Odd Lots - Fabio Natalucci on How to Think About Financial Risk Right Now

Episode Date: February 9, 2023

The Federal Reserve raised interest rates at the fastest pace in decades in 2022. But despite the rapid shift in borrowing costs, not much in the financial system actually 'broke.' Stocks and other risk assets went down, but aside from a few issues like the gilt market drama in October, we didn't see a big systemic event. On this episode of Odd Lots, which was recorded live at the Credit Market Structure Alliance conference in New York, we speak with Fabio Natalucci about how he's thinking of financial risk right now. Fabio is the Deputy Director of the Monetary and Capital Markets Department at the International Monetary Fund and he writes the IMF's annual financial stability report. He walks us through the key risks he sees as still lurking in the system, as well as what's changed since 2008.See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon Music. Hello and welcome to a special episode of the Odd Lots podcast. I'm Tracy Alloway. I'm Jill Wajenthal. So this is a live recording that we are doing at the Credit Market Structure Alliance Conference. We are going to be talking about one of the thornyest, most controversial topics in financial markets. And it's not. compensation, it's liquidity. Right. And so obviously, you know, it's kind of a wild year for markets overall in 2022. I guess markets have been a little bit more constructive, calm so far to start 2023. But like, I mean, I think it's still pretty clear that people are like anxious about like, what are, what are the various risks lurking out there, particularly like coming off such a big repricing of interest rates and such a uncertain macro environment. That's exactly right. And we have had

instances where liquidity risk has reared its head recently, notably with some real estate funds based in the UK that had to suspend redemptions. That prompted a well-known question of whether or not we should actually have these illiquid assets in a liquid wrapper. So we are going to be delving into all of that with really the perfect guest. We are going to be speaking with Fabio Natalucci. He is the deputy director of the Monetary and Capital Markets Department at the International Monetary Fund. He's responsible for the global financial stability report that the IMF puts out every year previously at the Fed and the Treasury. So really the perfect guest. Fabio, thank you so much for coming on all of us. Thanks. So maybe a very simple question. It seems like a simple question,

just to begin with, but it never is. What is liquidity? So liquidity and I think we talk about market liquidity here, not liquidity on the balance of the banks, but essentially is the ability to liquefy in a position at market prices, then at a price that doesn't move or the overall prices significantly. So you can do it quickly, you can do it without much market impact. So you can essentially liquefy a position

without having major impact on the overall market. So, you know, I mentioned it in the interim. 2022 was kind of a wild year for multiple asset classes, et cetera. By and large, though, not too much broke, right? I mean, I think like you'd have to, looking back, feels like it could have been worse. Yeah, so this is the big question. I see if you work in financial stability now

and you say, okay, if someone told you a year ago that the Federal Reserve would raise interest rate, 450 basis point, 500 business points, do you think it would have worked smoothly or what would have broke? And I think the answer you would be looking for place and things that something didn't work, right? Now, there were some instances, I think,

So the pension LDI thing in the UK was a good example of a liquidity problem interacting with leverage problem. So that's a combination of two vulnerabilities that amplify each other. Of course, the trigger of that shock was very unique. It was a fiscal policy shock that it's kind of idiosyncratic, if you want. There was some other example like a Korean asset back

security market, but generally speaking, particularly focused in the US, I think things are gone. pretty smoothly, which if you work on the other side, you need to worry about risk, then the question is like, did I miss something, or the system is really more resilient, and I should feel comfortable. And it's always uncomfortable to feel comfortable. Well, this is something that I always like to ask regulators, which is so much of, so much of the financial stability risk seems to be in things that we don't see coming. So given that we've been talking about liquidity risk for, you know, probably eight or ten years at this

point, like should we be looking at something else, or do you think the problem has largely been solved? So the way, if I made for a second, think about how we think about financial stability at the fund, right? So we don't try to forecast what the next shock could be. So I think I wouldn't miss all of them, right? If you think about COVID, that's not what probably was on my top list, the war. So I don't want to be in that business.

I think what we can do, and we try to do, is to figure out what are the vulnerabilities. So think of vulnerability as an amplifier, right? So there's any shock that hit, whatever that is. And then there are fragilities in the financial system and make the shock bigger. And so we have some sort of like matrix where we look at different sectors, so the sovereign debt, for example,

household, corporations, banks, and then what we call non-bank financial institutions. And then we look at different vulnerabilities. So liquidity is one of them, or lack of liquidity, leverage, financial leverage is another one, effects exposure, or interconnectness between the system. And then we try to fill the matrix based on the data we have, and we do this for the 20,

systemally important countries and we track them over time. So liquidity is one of them. Again, there were examples, like the Dash for Cash in 2020 was a good example that involved the specific NTD in the non-bank financial intermediation sector. There was the LDI in the UK. It's a combination of liquidity and leverage. There was Archiegos. It's another example, I think more of financial leverage, perhaps interconnectness.

So those are the things we are looking at. But again, the thing to me the biggest puzzle now is financial leverage. There's a lot of talks of leverage. position being unwound and rates move higher, volatility rises, but you don't really see the system breaking. So again, it's either because it's been the financial regulators have done a great job post-financial crisis, or maybe we are missing something. They're like, think of the LDI in the UK, maybe this is like a tremor that it's under the surface and we don't see it, but something else may break. That's the biggest concern at this point, that we're missing something and we're not looking

the right place. So I do think that like at the start of 2022, if you had said to someone, Fed is going to hike, 450 basis points, and by and large, things would be smooth. I think it would be surprising for a number of reasons. Everyone had become used to de facto zero interest rates. It was a dramatic hiking by any standards. Let's start, like, how would you, like, to what degree would you say that the smoothness of markets last year can be attributed to post-grade financial crisis reforms? So I think, I think. I think there's certainly an aspect to that, right? So the financial post-financial crisis regulation, in my view, most certainly made the

core of the system, so the banking sector more resilient, right? There are more liquidity, there are more capital, this resolution plan. There's a bunch of features that made, like, if you want, the fortress of the financial system safer. There is can move away from there, and they move to what we call the NBFI, or non-bank financial institution. I think of that as hedge funds, investment funds, sovereign wealth fund, pension insurance. And part of it I think it's okay because they have different risk profile,

the different investment horizon, different investment funding structure. And so part of it is fine. The question is one, whether we have visibility into this corner of the financial system, right? So do I can I actually assess the same way I will assess a bank? And I think the answer is no, because there is a number of data gaps that have to do with this institution, whether this has to do with leverage, for example, perhaps that's the most difficult one, or even liquidity. The other question is, are they systemic enough?

So suppose something goes wrong and the shock gets absorbed by that entity in the non-bank financial sector, maybe it's okay because it's not systemic. It can absorb, it doesn't create a financial stability event. F-TX. Yeah, in some sense. And then the other part is like, is there a feedback, though, into the banking sector, that we have not considered. So Archiegos, I think the example there was, yes, the entity per se perhaps was not systemic,

but there was so much feedback into the backdoor of the banking sector to prime brokerage, for example. So that's kind of why we think about it. I think the reform, there are some unfinished business in the non-bank financial intermediation reform agenda. Some of it, it's also not been covered by the reform agenda. Some of it's due with implementation. I don't want to just say that it's all bad, though.

I think there are advantage in positive of activity and risk moving to the non-bank financial intermediation. They have, again, different risk profile, different lending funding structure, different investment horizon, and they provide to grow to the financial system, provide lending, providing financial services. So that part is good. Other reason, and it's not just financial regulation, activity is move away from the banks to the non-bank financial intermediation sector also because of technology. So some changing market structure are conducive to being done outside of the bank's balance sheet. They're to structure,

they're not nimble enough. There are also conjunctual aspect, right? So for example, when you at zero interest rate for all 10 plus years, it's normal that some of the risk reshuffles around the way from the banking sector. And then the last one, perhaps, especially in advanced economy, central banks have played an important role, people may say too large a role in a number of markets. And so there's an impact on pricing itself. So there's a number of factors, I think, that contributed to this. Some are positive. Some are still, I think, open for assessment. You know, you mentioned archegos, and one thing I often wonder is in the market, we talk a lot about excesses and stretched valuations. And those seem like bad things, but they don't always manifest in terms of financial stability risk, except Arkegos was actually a really good example of that.

So could you maybe talk a little bit about how you see, you know, on a day when we're talking about financial conditions, basically going back to where they were before the Fed started hiking, talk to us about what excesses. in the market means for financial stability? So there's two aspects of this, right? So one is to do with the, if you want to call it, like, price misalignment or financial condition are too easy compared to the fundamental values, however you measure fundamental values. That's one piece. I think that per se, if there are no leverage employed, if there is no major liquidity mismatch,

it's not necessary systemic per se. Someone will lose money, someone will make money, but that's not part of my job. The concern is when that unwinding of financial condition, in the concern, interact with vulnerabilities. Liquidity, or in case of archiegos, it's financial leverage, right? Because then that vulnerability becomes a major amplifier. So it's not just that risk asset price, risk asset reprise, is that the leveraging in that case become an amplified of that reprise.

And I fire sale and all the de-leveraging that we saw during the financial crisis. There was that component there. I think there was financial-level employed through derivatives through prime brokerage. Then the other weak link there was that that was provided by banks, right? And so there was an entry point to the banking sector. That's where I think you need to be super careful, because for a lot of this financing structure or liquidity provision, somehow it touches a balance sheet of a bank.

In some form or shape, somewhere along the chain, hits the balance sheet of the bank. So part of it, it's a risk, but it's also an opportunity for the regulator. You should be able to see it once it touch the balance sheet of the bank. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it. it all. Hi, I'm David Gura. Join us every Saturday and Sunday for the new Bloomberg this weekend.

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You know, another thing that I think when I think about the last year, maybe the last two years, is setting aside the market volatility, there was a lot of growth. I mean, and maybe it's just nominal growth, but of course, if you have a debt, like the most important thing is you get it paid. How much does just maintaining a growing economy, unlike, say, what we saw in the second half of 2008, how important does that in terms of budgeting financial stability? is just they're not a lot of people defaulting because people have good incomes, whether it's households, low unemployment rates or low default rates for corporations. So usually, and the one this is that we used to look at the Fed, growth to me, it's a precondition for financial stability, right? You cannot have financial stability without growth.

You need growth. So growth, it's really important. And so that growth that came of the, if you want the recession, if you want that way, of the COVID, was in part because central bank stepped in majorly. So the Fed here at a major central bank and ended up backstopping the full financial system. If you compare that with 2008, the backstopping was faster, more aggressive and wider. The other difference with 2007-2008 was fiscal policy, right? So if you remember the size of the Obama administration fiscal plan and think about the number of fiscal measures

that have been taking the US during COVID and the size of those, right? The combination of the two easy financial conditions plus fiscal policy has turbocharge essentially, the economy. Now, the downside of that is I think perhaps we as a community in general, policymaker, maybe in markets too, we have been slow to recognize the inflation problem, right? So because growth was going fast and because fiscal policy and been using that size for a while, that's where I think the concern is now, and this is why we went into the tightening monetary policy and so on. So the flip side of that fast growth has been inflation at levels that we haven't seen since the late 70, early 80s.

How does inflation manifest itself in financial stability risks? Yeah, so there's the risk here, and I think that's why price stability is so important, is that if you don't tackle inflation now, so if you don't let prevent inflation pressure from becoming entrenched into the inflation dynamics, so core inflation wages, and you let inflation expectation on more from the target, it's going to be way more expensive to bring inflation down. So in some sense, personally, I think I think there is in asymmetry in cost here, right? So if you say, okay, well, it's the cost higher if I am

tightening not enough or if I'm not tightening too much. Personally, I think the cost is higher if you not aggressively approach this. If you think of the late 70, early 80, early this in the US, it took a lot of high tightening monetary policy for Paul Volcker to bring inflation down, right? So being proactive and preventing the entrenchment and increasing inflation expectation, I think it's crucial because you can control it, then you can bring eventually, you can bring rates down to where they're supposed to go. Now, of course, if you do this pace on which this is done, financial condition tightened. If anything, now, the puzzle is why they haven't tightened more than otherwise, right?

Any model that you run, if you say, okay, the frisk free rate moves by 450 basis point, I think Exxante, at least, based on historical relationship, who'll tell you the financial condition should be way tighter. I mean, we had March 2020, it was just the Fed, you know, in addition to the massive stimulus and then there were a couple other rounds of stimulus afterwards, and then the Fed just, you know, opening up one acronym after another trying to backstop a market and maybe, you know, in retrospect that contributed to inflation, but was that a sort of like, you know, from your perspective, is like, this is an example of we saw what happened in 2008, 2009 when we go slow and we let growth

collapse when we let nominal income collapse and a sort of a successful lesson learned? I have no doubt that was successful. I mean, the alternative would have been like fall into a crater of growth, right, in the great recession story. The issue is that that response and the easing of financial condition and the buildup of some of this vulnerability highlighted some of the reform agenda that you mentioned before has now been addressed though. Right. So the chapter that we put out in last October was about open-hand investment fund. And that's That's an example, I think a sector where there are liquidity mismatch, particularly those open-hand investment fund that have daily redemption for illiquid asset, right?

Think about high-yield, corporate bonds, for example. That's where I think the risk is, and that's what we have seen in March 2020. The outflows from those open-handed funds was about 5% of assets. That was larger than during the financial crisis. the counterfactual of the Fed not stepping in very quickly and starting to backstop not just QE or sub-purchase, but backstop in credit market would have been a much larger decline in asset prices, right? So what we show in that chapter, it's one that there is a link between the illiquidity

of the funds and what they hold, right? So assets that are held by illiquid funds tend to drop in prices much more, and that there are much more volatility in return. So for example, one standard deviation shock in the liquidity, so some sort of what you saw March 2020, increase volatility of return by 20%, which is a large, significantly large number. And that's where I think you need to think about what do we need to fit in terms of policy agenda. Is there a whole? Do we need to think about the regulatory perimeter? What tools do we need? So just on this note, there is that inherent tension between, you know, offering someone

illiquid assets and putting them in some sort of liquid wrapper that allows them to go in and out on a daily basis. What is the funds view on the best way to deal with that risk? And also, given what we saw in 2020, when the Fed effectively came in and backstopped not just credit markets, but the Treasury market as well, which is supposed to be the most liquid market in the world, like, does that mean, was that the end game? Problem solved? Central banks backstop this and liquidity risk is no longer an issue? No. So my personal view is that if you want to live in where every X number of years the central banks needs to step in and backstop the financial system

and every time push the line one more, I think you need to rethink the regulatory perimeter then. If you want to be on the preceding end of the financial sector backstop, then the perimeter need to be different, right? So you need to be within the perimeter. They're not outside the perimeter, obviously, but there's a different way of thinking

about financial stability risk, because systemic risk at that point, right? So the issue here is that you're providing daily liquidity when there is underlying illiquidus, Now, of course, they hold liquidity buffer and so on. So there's a threshold for period of non-stress. Perhaps the system is fine. People can have different views.

The problem is during stress, if you eat through the liquidity buffer, they're forced to sell us. You face redemption, you sell, you generate a fire sale. And because of the structure, there is an incentive to run first because you're not bearing the transaction costs when you get out first, right, the way this is designed. And so I want to get out first before the market's price are going down, essentially, the NAB. So that generated run dynamics that has important systemic implication because you go into fire sale. And that social cost of the first mover is not addressed by the way the design of these features are now. So what we look at, we look at a bunch of possible solution there on measure, and we did some work across countries.

Usually what the most common tools in terms of liquidity risk management tools are either suspension, obviously, or redemption gates or redemption. Those are pretty much widespread. What is much less common is either what we call swing prices, so essentially the ability to incorporate in the price you pay to exit of the externality or if you want the transaction cost that you impose of those to stay in the fund. Those are not common, not in the US for sure, and even in Europe are in some sense, they're voluntary. And then this is the open debate of what do you do with the liquidity buffer?

Do they work or not? So what we find there is that the liquidity buffer, there seems to be some relationship between the liquid of the underlying and liquidity buffer. That is, if you hold more illiquid asset, you generally, on average, tend to have higher liquidity buffer. The results that's more interesting, though, is that one, there is very widespread use of this liquidity buffer. Some, when you talk to people in market,

some tend to actually use them actively. So I'm going to sell the most liquid stuff, use my credit lines and hope for the best, if you want. Others don't want to touch it because they don't know what's coming next, and so they start selling the less liquid stuff. So there's a very different use of this liquidity buffer. But on average, at least what we find is that during stress, the average fund, if you want, tends to grow the liquidated buffer.

They just don't want to use it. They don't know what it's coming. So if that's the case, that is not helpful for the exanth incentive to run, right? It doesn't prevent that. Swing prices are mostly used in Europe. Again, swing prices, the ability, essentially, to correct the price which you take money out based on this transaction costs that you impose on others. The problem is that in principle they are effective to reduce volatility.

The problem is that the buffer of the swing factor, if you want, how much of this is used is too small compared to what would be used. And either because of competitive reason or because of stigma, whatever the reason is they're not calibrated to the way that they should be calibrated during stress time at least. Another option which is more extreme if you want is to more formally link your ability to exit these vehicles to the liquid of the underlying. So you mentioned the real estate one there. The liquidity is not daily, right?

You're only a specific period when you can withdraw. If you go into loan marketing in the US, and you go back decades, there was no daily liquidity. They used to be, if I remember correctly, intermittent funds, or there were quarterly or monthly liquidity. You need to give advance, and then when it comes time, you withdraw. That allows you to, I think, manage liquidity better.

I think there's a lot of controversy on whether you should restrict the liquidity that can be given based on the underlying. But that would be, in principle, the cleanest way to fix the underlying mismatch between the liquidity and the underlying assets. So just on that note, you know, one thing with liquidity is I think a lot of times when people talk about liquidity risk, often they're talking about basically price risk and the risk that you're going to see a big drop when you try to sell. How do you disaggregate those two things?

And also, there is an argument to be made that if you're holding illiquid assets and if you can get away from marking them to market that often, that it can actually see you through a rough patch, right? Again, we see this with real estate nowadays, which is like a lot of the big funds haven't had to mark their assets to market and they're sort of holding on waiting for a potential recovery. And that helps in the interim. So, honestly, I would deal with the liquidity one. I think take the Treasury market here or the guild market in the UK, right? The issue was that in some case it was really hard to sell, but you could not find a bid. Right. Even if these are supposed to be the most liquid fund.

So you should not see those in the most liquid markets. That's supposed to be a risk-free asset, right? You should be able to sell. The issue with liquidity, I think, has to do with the fact that often also interact with other vulnerabilities. Like I made the example of leverage, right? That's what we call liquidity spiral at least in the in the profession. That's where liquidity and leverage interact with each other. My personal view is getting rid of mark to market.

It's kind of like hiding a little bit. I want investor to be able to price risk and not market to market. And I can see the argument of say, okay, if I can only bridge to there, then the world is going to be in a better place. My view is that you need liquidity, you need to put, provide disclosure, more disclosure, I'm more in favor of disclosing trade, for example, because in the end, yes, you will take a loss, but you price markets where they're supposed to be. Past experience during the financial crisis, when the pricing of risk in the subprime market will

postpone, I don't think that's where we want to be. I think we want to be in a place where you price market. Yes, sometimes it's going to overshoot. You know, both of you talked about the LDI situation in the UK, and of course, in March 2020, we had that big dislocation in the Treasury market, but it was sold fairly quickly in terms of the central bank stepped in and was a buyer and then the prices returned to normal. And then subsequently to March 2020 and the Fed has stood up a standing repo facility. And so like there's even more liquidity available theoretically for treasury buyers. How powerful is that just looking at the sort of risk-free assets within any given country, to what degree should more is, should more central banks

set up more robust facilities to create sort of like both-directional liquidity for holders of government debt. So I don't think personally that the central bank should mean in the business of managing daily liquidity, right? So I can see a role where the central bank is the lender of last resort, of the liquidity provider of last resort. What the standing river facility is meant to do is meant to cap in some tense rates, right? So they don't want to see what you saw in September 19, where when they were normalizing the balance sheet, that's what the facility is meant to be. That is not meant to be a day-to-day normal way or providing liquidity. Liquidity is in the market, there are buyers and seller. That's how the system should work. What has changed in the treasury market is that the underlying structure has

changed, right? What the broker-deer used to do now is done by principal trading firms. It's done by firms that are not part of the traditional banking system and they're not within the traditional regulatory perimeter. That is technology evolution. I think the question is where, the perimeter should be. There are also other major discuss, again, have to do with transparency of trades, so disclosing trades, and whether you should use central country party to net some of this position out and reduce some of the exposure, whether they would free up balance it effectively to provide liquidity. I don't think the daily today job or a central bank should be provide liquidity to markets. To me, that's a lender of last resort function that I think it's super

important. That raises a question though, that if you have access to the lender of last resort function of a central bank, where the perimeter of the regulations should be? You can't be just receiving a check and then the central bank should complete out that business. Personally, I think that's a very uncomfortable business for a center bank to run. Just on this liquidity question, one of our all-time favorite odd thoughts guests, Chris White, said something on the podcast once, which was He asked a question, which is, is liquidity something which sort of happens naturally if you have a market that is properly networked with people talking to each other? Or is it a service that you should have to pay up for? And I'd be curious to hear a regulator's view on that topic.

I think liquidity is a financial service, and like any other financial service, there's a price. The problem, I think, after 15 years of zero interest rate, zero volatility, pre-fat tightening, was that liquidity was no properly priced. That was a big problem. So you get used to a place where liquidity is abundant, it's essentially free, and you don't price the risk, right? So think about price of liquidity, break it down in two pieces, right? They expected liquidity and the risk premium. How much you want to pay for insurance if you're probably.

I think that part that's where it was misprice. There was liquidity premium was not paid. People were not paying for the, they were not willing to pay for a situation where liquidity would go away. And I think with interest rate normalizing, volatility rising eventually the hope is that people will start to price liquidity. It should be. Liquidity is not free.

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or wherever you get your podcasts. I want to go back to some of these funds that occasionally have issues with redemptions. There was the real estate one recently. I think it was after the energy crash, like in 2015 or 2016 or that people started worrying about the high yield funds or the high yield ETFs in the US and so forth. But none of those turned out to be systemic per se. I mean, people got anxious about the funds themselves, et cetera, but even some of the recent stuff didn't seem like

there were huge spillovers. What is the scenario in which something, some stress that emanates from some fund or some class of funds becomes something that regulators should be concerned as systemic risk? So it's a question about mutual for open-ended fund or ETFs or both? Either one, however you want.

Well, let me start with the first one with the open-ended funds. I think the risk is, again, what I was described before. The PEO, you run for the door because I don't want to come after you, because they're incentive to do that. And then by going out, you generate a spiral where you get fire sale because they need to liquidate to pay you, and the price moves much more than it should have. I would argue if you take 2020 as an example that saying the system didn't break, it's a little bit too generous as a view.

The system didn't break because in a month, the Federal Reserve back of the entire financial system, right? So if I give you a counterfactual where instead of that month, they were in another month, my expectation is that the system would have cracked in different places. DTFs, I think my view of change over time. I think I was trying to look for places what could go wrong there. I think they provide an important liquidity function.

You can get out, you just sell, you share with the Fs, and in some sense they do sell a price, right? The concern that I have there is more the opaque world. of the authorized participants, right? So the dealers that create and redeem shares, particularly in fixed income where in equities, I think it's easier if you have the SMP 500, the bucket that you use is more or less the index. With fixed income, the basket you use to create and redeem is way smaller than that.

And there is a lot of opacity exactly what's in those basket, who's provided to whom. If they don't provide that function and it breaks down, then the creation and redemption can break. Now, whether that's systemic or not, I don't know. To me, that's where one question mark is. Just on March 2020, specifically, it's like, okay, that situation required enormous support from the Fed and other central banks. But I think it was a point that we talked to Josh Younger, who's then at J.P. Morgan, now at the New York Fed. Like, should regulators be optimizing for the type of crisis that emerges from a once-in-a-century pandemic? I don't know, like, is it worth, like, having the system be robust?

Or should we say, okay, once in a century pandemic, it's not so bad if that requires the Fed to step in and start spraying money everywhere? First of all, it's two times in a century now, because it's from the GFC to COVID, right? So it's kind of close to each other. Okay. I agree. I don't think you should calibrate to financial disaster every time. But I think there is something in the middle between calibrating like that and

what is done now. I think there are steps that can be taken to fix some of this liquidity mismatch, whether this is swing prices, for example, in utilization of those. So Regulero can, for example, provide guidance on the implementation of some of these liquidity tools. They can consider whether some of these liquidity tools should be mandatory. The problem is there's no alignment between the incentives of the individual manager of the funds and the system financial stability objective. If you align those, then the system works better. So whether this is, again, guidance, mandatory use of some liquidity tools, whether this is stress testing, whether this is disclosure.

I think you can find a combination of this. It's going to be a function country by country, depend on the institutional setup, the legal setup. Some things can work better than others, and again, or minimizing the gap between the liquidity that you provide and the liquidity of the underlying. One last point. There is another aspect that often is not discussed in the US, but some of these players are made of these open-ended funds are major players in emerging markets. And when you see this in and out of those flows of those countries,

you can break those markets very easily. And so there is any, if you want, the cross-border systemic aspect to this, and maybe it's not just US focused, but at least for me working at the fund, for some countries, those are large, large movers. Yeah, I think that's a good point. You know, you mentioned incentives there. Can you talk a little bit more about the incentives at play for, you know, fund managers, for instance, when it comes to handling liquidity risk?

And one thing you said earlier was very interesting to me, this idea that, you know, a lot of these funds will build up liquidity or cash buffers, but will be reluctant to actually start running them down in times of stress. So that was like, there was a time I talked to a few people in the loan market, how they were managing liquidity, right? One was trying to understand what is your definition of liquidity buffer. That would you use. Is it cash? Is it lines of credit? It's the most liquid leverage loans. Do your whole treasury securities?

is how big the buffer is. I mean, there's a trade-off between, yeah, of course, you can hold a huge liquidity buffer, but it's going to hit your return at some point, right? So if I want to invest in leverage loans, I don't want you to hold 20% in liquidity. So that's one piece. The other one was trying to understand the waterfall,

if you went, right? How do you manage this? And I thought it was quite interesting then, I got two very different response, like from I'm gonna start using and selling the, if I have some liquid-like securities, after cash, then maybe use my lines of credit, then progressively move to the less liquid stuff.

And then others, they would tell you, I would never touch it, no, even if you should me. I just, that's because I don't know what's next year. I need that as my insurance. So I don't think the regular should tell you exactly whether you should manage this personally. I think they should provide some guidelines. My sense now that it's too much left to the individual manager

that does not internalize what the systemic implication of the behaviors are. So one of the things that's happened on this podcast of doing it for seven years is we've seen this evolution in the type of things that we talk about. And we used to do a lot of episodes on like the repo market and credit market liquidity, all these type of things. And then in the last two years, many of our episodes have become like very like physical world, commodity risk. The one financial crossover with commodities we saw, like, you know, there was the crisis at some point last year in the nickel trading at the London Metals Exchange. Can you talk a little bit about how like as this, and I don't know how long like commodity markets or energy security is going to remain so top of mind, but, you know, we weren't really talking much about that prior to COVID and some of the commodity shocks. Can you talk a little bit about how you're incorporating some of those stresses into your thinking and the challenges of thinking about the markets from a financial regulatory perspective?

Yeah, so if the matrix I was describing before, energy trading were not there, obviously, right? So those were not the entities were following closely for which we did. So that was one lesson I think learned during the February episode. I think it's important to follow for a number of reasons. One, because they are important players in the financing of the physical assets, right? So they provide collateralized lending to shipments of various commodities. So that's one important piece. So they're very much linked to the physical asset.

Two, because they are crucial players in the derivatives markets. The derivative markets used by producer as a hedge. And so they play a crucial role in the middle. Obviously there are banks involved and so on. So they play a function that is important for the smooth operational that market. Commodity is a global market. The risk from a financial stability perspective, one that we quickly discovered is that there were no data.

And so if you want to say, okay, I'm going to have a chart. And I don't know what chart to show. Some of these entities have publicly traded bonds. So that's what we were showing. That was for us proxy of investor concern about these firms, but that was pretty much here, right? There's no visibility into their leverage position, who they were playing, what market, that was huge sense of opacity in terms of where there is square.

That was the big question, I think, the big flag, red flag came up. So we're trying to do better job going forward. I mean, the big gap, again, it's data. Data and honestly, they're not the easiest one to have conversation. Glenn Corps doesn't want to talk to you, I can't imagine. I see an easier conversation with other people. You mentioned cross-border spillage risks earlier. And one of the things that I've thought about and I've written about at various times

is the role of benchmark index providers in directing inflows and outflows. And I think the IMF has done some work on this too. But how much of a risk is that, just this idea that you create a benchmark, everyone tries to hug it as closely as possible. And if you get a major change in the index, for instance, if China is added or taken out, it triggers all these flows. Okay, so again, this positive is like everything, right?

Opportunities and risk, right? So I think opportunities of being added to the risk, it means that country opens up to capital flows. So capital flows are important for growth, for financial transactions. So there's the positive of coming with it. The risk are that the behavior or passive investor or benchmarking invest is very different from, say,

EM dedicated funds. Right EM dedicated fund, it's really about going in and picking the right country, picking the right credit, doing more the credit work, if you want, or sovereign work. Benchmarking is just following an index. And what we found is that the behavior of investors that just benchmark are much more linked to global financial conditions. So when financial condition change and they're talking globally, this guy tends to leave. And so by being in the index, yes, you get more capital, but you are much more responsible

before, if you want, to the risk-capital change of the global investor. That's the downside of being in the index. So that's where I think then it's important for the local. Now, there's another opportunity, actually. They often tend to deepen the liquidity of the local markets, right? So their benefits. That's where the local regulator, I think they need to play a role in terms of regulation that it's appropriate for those kind of flows.

Because those investors are not the typical EM-deligate investor that sticks there. are investors that moves with global financial risk capital. And we have seen that over the last past few years. I want to go back to something you said near the beginning that I found to be really interesting, the idea of growth being a precondition for financial stability. And often when I think about central bankers around the world of regulators, it feels like to me that like the sort of macro part of their job and the regulatory part of their job are like two separate things. And that there's, you know, managing the banks, making sure this and then also like making sure they hit their inflation and unemployment goals, et cetera. Is that the case of my misperception or do like, should

central bankers, should regulators recognize the interlinkages between maintaining robust growth and financial stability more than they currently do? Think of like the banking sector, right? The best ingredient for success of banks is growth, right? Because they have healthy balance sheet. They have healthy capital position, liquidity position. And so to me, without growth, the system is much more fragile. The way we think about financial. stability in terms of our framework, we use financial conditions, we use economic condition, then we try to forecast what the distribution of growth will be, right? And so we think about financial stability as the left tail, if you want, the downside risk. That's for us the link

between financial condition, vulnerabilities and growth. What policy makers are trying to do when they think about financial stability are trying to minimize the downside, the tail. That, to me, it's the link between growth and financial stability. That's the framework we use in the financial stability report. I have just one more question and I'm sure this is the one you get asked at every interview, but what are you most worried about at the moment? I think what I'm most concerned now is this sense of comfort that nothing is broken. As evidenced by this interview in many of our questions. But it is because I am reluctant to embrace this idea that we made the system more and then this has worked out smoothly.

Maybe it's the case and then we should celebrate. I'm just concerned that, I don't know, the energy trading firm was an example. That there are corners of the system that I've not paid enough attention, they've grown over time, that they become systemic either because of size or because they use leverage in forms

that they're not apparent or I don't have data or I don't understand the dynamic, right? So the LDI was a good example. People knew about LDI. This is not a new thing that was learned, right? It just happened that combination of the that business model with illiquity in the gilt market, with the policy shock that startups,

no one was difficult to forecast. But the combination of all this factor create a situation where what was going up in the UK had tremors across the globe. You have reprising of credit risk in the US. You have reprising of asset-backed securities in as far as Australia because people were selling across assets. That's the part that's concerned me on missing something

and becoming too comfort in this, okay, we got the right matrix, with the right vulnerabilities, their right level model, because a lot of these have created with the lens of the past, right? So the lens of the last crisis. And crisis tends to be different. So I'm reluctant to be too comfortable that we manage to handle financial stability. It's good not to be complacent if you are a financial stability person. The regulatory financial, it should be a healthy paranoia.

I think it's also true that no one had, you know, liability-driven strategies on their bingo card for 2022 financial stability risks. so that's a really good example. Shall we leave it there, Joe? Yeah, let's leave it there. All right. This has been another episode of the Odd Lots podcast. I'm Tracy Alloway.

You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthal. You can follow me on Twitter at the Star Wars. I'm Michelle Hussain, and for more than 20 years, I was at the BBC. But all the time I was delivering the headlines, I wanted to go further than the news of the day. To spend more time with the people. shaping our world. And that's what I'm doing here on this podcast. Speaking to people from Nigel Farage, to say, Russia needs to be taught a lesson. To tech journalist Karaswisher.

And the tech industry is running wild. You know, they've gotten what they wanted and they've seen a huge run-up in their stock prices. This will be a place where every weekend you can count on one essential conversation to help make sense of the world. So please join me. Listen and subscribe to the Michelle Hussein show from Bloomberg weekend, wherever you get your podcast. You certainly ask interesting questions. What separates good leaders from transformational ones? I'm Jessica Chen, and in season two of Leading By Example, we'll sit down with executives like Grace Chen of Bertie Gray to find out. It's important to understand where you spike, but also really acknowledge where you don't and find people who can,

fill those gaps. Listen to leading by example executives making an impact on the IHeart radio app, Apple podcast, or wherever you get your podcasts.