One of the beauties of my job is that I spend much of my time comparing notes with senior officials around the globe about the most important issues at the intersection of finance and public policy. (There is a brief explanation of my role and background at the end of this paper.) Based on those discussions, here are five key policy issues that will be top of mind in 2022.
- Potential for persistent elevated inflation and higher interest rates
- Asset bubbles and market fragility
- Climate-related risk and finance
- Digital assets (cryptoassets, stablecoins, and central bank digital currencies)
- Corporate solvency, post-pandemic
The Short Version
(3 min read)
For those of you with less time, here is a brief summary. The long version expands considerably on this.
Potential for persistent elevated inflation and higher interest rates
Virtually all of my discussion partners see a plausible downside scenario in which higher inflation becomes baked into the economy and markets for a prolonged period, although few of them have this as their base case. Most of them worry, as I do, that key decisionmakers in both the private and public sector will struggle to adapt, given that it has been decades since inflation was a serious issue in most of the major economies. I believe this is an underestimated risk for financial institutions. Their executives mostly seem focused on the benefits of higher spreads that may be associated with higher overall rates. However, there could be many harmful indirect effects, including troubles in the financial market, discussed next.
Asset bubbles and market fragility
Many officials share my personal belief that asset prices are generally very rich, in some cases in bubble territory. Bubbles always burst eventually, even though it is hard to predict when and why specifically. A plausible candidate to trigger market declines would be a rise in interest rates, but it is not the only potential cause. Financial institutions are likely to be more vulnerable to a sharp market decline than they think. The fact that Archegos could cost banks $10 billion by taking long positions in a bull market suggests that a bear market could be a lot more expensive than that.
These market risks are exacerbated by known problems of market fragility that were demonstrated in 2020, sometimes echoing problems from the Global Financial Crisis. Few of these problems are fixed yet, as policymakers work their way through the involved processes of change.
Climate-related risk and finance
This was a big issue in 2021 and will be even bigger this year. Actions will focus on: overall climate disclosure requirements for public firms; risk management at financial institutions; associated data management issues; climate stress tests; and potential changes to risk weights to reflect relative climate risks.
Digital assets (cryptoassets, stablecoins, and central bank digital currencies)
Policymakers are wrestling with the complexities, challenges, and opportunities of digital assets. Areas of focus include: regulation of “traditional” cryptoassets such as bitcoin; regulation of stablecoins that try to keep a fixed value to the US dollar or other currency; and the design and issuance of central bank digital currencies that are direct obligations of central banks.
Corporate solvency, post-pandemic
Officials became less concerned in 2021 about the ability of businesses to weather the storms from the pandemic and the related recession. However, the ending of many government support programs and the heating up of the pandemic due to Omicron have raised the visibility of this topic considerably. The possibility of higher interest rates damaging debt-laden companies is another factor of concern. At this point, officials are in the mode of “watchful waiting”. Developments with Covid-19 and the economy will determine whether the concerns fade or increase.
The Long Version
(13 min read)
Potential persistent elevated inflation and resulting higher interest rates
There is a significant probability that higher inflation will persist long enough and strongly enough to alter inflation expectations among the public and in the financial markets. Few of the officials I speak with have this as their base case, but the large majority view this as a plausible scenario that must be considered. This situation could be triggered by some combination of: pandemic-related supply shortages and temporarily increased demand; demographic factors; the restructuring of global supply chains; geopolitical tensions; and political polarization that encourages strong voices to argue that government leaders are stoking out of control inflation and central bankers are unreliable, which can help create a self-fulfilling prophecy.
This scenario would be made considerably more dangerous by the lack of experience with high and volatile inflation of most decisionmakers in the private and public sector, since the largest economies have not encountered this for more than three decades. (US inflation, for example, peaked in 1980, with a much lower secondary peak in 1990.) Book learning is no substitute for lived experience and I believe that the most of the decision-makers in the financial sector and related official sector are not genuinely prepared should we face these conditions.
An increase in inflation expectations would almost certainly push medium- and long-term interest rates up and central bank responses to inflation could raise short-term rates significantly as well. Higher interest rates do have some benefits for financial institutions, generally allowing banks and insurers to widen the spreads between what they can earn on new loans and investments and what they pay on deposits or promise on policies. However, there would also be direct losses on existing investments and the potential for very significant losses on their indirect exposures to the markets through loans and investments in firms with substantial exposures. This is discussed further in the next section.
Pessimists who fear prolonged higher inflation often view central banks as seriously constrained in their ability to raise interest rates, due to high levels of debt issued by governments and the private sector. I, personally, do not share that level of concern, although debt levels clearly would be a factor in central bank decisions. However, assessments of this risk are necessarily subjective, requiring a judgement about how much political pain central banks would feel from raising rates and how susceptible they are to such pressure.
Asset bubbles and market fragility
Many policymakers share my personal concern that most financial assets, and some tangible assets such as housing, are priced very richly in many countries. Indeed, I believe some markets are in bubble territory. By now, we all know that bubbles can last considerably longer than one would expect, but they do eventually burst, even if the timing is unpredictable. (I use the analogy of the “Roadrunner” cartoons, where the roadrunner would routinely lure his arch-enemy, Wile E. Coyote, into running off a cliff. Notably, it is not until the coyote looks down that he starts falling. I believe many markets have run off that cliff edge; I just don’t know what will trigger them to look down.)
A sharp rise in interest rates could be such a trigger for market declines. These could be large, as the market first adjusts to the old reality that it was ignoring, then falls further to reflect lower valuations due to higher interest rates, and likely declines further still as a result of the forces of momentum that usually cause substantial overshoots on any swing from bull to bear markets or vice versa.
Many financial institutions likely have large indirect exposures through loans, investments, and derivative and other credit exposures to firms and individuals taking market risk. The fact that Archegos could lose its banks more than $10 billion when it was primarily making long bets in a bull market strongly suggests that aggregate losses would be much bigger if a major bear market arises. In addition to the fact that most investors are net long, there are much larger exposures to interest rate markets than to equities, widening the room for potential losses.
Exacerbating these valuation concerns are a number of known risks around market fragilities, such as those that led to serious problems in 2020 in the most liquid market in the world, that for US Treasury securities. There are many ongoing policy discussions around restructuring various markets (such as perhaps introducing central clearing for Treasury repos or putting new regulations on non-bank financial market actors), but little has actually been done to date, leaving these fragilities in place. Central banks may be able to ride to the rescue yet again but this could be harder for a variety of reasons this time around, particularly a potential conflict with the need to tame inflation.
Climate-related risk and finance
This is an area that received a huge amount of attention in 2021. Movement will accelerate in 2022 as policymakers, as well as financial institutions and markets, continue to transition from analysis to actions. I’ll focus here on issues specific to the financial sector, but there will also be important decisions about disclosure requirements for public companies. These will affect financial institutions directly as reporting firms and also indirectly, by expanding and shaping the information available for their decisions about loans and investments.
There are four main policy areas for climate-related risk at financial institutions: internal risk management practices; data management and analysis; stress tests; and potential changes to capital requirements. The first two areas focus on ensuring that climate-related risks are appropriately assessed and that the necessary data is available to do this properly. The devil is in the details for these tasks, so I will not write more in this short paper.
Financial regulators have begun to design and implement scenario analyses for banks to run to calculate financial exposures in the event of adverse climate outcomes, whether as a result of direct physical losses or the costs of adjusting to government climate transition policies. These are intended to allow regulators to understand the levels of exposure and to ensure that banks have the data and capabilities to analyze these risks.
Two big, and related, decisions are necessary when designing these scenario analyses. First, is the time frame relatively short, say three years, or should it capture the peak of direct climate impacts, decades out? Second, should the primary focus be on physical harm from climate change or on the effects on the recipients of bank loans and investments of government climate transition policies and investor and public pressure?
Use of a shorter time frame effectively mandates a focus on transition policies, since the degree of loss from physical damage would be relatively low in the shorter run compared to the size of the banks. Further, it may require assuming strong transition policies in order to show substantial impacts, even if it is unrealistic to think they would be put in place that fast. A longer time frame would allow for the fuller effects of both physical and transition losses, but runs into the problem that it implicitly assumes, unrealistically, that banks will stick with their current portfolios and policies decades into the future.
Thus, any climate scenario analysis analyzing financial risk requires some crude assumptions as a way to focus on the core issues. It is then a choice of which approach is most helpful, playing off the pros and cons. This contrasts with traditional financial stress testing, where it is possible to construct a plausible stress scenario in considerable detail based on historical experience, adjusted for subsequent changes in the financial system.
Generally, regulators try to avoid calling these climate scenario exercises “stress tests”, since that term could imply that the results would be used the same way as traditional financial stress tests, including setting capital requirements. Unfortunately, this is a losing battle, as the media and other interested parties almost universally call them stress tests and expect them to be used like traditional stress tests. Indeed, many of these stakeholders assume climate risks will be directly integrated into traditional stress testing. In their defense, we have trained politicians, the media, and the interested public to view stress tests as the best way to analyze big systemic risks and to determine whether capital levels are adequate to deal with those risks. It is only natural that they would assume this applies equally to the financial risks stemming from climate change.
Unfortunately, the situation is not this simple. For one thing, there is likely to be only a relatively weak correlation between the realization of financial losses from climate-related risks and the realization of losses from traditional financial stresses. That is, the next financial crisis is probably not going to be caused by climate-related risks and, symmetrically, a financial crisis is unlikely to be the trigger for major climate-related losses. Thus, adding together financial losses from a traditional crisis scenario and from climate-related risks is likely to overstate total losses from a realistic stress scenario. Further, modeling financial losses from climate-related risk is necessarily much more difficult than applying lessons from historical financial crises, in large part because we have never been through such a transition before.
This unsatisfying result leads a number of observers to call for capital charges related to climate risk to be implemented in another way, by increasing the risk weight of “brown” assets and decreasing risk weights of “green” ones. Regulators generally oppose this approach, in part because they believe it extremely difficult to correctly calibrate these adjustments. However, my own view is that something along these lines is nearly inevitable, over time, unless capital charges are generated through stress tests instead. There will simply be too much public and political pressure demanding that capital requirements reflect climate risk.
Digital assets (cryptoassets, stablecoins, and central bank digital currencies)
Officials consistently demonstrate a high level of interest in digital assets, which will likely be even more evident in 2022. Some of this is about bitcoin and the many cryptoassets it has inspired whose value is unrelated to traditional currencies like the US dollar. (I’ve taken, somewhat tongue in cheek, to referring to these as “traditional cryptoassets.”) These cryptoassets continue to grow and are beginning to be institutionalized, with banks, for example, starting to play roles in this asset class. Not surprisingly, officials generally struggle to understand this novel asset class and are also very concerned about the many ways they fear it could blow up, as well as the potential for the development of a lightly regulated financial system operating in the shadows. As a result, they are devoting major efforts to find the best regulatory approaches. The Basel Committee on Banking Supervision, for example, issued a proposal on bank capital requirements for cryptoasset exposures, which will be re-proposed with substantial revisions this year.
Among my official sector contacts, there is even more interest in stablecoins, which try to keep a value equal to a dollar or other currency, and in central bank digital currencies (CBDCs), which fill a similar role to stablecoins but through the issuance of a digital currency that is a direct obligation of the central bank. The Facebook-led consortium that in 2019 proposed the Libra stablecoin (now called “Diem”) fully captured the attention of central bankers, finance ministries, and financial regulators, spawning a whole series of global regulatory efforts on stablecoins. In the US, the President’s Working Group on Financial Markets recently issued a set of proposals on stablecoin regulation. A certain level of regulatory consensus is developing, but core issues have not been decided, in particular whether stablecoin issuers should be regulated as banks or something more akin to a money market fund or via another model altogether.
The Libra proposal also sharply increased the level of interest of central banks in issuing their own digital currencies. It seems clear to me that most major central banks will start to issue CBDCs over the course of this decade, with China being the first of the big economies. I’ve written previously on CBDCs and will be writing more. (See my paper on CBDCs: Six Policy Mistakes to avoid).
Corporate solvency, post-pandemic
The threat of corporate insolvencies as a result of the pandemic and the related economic crisis were top of mind for officials in 2020. (See, for example, the Group of Thirty report that I co-authored for a high-level group co-chaired by Mario Draghi and Raghuram Rajan). However, the issue had a lower profile in 2021. This reduction in concern was primarily the result of massive fiscal and credit support for businesses, combined with a faster economic rebound than was feared at the worst points of the crisis.
The combination of the Omicron variant and the ending of many government support programs has raised the concern of many officials, although not to the levels they felt early on in the crisis. The revived concern is also tied to the potential for higher interest rates, given higher debt loads at many companies as a result of pandemic-related losses and the strong emphasis on subsidized credit as a government support mechanism for troubled companies.
The officials with whom I speak are generally of the view that the size of the problem in their countries will be manageable, but, as with the higher inflation scenario, they see a plausible downside case in which corporate solvency becomes a tougher issue. Thus, this risk has their attention; whether it keeps it will depend heavily on a combination of pandemic and economic developments.
There are numerous other concerns on the minds of top financial officials and some observers might elevate one or more of them to the top five list, replacing some of the ones I chose. Other key issues include:
- Operational resilience and cyber risk
- Macroprudential policies and the structure of capital buffers
- Social justice and finance
- Cross-border banking issues and home/host relations
- Impacts of Brexit and the restructuring of UK financial regulation
- Implementation of the final stage of Basel III
Douglas J. Elliott is an Oliver Wyman partner focused on the intersection of finance and public policy, particularly financial regulation. Prior to his current position, he was a scholar at the Brookings Institution and a Visiting Scholar at the IMF. He began his career with two decades as an investment banker, primarily at JP Morgan. He has written extensively on capital standards for the IMF, Brookings, and Oliver Wyman.