Central banks seem to have used up their arsenals

Soon after global financial markets overcame their fears over the Chinese economy, its stock markets and currency, a new scare erupted in February with the announcement of negative interest rates by the Bank of Japan. It was intended to inject some life into an unresponsive economy.

Instead of doing the needful for the third-largest economy, the negative interest rates poisoned global bank shares and plunging them to level last seen during the 2008 global financial crisis. Very low interest rates — and especially negative ones — hurt the profitability of banks by reducing margins.

Loan and deposit pricing mechanisms and high levels of cash sitting in their balance-sheets — due to a combination of regulatory obligations and managerial caution in lending — mean that negative central bank rates reduce interest income more than expenses. That’s why investors sold bank shares everywhere and not just in Japan, because expectations were such that the European Central Bank would be next in announcing a similar move and then, maybe, the US Federal Reserve.

To top it all, Deutsche Bank frightened everyone by bringing back memories of the failed Lehman Brothers, when its share price — due to investors’ loss of confidence in its CoCos (contingent convertible capital instruments) — collapsed by some 40 per cent in just over a month. Over the same period, other European and US bank shares suffered similarly.

Almost a decade after the 2008 crisis, banking is still far from having reformed successfully to serve economic growth. Furthermore, regulators are still unsure about how much — and what kind of — capital can make banks safe. Sir John Vickers, the architect of structural reforms in UK banking, publicly criticised regulators at the Bank of England for not following his advice in setting higher capital buffers for banks.

Another regulator across the Atlantic, Neel Kashgari, president of the Federal Reserve Bank of Minneapolis and one of the architects of the US bailout of banks, announced that the problem is the size and complexity of banks and not the levels of capital. He called for a radical splitting up of banks into utilities, though both the Dodd-Frank Act in the US and the Vickers Report in the UK had ruled out such an outcome.

Plunging Chinese financial markets followed by global bank shares, with the background noise of top regulators in the UK and the US expressing concerns about banks, are not good signs for the global economy. The meeting of G20 finance ministers and central bankers in Shanghai in the last week of February signalled worries that central bankers are losing their credibility with financial markets and have run out of policies to stimulate their national economies.

Only two months into 2016 and it looks like it is going to be a bumpy ride for the global economy for the rest of the year. The G20 has to recall the spirit and determination to act together that it showed after the 2008 crisis before it becomes too late.

There has to be a new permanent institution to coordinate central bank policies globally. The Federal Reserve’s unilateral decision to increase interest rates in December was wrong.

The idea that the Fed’s monetary policy can be decided by inadequate macro-economic data from the US is the result of an outdated orthodox economics that central banks and mainstream economists continue to believe in. As we all found out in February, US banks and consequently the US economy suffer from the global repercussions of the dollar interest rate increase.

Macro-economic models of central banks fail to reflect the interconnectedness of global financial markets and the way banks and firms make decisions in real life.

This does not mean that low interest rate policy is the right one for the US and the world. Europe, Japan, China and the US need to coordinate their central bank policies to keep global financial markets stable.

And in parallel to such coordination, individual countries need to deploy fiscal policies and reform capital allocation mechanisms in their economies to channel the abundant available funds into productive long term projects in infrastructure, energy, health and education. The world urgently needs a new IMF and World Bank suitable for the post-2008 global financial crisis world.

— The writer is with the Manchester Business School.