason: The societal costs associated with financial crises are enormous.

In the paper, I present new calculations of the societal losses resulting from financial crises in the Nordics. I do as follows. Societal losses are calculated as forgone economic activity due to financial crises. And this, forgone economic activity, I calculate by projecting economic activity, from the start of a financial crisis, by the growth rate of economic activity. The result is a path of economic activity in the hypothetical event that there had been no crisis. I contrast this with actual economic activity during the crisis. The difference is the cost of the financial crisis.

In the paper, I present results from such calculations for Denmark, Finland, Norway, and Sweden for the crises in the early 1990s and the crises in 2008. Let me present just one of the calculations here. This figure shows the result for Denmark for the 2008 crisis:

GDP and hypothetical non-crisis GDP for Denmark.
Data source : St. Louis FRED database.

The blue line shows developments in real per capita GDP (in USD to allow for a comparison across the Nordics) whereas the red line shows hypothetical GDP assuming no crisis. Before the crisis, real GDP per capita was developing steadily around the growth trend. The crisis changed this dramatically. GDP fell 5% during the crisis, itself a huge drop in GDP. On top of this, however, the recovery was slow. In 2018, ten years after the crisis, GDP had not recovered to the level that could have prevailed had there been no crisis. In fact, ten years after the crisis, the accumulated difference between hypothetical no-crisis GDP and actual GDP amounts to 91% of GDP in 2008. One year of GDP was lost due to the crisis.

I present these calculations for the other Nordic countries and other crises. The editors of the publication, Lars Calmfors and Peter Englund, in their introduction, summarize the results as follows: “Losses accumulate to a staggering one or two years of economic output”. This is why it is important to deal with financial crises.

In the paper, I describe the underlying causes behind the crises in the Nordics, as well as similarities and differences across countries. I skip this here. Read the paper to get it.

Risks assessment

As the next step, I venture into a kind of risk assessment.

Literature on financial crises concludes that even when it is difficult to foresee crises, some variables tend to be more informative about risks to financial stability than others are. I mainly discuss credit growth, house price growth, and household leverage. I conclude that lights are not flashing red.

Credit growth is the indicator to which most attention is typically paid. For instance, credit growth is the most important indicator when the counter-cyclical capital buffer is determined in the new Basle capital-regulation regime. Credit growth has been low during recent years.

House prices and household leverage are other important indicators. In the Nordics, they have been growing for almost three decades. House prices are currently high, as are levels of household debt.

At the same time, it is difficult to use an indicator that has been increasing for almost three decades as a predictor of the timing of a turnaround. The literature typically uses a three-year window for house-price growth when predicting crises. House-price growth has not been particularly strong during the recent couple of years.

So, house prices and household debt levels are high today. But twenty years ago, they were higher than they were thirty years ago. And, ten years ago, they were higher than they were twenty years ago. Today, they are higher than they were ten years ago. It is very difficult to say when the level is “too high”, in particular when interest rates have been fallen throughout the last thirty years, too (I return to this below). Had there been an explosion in house prices during the last couple of years, like prior to the 2008 crisis, it would have been a different matter. But this is not the case.

I conclude that house prices and levels of household debt are high but their developments are not particular useful to predict the timing of a crisis, and thus not supporting a conclusion that “a crisis is around the corner”

Robustness of the financial sector

Traditional indicators of risks to financial stability are not flashing red in the Nordics, but my introductory point was that crises tend to arise in unforeseen ways. The financial system should thus be robust to withstand unforeseen shocks. Prior to the 2008 financial crisis, the financial system was clearly not resilient enough. Banks “too large to fall” had to be rescued by governments and taxpayers. As a consequence, increasing the resilience of the financial system has been high on the agenda since the financial crisis.

Capital and liquidity requirements have been tightened, stress tests are conducted more systematically now, assuming even more severe stresses than assumed in stress tests conducted before 2008, restructuring and resolution regime have been introduced, macroprudential instruments employed, etc. I conclude that the financial system in the Nordics is more resilient today. This graph is just one way of illustrating this:

Capital ratios of selected large Nordic banks, before and after the 2008 financial crisis.
Data source: Eikon.

The graph shows capital ratios of selected large Nordic banks before (2006) and after (2018) the financial crisis. Prior to the financial crisis, large banks financed around 8-10% of their risk-weighted assets with equity. Today, the ratio is between 18-20%. In other words, capitalization of banks has been basically doubled since the financial crisis.

Causes for concern

Does all this (no lights flashing red and a more resilient financial sector) mean that there is no cause for concern? That would be going too far.

I am concerned by the current low-interest rate environment. Or, rather, I am concerned about the consequences if interest rates at some point start rising.

Today, interest rates are very low in an historical content. I use this graph to illustrate:

Monetary policy rates in the Nordics.
Data source: Datastream via Eikon.

The figure shows monetary policy rates in the Nordics since the early 1990s. Rates have been constantly falling, reaching negative territory in Denmark and Sweden (Sweden now back at zero again).

As mentioned above, house prices and debt levels have been increasing for app. 30 years in the Nordics, most likely driven by the fall in interest rates. Higher house prices and levels of debt might be justifiable when interest rates are low, but should interest rates rise, they might not be sustainable any more. Furthermore, asset prices are even more sensitive to the interest rate when interest rates are low. This means that it takes less of an interest rate increase to cause drops in assets prices (such as house prices) at low levels of the interest rate. Interest-rate risk is important to monitor, in my opinion.

On the other hand, if interest rates stay low, this might squeeze bank profits, if banks are unwilling to pass on low or negative interest rates to customers. This seems to be the case. In spite of negative policy rates since 2012 in Denmark, it was only in 2019 that Danish banks started charging negative deposit rates towards retail customers, and still only on large deposits (typically above EUR 100,000). An incomplete pass through of negative rates hurts bank profits, squeezing their resilience.

Finally, in the paper, I discuss briefly the possibility that the next crisis might arise in nontraditional banking areas, such as the emergence of credit extension by non-regulated financial institutions or cyber risks.

Discussion

The publication (Nordic Economic Policy Review) also includes great comments from two discussants of my paper: Anneli Tuomenin, CEO of the Finnish Financial Supervisory Authority and Peter Englund, Professor at the Stockholm School of Economics. Both largely agree with my assessment that the Nordic financial system is more robust today. Anneli is, though, perhaps even more worried than I am about the current low interest rate environment and outlines an additional number of non-traditional risks, such as climate risk and cyberrisk. Peter discusses whether banks really are that much better capitalized today (has capitalization gone up or risk weights down?) as well as additional risks associated with low interest rates. Read their comments. The main point is, I believe, that all of us share the view that we are particularly concerned about risks associated with low levels of interest rates.

The publication also contains additional interesting articles on the banking union, on macro prudential regulation, on monetary policy and household debt, on bail-in instruments, and other interesting topics. If you are interested in financial stability, the publication should be a must-read.

Lessons in light of the corona crisis

As mentioned, I wrote this paper in January 2020, right before the outbreak of the corona crisis. In the paper, I conclude as mentioned that the financial sector is more resilient today than in 2008. Now, we are in the midst of a recession that will cause a considerably larger fall in economic activity (on the short run) than during the financial crisis in autumn 2008. In autumn 2008, banks went belly-up and many had to be rescued. What has happened this time around? No bank has gone bankrupt, no banks have been saved, spreads are up on financial markets but not as much as in autumn 2008 (they were briefly in March, but came down quickly again). In autumn 2008, banks cut lending dramatically. Today, banks are helping customers getting through the crisis. I think this is important to emphasize, as you can still find people who argue that banks are not much more robust than they were in 2008. I judge that they are.

I am not saying that all banks will survive this, and I am not saying that we will not face any threats to financial stability. But I am saying that, given the fact that this recession is even deeper (on the short run) than the 2008 recession, and the fact that we are not witnessing the problems we did in 2008, this indicates – at least until now – that the financial system is more resilient today. Of course, should the situation turn to the worse, e.g. with a new wave of the virus, things will look different.

Webinar

The paper was presented at a webinar on June 16, 2020. The presentation was followed by a panel discussion on “Will the corona crisis also trigger a financial crisis?”. Panelists included Karolina Ekholm, Stockholm University and former deputy-governor at Riksbanken, Lars Heikensten, the Nobel Foundation and former governor of Riksbanken, Kerstin Hessius, CEO of the Third Swedish National Pension Fund and former deputy-governor at Riksbanken, and myself. The panel was moderated by Peter Englund. It was an interesting debate.