My predictions in January of 2022 for five key policy topics in finance for the year were well received and proved quite accurate, so I am trying my hand again this year. My choice of topics is informed by roughly 700 meetings I hold each year with senior policymakers, (including central bank governors, heads of regulatory bodies, and senior finance ministry officials), and with senior executives of financial institutions.
All of the issues from 2022 should remain of keen interest throughout 2023. However, there are three levels of difference in this new year. First, I believe a meta-theme is developing as policymakers and executives strive to make sense of how the financial sector will differ in the next dozen years from the extraordinary dozen or so years of “low for long” monetary policy. The structure of the financial sector evolved substantially in this period to respond to low for long, as did the business models and behaviors of key players. A new period of evolution will occur in reaction to the new conditions.
Second, I’ve expanded my list beyond five, given additional issues that have become hot topics. Finally, there are major developments in the specifics within each of these areas of policy interest. For example, digital asset policy remains of keen concern, but the underlying situation and the views of policymakers have transformed dramatically over the last year.
Key Policy Issues for 2023 in Finance
- The New Monetary Order and its impact on the financial sector
- Higher and more volatile inflation and interest rates
- Smaller central bank balance sheets
- Stronger constraints on central bank interventions in financial markets
- Shifts in market share between banks, non-banks, and financial markets
- Interactions between these trends
- Evolution of the financial sector in response
- Market fragilities and repricing of financial assets
- Credit risks
- Corporate solvency risks
- Mortgage and household solvency risks
- Sovereign debt risks
- Geopolitics and Finance
- Digital asset policy, regulation, supervision, and enforcement
- Climate-related risk and Finance
As a recap, the key issues I highlighted in 2022 were:
• Potential for persistent elevated inflation and higher interest rates (and their impacts on the financial system)
• Asset bubbles and market fragility
• Climate-related risk and finance
• Digital assets (cryptoassets, stablecoins, and central bank digital currencies)
• Corporate solvency, post-pandemic (and impacts on the financial system)
The Short Version
For those of you with less time, here’s a summary version of the points.
The New Monetary Order
Policymakers and financial executives are striving to understand what the future shape of the financial sector will be as the period of “low for long” interest rates recedes further in the rear-view mirror. This requires making sense of at least four broad trends, the interactions between them, and the practical implications of that understanding. At a minimum, these trends are:
• Higher and more volatile inflation and interest rates
• Smaller central bank balance sheets
• Stronger constraints on central bank interventions in financial markets
• Shifts in market share between banks, non-banks, and financial markets
Given the impossibility of predicting the future, the best analytical approach is scenario analysis. One interesting potential scenario would see banks regaining some of their lost market share from non-banks and financial markets, since wholesale and market-based funding has ceased to be nearly free and readily available under virtually all circumstances.
This meta-theme is particularly complex, so please do go to the long version for a deeper explanation.
Market fragilities and repricing of financial assets
Policymakers have two broad classes of concerns about financial markets. First, some ultra-safe assets, such as US Treasuries or UK gilts, trade in markets that have developed structural fragilities. Policymakers are aware of these risks, but have not reached the stage of fixing them, given the complexities and constraints. Second, policymakers tend to believe that many risk assets are substantially over-priced, not yet properly reflecting the underlying risks or the new interest rate structure. I agree, but it must be admitted that I share a conservatism with most policymakers that could bias our viewpoint. In any event, if this view is correct, then there is a substantial risk of a sharp repricing at some point as reality seeps in, which could produce financial stability problems in various ways, including the potential for multiple blow-ups similar to what Archegos suffered.
2023 could be the year in which credit losses start to bite the financial sector in a serious way. Policymakers have a keen eye out for risks from all major categories of borrowers: households; businesses; and governments. At the beginning of 2022, there was much less concern about household solvency or that of most governments outside of a few emerging market countries. These concerns are now more general, given much higher interest rates and considerably greater risk of recession than was perceived a year ago.
Geopolitics and finance
The Russian invasion of Ukraine and its many economic consequences has considerably increased policy debate about the impact of geopolitics on finance. The war in Ukraine continues to be a source of further potential macro-economic shocks, positive or negative, including the possibility that peace might break out at some point. The other major focus is on relations between China and the US and its allies, including the potential for China to move militarily on Taiwan or for China and Russia, with a few allies, to try to set up an alternative financial and economic grouping separate from the existing global structures.
Digital asset policy, regulation, supervision, and enforcement
Digital assets will continue to consume large amounts of policymaker time and attention. The debates in 2023 will be considerably influenced by the disasters of 2022, including: Crypto Winter; the blow-up of the Terra/Luna algorithmic stablecoins; the bankruptcy of firms taking quasi-deposits and lending them to risky crypto asset players; and the scandalous FTX debacle. A few things seem clear:
• Digital assets will not go away, in large part because there are many sub-sectors that are quite removed from the parts of the ecosystem that blew up
• The healthy sub-sectors will continue innovating rapidly
• There will be major moves to regulate digital assets much more widely and strictly
• Crypto exchanges and similar service providers will find themselves under regulation similar to traditional financial exchanges and custody providers, although this may take several years to come into force
One thing that is not clear is what the price level of Bitcoin and similar cryptoassets will be and what level of investment and speculative interest there will be. Prices are down a lot from peaks, but already bounced back 30% or so from the lows. The lack of underlying financial flows (such as from the earnings of a business or interest and principal payments on a loan) makes pricing much more dependent on investor sentiment than with most financial assets.
Climate-related risk and Finance
Policymakers globally continue to advance the agenda to reflect climate-related risks for financial institutions. Regulators continue to push the industry to gather better data on these risks and have also put financial institutions through stress tests to better understand the size and nature of the risks. More broadly, securities regulators, such as the SEC in the US, are moving to require considerable disclosures of climate-related risks by all public companies, including financial institutions.
All of these trends will continue, although there has begun to be more resistance, partly because regulatory moves have become more concrete. Some of the resistance is based on overall opposition to the regulatory approaches, as from those who believe climate risks are smaller than generally perceived or that regulatory approaches are too heavy-handed. For others, the argument is that the current energy crisis requires a delay in these moves.
The Long Version
The New Monetary Order and its impact on the financial sector
A number of the key issues are inter-related and may be best understood as parts of a broader meta-theme, which I’ve dubbed, for now, The New Monetary Order. The Global Financial Crisis (GFC) in 2007-10 marked a turning point which generated huge changes in central banking and the composition and workings of the financial sector. (Some of the trends started before the GFC, but were accelerated sharply by that crisis.) I believe the current period, starting with the pandemic, marks another profound turning point. My colleagues and I are at the early stages of exploring this meta-theme, so this section of the paper provides only a high-level explanation of the premise. Many others in the policy community and the financial sector are focused on pieces of the puzzle as well, which is why I include this in a discussion of key topics for 2023. Relatively few, however, are exploring the puzzle holistically, as we are striving to do.
Some key ways that the next dozen years may be different from the last dozen or so are:
Higher and more volatile inflation and interest rates. This significant transition is partly intentional. Central bankers chose to hold interest rates at near-zero for many years, which also almost eliminated interest rate volatility. Therefore, it was clear that interest rates would rise as low for long ended and that more normal levels of volatility would return. More of this, I would argue, is unintentional, as central bankers temporarily lost control of inflation and found themselves forced to dramatically increase interest rates. My view is that we will not return to strongly anchored inflation expectations for a long time.
Smaller central bank balance sheets. Central banks are striving to return to more normal balance sheet levels by reversing quantitative easing. This changes the composition of financial markets and the financial sector, given how large those balances sheet had become.
Stronger constraints on central bank interventions in financial markets. Central banks intervened massively in the financial markets in 2009/2010 and even more strongly in 2020 to counter widespread liquidity problems that were impacting credit provision and asset prices. The breadth and size of these market interventions were unprecedented. Certain central banks have intervened in other specific situations as well, most recently with the Bank of England’s response to the problems in the UK’s government bond markets in October 2022. Such interventions will be more problematic going forward, as already demonstrated by the UK experience, for at least two reasons. First, these interventions expand central bank balance sheets, which went with the grain of monetary policy during the GFC and the pandemic, but becomes problematic when a contractionary monetary policy is desired. Second, many central banks are showing financial losses from their balance sheet positions, which is creating a political environment in which it is more difficult for central banks to take on financial risk.
Shifts in market shares between banks, non-banks, and financial markets. Banks have lost a significant amount of market share to non-bank financial institutions and to financial market activities. This trend was already in place but was accelerated by responses to the GFC, including large increases in regulatory capital and liquidity requirements for the banks, which made them less competitive. Importantly, wholesale funds were readily available very cheaply, providing a major funding advantage that is not normally available.
Interactions between these trends. Each of these changes has received a fair degree of attention, although not, in my view, enough. However, there has been less consideration of the interactions and there is more uncertainty about the impacts when taken together.
Evolution of the financial sector in response to the meta-theme. I believe scenario analysis is the best approach to examining the consequences for the financial sector of these major, and inter-related, changes. Monetary policy and finance are both huge and complex areas for analysis, so it would be foolish to believe anyone can predict the future evolution with high accuracy. Scenario analysis has the twin advantages of encouraging the analysis of a wide range of potential outcomes while also forcing detailed thought about each of a set of possible futures, including what developments would have to happen for that future to occur, what consequences would necessarily happen simultaneously, which ones are mutually exclusive, etc.
One possibility – not, at this point, a prediction -- is that the cumulative impact of these trends would be to shift market share back to the banks. Non-bank financial intermediation grew significantly during the last dozen years in substantial part because wholesale funds were readily available at very low rates. This is unlikely to be as true in general and there is now more likelihood of market shocks that could dry up liquidity for a significant period of time, making shorter-term wholesale funding much more dangerous. This is the result of higher and more volatile interest rates, combined with less assurance that central banks will intervene to smooth wholesale markets, except in extreme situations.
The New Monetary Order will have many other important implications for the financial sector. I expect a great deal of attention in 2023 will be directed to discerning these.
Market fragilities and potential repricing of financial assets
Financial policymakers across the globe continue to be concerned about financial stability risks stemming from financial markets. This can be seen in the focus on this topic from the Financial Stability Board and the many mentions of these risks in the financial stability reports of central banks and regulators. This focus is unlikely to waver in 2023.
There are two sets of financial stability concerns. The first concerns very safe assets with somewhat unsafe market structures, such as government bond markets in the US and UK. The second concerns the possibility that risk assets could fall sharply further in value, triggering fire sales and insolvencies or the requirement for strong central bank interventions to limit those problems.
The Financial Stability Board, other global bodies, and many national policymakers are quite focused on liquidity risks in government bond markets. This reflects recent problems as well as an awareness of the fragilities; there have been hiccups in US government bond trading and the UK faced very serious short-term problems in the Gilts markets last October. At least 3 factors are expanding these risks: greater volatility in rates; decreased levels of market making by banks; and the high volumes of new government bonds issued in recent years that have resulted in larger supplies in comparison to market-making capacity.
It is heartening that policymakers are so focused on these issues, but it is not clear that they will be able to reduce the risks by a large amount, in part due to political constraints on their policy choices. For example, the US has additional leverage ratio requirements for banks in excess of global standards, which means market-making for safe assets is more expensive for banks to conduct. There is discussion of reducing these requirements, but I believe it will be difficult to reduce them in the face of strong opposition from progressive Democrats and some Republicans.
Risk assets present a different set of issues than safe assets do. Here it is not so much the structure of markets, although these can be problematic, as the simple concern that the prices of a wide range of risk assets (equities, junk bonds, commercial real estate, and others) are higher than warranted by economic conditions. A particular concern centers on commercial real estate, private equity, private debt, and other assets traded in illiquid and opaque markets. There is a fear that many of these assets have not been sufficiently marked down to reflect the damage from high interest rates, slower economic growth, and, in many cases, permanent changes in business conditions caused or accelerated by the pandemic.
Policymakers are generally risk-averse and may underestimate the resilience of the markets, but the ones with whom I speak generally share my own view that there is a very plausible downside case in which prices of risk assets fall markedly and suddenly. This could trigger a series of Archegos-like events that might create wider financial stability concerns. There is an active debate as to whether the absence of other blow-ups like Archegos signals that risks are being well handled or simply that these blow-ups haven’t come to light yet, which ties to the point on valuation of assets in illiquid and opaque markets.
Corporate solvency risks
This topic stands roughly where it did at the beginning of last year. Policymakers are concerned that there will be a wave of business insolvencies as a result of recessions and near-recessions, combined with much higher interest rates than were in place for over a decade prior to the inflationary surge. At the same time, actual insolvencies remain relatively low so far. It seems almost certain that credit losses will rise substantially for financial institutions this year and next. Not surprisingly, this is a major focus of supervisory attention and will remain so throughout the year.
What is less clear is whether the level of credit losses will be in the normal range of recession losses or not. There is a chance that the combination of recession, high and volatile interest rates, and delayed impacts of the pandemic-related restructuring of the economy will lead to losses well in excess of previous recessions. These factors could be exacerbated if there are also substantial declines in financial market prices that make funding from market sources difficult for borrowers. Commercial real estate is a particular topic of concern for policymakers, as this area is highly affected by interest rates and many sectors, such as office buildings, are still coping with a massive fall in demand.
On the other hand, many of us expected severe business insolvency problems to arise from the pandemic and related economic changes. (See, for example, the report that I co-authored with Victoria Ivashina for the Group of Thirty on policy prescriptions to deal with that expected solvency crisis, Mario Draghi and Raghuram Rajan co-chaired the committee overseeing the report and many other prominent officials and ex-officials assisted in the report, reflecting the high level of concern in both the official and private sectors.) That expected crisis didn’t happen, reminding us to be humble about predictions. Of course, it took a huge amount of fiscal and monetary aid to stimulate the economy enough that this problem was circumvented. Governments are much more constrained at this point, although we’ve already seen government rescues in the energy sector in Europe and broader policy actions to hold down energy costs for consumers as well as businesses.
Mortgage and household solvency risks
I did not include household credit risks, mortgage or otherwise, in my key topics last year. In general, households in the advanced economies started 2022 with a high level of savings because of government aid during the pandemic, combined with the reduction in spending on many goods and services caused by the pandemic. Further, the employment situation was improving in most countries, which is the most crucial driver of household solvency. In terms of mortgages, interest rates were still quite low, even if rising, and most homeowners had substantial equity in their houses as a result of large run-ups in prices during the pandemic period.
The outlook in 2023 looks different. Household savings rates have declined considerably, unemployment has begun to rise, interest rates on mortgages are generally much higher, and house prices have fallen in many countries, reducing homeowner equity. All the signs indicate that credit losses on household borrowing will rise substantially, although this is a lending sector which varies a great deal across countries, so one must be careful about generalizations.
The real question is the degree of pain that is coming. In addition to the uncertainty about global economic and financial trends, there are major differences across countries in the state of the real estate market for homeowners. Canada is an interesting example. Officials there are very aware of the risks that stem from what many see as a large housing bubble that developed in recent years. On the other hand, Canada has a high level of new household formation, due largely to immigration, which supports demand for houses. There is considerable debate, therefore, about the extent of the risks of substantial declines in house prices.
Sovereign debt risks
Sovereign debt problems did not make my list last year either. I include it now because it is increasingly part of the global policy discussion.
The policy conversation generally divides into three streams. First, some emerging market economies are in trouble; we have already seen issues with Sri Lanka, Argentina, and Pakistan, among others. “Emerging markets” is a very broad category and many of these countries are in good shape, either due to sound management or more fortunate economic circumstances, such as for commodity producers. However, some nations are struggling with a combination of the commodity price shock, high interest rates, a strong US dollar (although 10% off its recent highs), and recessions in their trading partners. This is particularly devastating when it comes on top of underlying structural weaknesses, such as excessive debt loads.
Second, advanced economies are not immune to concern about their sovereign debt. Some observers fear a repeat of the Euro Crisis that started in 2011, pointing to Italy as the likely trigger. Although this cannot be categorically ruled out, the Eurozone is much better positioned to head off such a crisis than it was in 2011. The European Union and the Eurozone now have many institutional arrangements intended to prevent or ameliorate any crisis, which they have demonstrated a willingness to employ. Banks are also much better capitalized than at the beginning of the Euro Crisis, reducing the risk of a bank-sovereign doom loop. That all said, a more modest version of the Euro Crisis is a plausible downside case and fear of this is also likely have at least temporary effects on financial markets in Europe from time to time.
Finally, there is the special case of the United States. No one doubts the overall ability and willingness of the US to pay its debts, but there is a chance of a temporary default due to extreme political polarization and the unfortunate existence of a formal debt ceiling in US law. Republicans are threatening not to allow an increase in the debt ceiling unless there is also an agreement to cut spending, which Democrats are currently refusing. Failure to raise the debt ceiling would force the government to default on payments, since the budget includes commitments larger than can be funded by taxes and other revenues. The political situation is complex, as are the details of Congressional rules. It’s highly likely that default will be avoided at the last moment, but there remains some possibility of disaster.
Geopolitics and finance
Russia’s invasion of Ukraine underlined the potential for geopolitics to strongly affect financial markets and the sector as a whole. Even before that, policymakers were giving a lot of thought to the ramifications of a potential major rift between China and the US and its close allies (“the West”, for short.) As a result of the war, there is even more concern about conflicts between China/Russia and the West.
Geopolitics could affect the financial sector in several ways. First, as we saw with the Russian invasion, war and threats of war can create major effects on economies, in terms of growth, inflation, and interest rates. For this reason, policymakers are keeping half an eye out for potential escalation of the war in Ukraine or the opposite possibility of a cessation of the conflict. There is considerably less concern about a potential war in Taiwan in the next year or so, but real worries about this in longer time horizons.
Second, there is a concern about potential further deglobalization and damage to supply chains. This could reduce the efficiency of many businesses and increase the chance of further disruptions that could both cut economic growth and push up inflation.
Third, some fear that China, Russia, and their close allies may split off from the global financial order and form their own financial ecosystem, in order to sharply reduce the ability of the West to exert influence through sanctions or trade-related actions. I’m not personally worried about any strong form of this threat, barring a war in Taiwan, although some movement in that direction is almost inevitable. China, Russia, and other countries that fear Western pressure may be applied to them have certainly learned from the very strong financial and trade actions taken by the US and its allies. However, it is one thing to find ways to reduce reliance on the West and another to create a competing financial and trade system without taking a major hit to economic growth.
Digital asset policy, regulation, supervision, and enforcement
Digital asset policy will obviously be a major focus of financial policymakers this year, given the combination of:
• “Crypto Winter” (a major decline in cryptoasset prices and investment/speculative interest)
• The blow-up of the leading algorithmic stablecoins
• The bankruptcy of firms offering high yields for quasi-deposits that were then lent to risky parts of the crypto ecosystem
• The scandalous FTX disaster
• Ongoing policy discussions on how to regulate the sector
We will shortly be publishing a more comprehensive paper of mine on the state of play in digital assets, so I will confine myself to a few points here. First, it’s a damaging mistake to label everything in digital assets as one big blob of “crypto”. The digital assets sector comprises many sub-sectors with very different characteristics. The underlying long-term case for most of these sub-sectors is unchanged by the events of 2022. As a result, we should see continued progress in many parts of the sector, even if not at the frenetic pace of the period prior to the onset of Crypto Winter in mid-2022.
Second, some sub-sectors are strongly affected by the events of 2022 and the lessons learned from them. Crypto-asset service providers, such as FTX, will clearly face much greater regulation. Limitations will be placed on which business activities can be combined with exchange activity. Inter-affiliate transactions, such as FTX’s massive loans to the Alameda hedge fund, will be disallowed or very seriously constrained. Custody activities will be more clearly defined and will be required to include holding client assets separately from that of the service provider. Greater transparency will be required across the board. Finally, core governance requirements, especially in risk management, will be mandated.
Decentralized Finance (DeFi) will continue to evolve and policymakers will struggle with how best to regulate the sub-sector or whether to even allow it to operate. Underlying these issues is an underlying question of the extent regulators can control DeFi, given its global, decentralized approach. Another sub-sector seeing substantial change will be in investment and speculation in cryptoassets such as Bitcoin. The market price of Bitcoin and many other cryptoassets dropped by 75% or so from their peaks, despite an inflationary environment that was supposed to be good for these assets, at least in the long term. Crypto Winter could prove to be a useful washing out of the massive speculation, preparatory to a new, more sustainable, upward trend, or it could be the first stage of a long-term decline to much lower prices, or anything in between. In this sub-sector, the biggest regulatory trend is likely to be an increased focus on investor protection, along with a continued debate on when to regulate a cryptoasset as a security, a commodity, a non-financial asset like a collectible, or something else.
Third, policy choices will be heavily influenced by the existence of four disputing camps among policymakers, with disagreements centered on the social utility of digital assets. This is shown most clearly in views of Bitcoin and similar cryptoassets. (See my paper, “Cryptoassets: Tulips or Dot Coms” for a longer discussion). In very broad terms, the camps are:
Dismissive. Perhaps 10% of policymakers now believe that these cryptoassets will fade on their own, as the speculative bubble continues to reverse. They oppose comprehensive regulation, since they believe it would give cryptoassets an appearance of safety without providing real protection.
Opponents. This fairly large group does not see social value in these cryptoassets, but doesn’t think they will go away. Therefore, they are in favor of heavy, restrictive regulation, ideally in a way that keeps them out of the traditional financial system.
Pragmatists. Another large group doesn’t much like these cryptoassets either, but believes they are here to stay and will increasingly intertwine with the traditional financial system. Their focus is on ensuring there are appropriate laws, regulations, and supervisory approaches to protect the financial system and its users.
Supporters. Another perhaps 10% of policymakers are broadly supportive. They see a parallel with the Dot Coms in the late 90’s, with a massive amount of speculation, and even fraud, on top of what turned out to be a massively beneficial economic transformation. Therefore, they favor the creation of appropriate guardrails, but oppose excessively heavy-handed regulation.
It will be interesting to see in 2023 what balance is achieved between these different camps. Clearly, the events of 2022 have increased the weight of the groups most suspicious of cryptoassets, but there are still supporters and many pragmatists.
Climate-related risks in finance
It won’t come as a surprise to anyone who follows the industry that there will continue to be a focus on climate-related risks for financial institutions. One set of issues in this area is common to all public companies. The large majority of financial institutions are publicly traded and therefore subject to standard disclosure requirements which increasingly include climate-related disclosures. Large private financial institutions are under pressure from customers and investors to make similar disclosures as well. In some cases, these disclosures produce further pressure from activists and various stakeholders to reduce the business that companies do with “dirty” segments of the economy.
Policymakers and regulators across the globe are also pursuing evaluations of the prudential risks financial institutions, especially banks, face from climate-related risks. Thus far, the focus has been on two related strands of work: (1) development of climate-related data and (2) stress tests to estimate the level of risk from climate-related issues. As progress continues on these fronts, there is growing pressure for explicit capital requirements to reflect the climate-related risk that is uncovered. Such capital requirements appear to be some years off in most jurisdictions but, as described in the 2022 version of this paper, I believe that they will eventually be put in place in most countries, despite the practical difficulties of calculating the right level of capital.
Two things look different this year than they did at the beginning of 2022 in this area. First, regulators and financial institutions have made considerable progress in defining and gathering data on climate-related risks and on constructing stress tests. Second, resistance has grown to considering prudential risks from climate. Some of this was to be expected as policy and regulatory pressures became more concrete. On top of that, the energy crisis brought on by Russia’s invasion of Ukraine has led many to argue that near-term energy availability problems currently outweigh the need to move on climate-related issues. These and other factors have led many Republicans in the US, for example, to push for legislation prohibiting banks from pulling back on their lending to energy companies, and to urge boycotts of business with fund managers that are leading the charge for a reduction in investment in such energy companies.
Overall, climate-related risks represent a major long-term issue for the financial sector that will continue to receive a great deal of policy attention this year.
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.