Odd Lots - Huw van Steenis On What Central Banks Will Do Next

Episode Date: September 9, 2019

Last month, central bankers gathered at the annual Economic Symposium in Jackson Hole, Wyoming. A lot of the talk was about the limits of monetary policy when it comes to boosting economic growth and what negative interests could do to the financial system. Bank of England Governor Mark Carney also gave a speech in which he talked about replacing the U.S. dollar's role in the financial system with something else­­—maybe even a central bank-run digital currency similar to Facebook's Libra. On this episode of the Odd Lots podcast, we speak with Huw van Steenis, who was senior adviser to Governor Carney and spent the last year chairing a BOE review of the 'Future of Finance.' He talks about how central banks might respond to a number of issues including the rise of new technology, the changing nature of money, and the harmful effects of negative rates.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 another episode of the Odd Lots podcast. My co-host Joe Wisenthall is away this week. I've actually noticed a pattern to Joe's absences, which is that he suspiciously goes missing whenever we're scheduled to talk about negative rates on the show. In any case, we recently had the annual gathering. of monetary policymakers in Jackson Hole, Wyoming. And as you can imagine, negative interest rates were a big feature of that meeting. And in fact, the title for this year's symposium was challenges for monetary policy, which kind of gives you an idea of the headspace that a lot of central bankers are operating in at the moment. But one of the most interesting things to come out of Jackson Hole this year, certainly

a thing that got a lot of attention, was a speech by Bank of England Governor Mark Carney, where he talked about the idea of getting rid of the dollar as a reserve currency and basically replacing it with a virtual currency that would look a lot like Facebook's Libra in the sense that it could be a sort of consortium of digital currencies maintained by central banks, a multipolar virtual currency. He actually called it a synthetic hegemonic currency or S-H-C for short. Now, Carney's idea did raise a lot of eyebrows, not least because central banks have been critics of cryptocurrencies in general and of Libra in particular.

So I thought to myself, who better to help us gain more insight into Carney's thinking and to also talk to us about negative rates and the future of payments and the future of all of finance, in fact, than Hugh Van Steenis. Hugh chaired a review of the future of finance for Mark Carney and was his senior advisor at the B-O-E. He'll also be shortly joining UBS as an advisor to their CEO, and he's taking a break from his gardening leave to come on odd lots. Hugh, it's so good to have you. Tracy, thanks very much for having me. So I guess we need to start with Carney's Jackson Hole speech. But we do know that Carney is due to leave the BEO in a few months. So I guess my question is, since you are

someone who worked quite closely with him, how seriously should we take his proposal for this sort of multipolar virtual currency? Well, look, I mean, I'm going to speak for myself here rather than for Mark. I mean, I thought it was a really great speech because it put its finger on a number of the dilemmas that policymakers are wrestling with. I mean, first, let's be clear, technology is transforming the basis of advantage in financial services and big techs are entering, fintechs are playing, scale is far more important, and the regulations need to catch up. So I think first and foremost, it's about the way technology is transforming the system. I think second is that payments is the battleground between big tech, payments firms, and banks.

And it's kind of existential. And as you've pointed out regularly, Tracy, the combination of negative rates and a disruptive environment is one which is, you know, an existential threat for banks. And I think the challenge for firms entering payments, Libra, Facebook is just the first of which, most recent of which, is pretty challenging. And I think that one pushback that some had is that, you know, this was a little bit, you know, right out there in terms of forward thinking. But one question I often got challenged is what can we learn from the Chinese financial system? Is it just the Galapagos of the financial world. And I think it's not science fiction. I mean, there you've got Ant Financial and WeChat Pay controlling 90% of online payments. And Ant Financial now has got the most

customers of any financial services firm in the world. If you can combine what they've got in China and India, it's over a billion, five-time city group. So I think that there's payments both in terms of currency and in terms of new entrants being the battleground, I think he's put his finger on something really important. Right. And China has actually announced that it is close to releasing its own cryptocurrency, whether or not that's going to be an actual cryptocurrency or something that's more akin to digital cash. We don't know just yet. But definitely there seems to be some interest from some central banks, at least, in virtual currencies. So just on the notion of payments, You know, you've said before and you just said it then that payments are now the battleground.

Can you expand on that a little bit? Why is there so much pressure around this particular space? In financial services, particularly low rates, they're not that many areas which have got strong growth. And payments clearly is one where people are moving offline to online. I mean, one thing that we unearthed in our report was that, let's take Sweden, we've had an 80% reduction in cash transactions the last decade. The UK is probably four or five years behind that. The US is probably another four or five years behind that.

There is a very long tailwind of shifting commerce online, and everyone wants to be the gateway into the online commercial world. So I think that's one key aspect around payments. I think second is these person-to-person apps, whether it's, you know, Ali in Pay in China, whether it's Swish in Sweden, whether it's Idial in Holland. These are sort of category killers. You know, they really munch through cash.

and provide convenience and flexibility for customers, which, you know, customers are quite frankly lapping up. So I think there's that transformation. But I think the big thing for a financial regulator and a particular central bank where, you know, money is what it's all about, is the role of big techs either becoming a toll road that they just want to be the toll which people get into the commercial world, but potentially becoming much bigger in financial services. And with their advantages of scale, with other related businesses, and quite a very important frankly, a way of thinking which is very different from financial services. So if you take the Libra white paper plus all the other papers they put out on that day, you know, there's over 80 pages

on the tech, there's just under a dozen pages on the way the syndicate work, there's not a single page on regulation. Right. And I think that's really atypical. And I think that's something which that means it's really difficult for a traditional policymaker regulator to get the heads around because there's just nothing there. Well, I was going to ask you, the fact that a lot of these tech companies have made such massive inroads into payments so quickly. Is that actually down to the tech or is it down to regulatory arbitrage in the sense that they are not hindered in the same way that banks are? I think there's an element of an unlevel playing field where they are coming in on a different

basis. But it doesn't have to be that the big techs win. I mean, just go back to Sweden. Swish is a bank consortium app which allows anyone to pay well at anyone. So you need to get over the hurdle of antitrust about how banks collaborate with each other. But there's a country where actually it wasn't the big techs who drove the innovation. So I think this is much more about do the banks have the budget, do they have the ability to respond? And of course, going back to one of your favorite topics, in a world of negative rates, bank profitability is pinched. And as a result of that, they just don't have the tech budgets that some of these other firms have. And I think the other

bit is that, you know, I mean, I met with over 300 entrepreneurs and fintech companies for the review I did for the governor. They have a very different profit motivation. They can withstand losses for three, five more years. There's not a single bank which can really do that for a five-year basis. So they just start with a very different basis of competition. I do want to ask you about regulating payments companies. But before I do, you've mentioned China several times as being very ahead in the payment space. We have things like AliPay and WeChat over here. How did they get to that place?

Because a lot of people would call them a sort of special case in the wider evolution of technology and financial technology in particular. I think it's a really important exam question to think about what we can understand and what may be borrowed from other markets and what's different. So first is the payment firms are really pump primed by a big tech firm. firm, so whether it's Ali with Ant Financial or WeChat with WeChat Pay, they used their existing clientele and network effects to hugely their advantage. I think second is, though, they really did offer phenomenal promotions to get acceptances. So in one case, they offered taxi drivers in Beijing a premium if clients paid with at Ali Pay and also gave the clients a discount if they paid. So they were really smart about discounting and generating clients.

interest. And their third of course is maybe what is different is they've got a whole financial supermarket. Now, in most Western regulatory structures, different regulators have purchased on different parts of the financial system. And so you've got one financial supermarket, which is a bit different. The other area which is different to China is identification. There is an element that everyone is identified. And one of the big issues that everyone's wrestling with in the West is how you can make, how you reduce fraud and how you make sure you know who your client is. And actually some of the emerging markets probably have leapfrogged the West on this. And maybe, and obviously quite frankly have a different sense of, you know,

libertarian values about what the state should or shouldn't know about you. Right. So how much of the China example would be replicable in, for instance, the UK or the US? Well, I think, so first, you've already got some pretty strong competitors. And I love Alex Randpullet, A16Z, has got a great line that the quintessential debate between an incumbent and a new entrant is does the new entrant get distribution before the incumbent gets innovation? And I think that battle is really about, you know, what China shows us is that the new entrant got distribution incredibly quickly. And I think as you look into the States, you've got some pretty serious payment firms, visa, Master Guard, Amex. PayPal, as well as some of the key banks, JP Morgan and so forth, which have got really big positions in payments already. I think too, very few big techs want to have the hassle of bank

and payments regulation and all the capital that goes with that. So most of the firms so far have tried to be a wallet or a toll road on the back of the existing banking system. But what I think we could see is that over a period of time, these firms could grow broad. and deeper. And many of the financial fintechs that I met have ambitions for, you know, quite frankly, world domination. And I think therefore it's about making sure that the banks and the payment firms respond, you know, and really understand that existential challenge is pretty real. Right. So as these tech firms potentially grow bigger and encroach ever more on the financial space, and to your earlier point, what are the challenges posed by that for central?

bankers, how are they exactly supposed to respond to this new group of financial intermediaries? So there's a couple of things, and it does vary country by country. So first is about innovation. Most geographies want to encourage innovation of new firms, but in many jurisdictions, you've got a concept of a startup or you've got a systemic financial payments firm and very little in between. And so as I was struck that the Singaporeans in the last year, injected a new third category saying, actually, if you've got half a million and billion customers, we need to deal with you in a different way. And so payment regulation has to probably be updated to reflect that these are now very large firms, which may not yet be systemic,

but whose failure would be pretty brutal for the system. I think second is around what it means for the banking system. I use skimming off the cream of profits for banks and leaving them just simply as dumb pipes, in the words of one of my colleagues who looks at this space. Or maybe even, maybe not dumb pipes, that's unfair. High cost due diligence machines, but nonetheless not very profitable. I think that's worse. Well, yeah, I think that is. And I think that, but it is interesting that quite a few of the payments firms are trying to rely on the know-your-custom checks that the banks do, and then they don't get rewarded for it. And so there is, to be honest, a slight unlevel playing field between payment firms and banks in most. But let's be

as not all jurisdictions. But the third thing, Tracy, though, is coming back to actually who's been left behind. And I know that I was struck by a huge interest in what does the decline of cash mean for those who potentially may be getting left behind, whether it be elderly, disadvantaged or potentially disabled. And if you look at Sweden where cash has fallen by 80% of the last decade, they start to hit some crunch points. And one thing that I spent some time looking at in the review is how close are we to those crunch points in the UK or in other markets? And what would you do to make sure that there is a minimum or even a viable infrastructure to at least maintain that cash system? And so you end up with some quite out there

discussions of should in the long term it be the responsibility of the state or the central bank to keep the cash economy viable. And I think, you know, for many listeners in the states, that sounds like a bit of sci-fi. But it's something which in Norway and Sweden, where less than 10% transactions are now done with cash is something which is pretty important. So why exactly do we need cash? So there's a big debate, as always, about what is the right mandate for the central bank? At the moment, it's society's decision how we pay, not the central banks. And so I think that the bank of England, like other central banks, takes it as a political

decision what the future of cash should be. And if you look at the sort of debates in history, I mean, in the not, in the not 19th century, there were some pretty big debates about who had the responsibility to print money, should you have private sector money or not. Today, we're going to be debating how much, should there still be cash in the system? I think over the next 10 years, what we're talking about is not cashless, but just increasingly cash light. As year by year, more payments are done online. But I think it's really a political discussion. And if you look in Sweden, it's getting more intense about where the politics lie. And I think at the moment, the assumption is there should be some cash.

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That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. When it comes to the sort of value of cash in a society, if we go back to the negative rates idea, I mean, negative rates basically make cash uncompetitive, whether it's physical and you're stuffing it under your mattress or whether you're putting it in a bank and it's a sort of digital number. What does that mean? for central bankers, whose purview is, you know, of course, monetary policy. It's all about the money and cash is uncompetitive. So look, on this, I should really say this is my personal view than the

bank's view, but obviously we don't have negative rates in the UK. When I was Morgan and Stanley, I argued vociferously that negative rates were a high-risk experiment. And in particular, that, you know, most of modern macroeconomics takes the financial system and then assumes it way, just basically ignores banks and intermediaries and their own actions. And I think ignoring that friction comes at a cost. And you can see that the way that negative rates are played out as you know, you were discussing a few weeks ago, Japanese bank, regional banks are the least profitable in the world and actually have really been sort of supported by clipping coupons as government bonds get revalued. I think that the corrosive impact of negative rates on bank

profitability is very strong. And I think there's been two great new papers, one by Professor Charles Goodhart of the LSC and another a Norges Bank working paper, both of which you challenge the orthodoxy and say, actually, if you ignore banks and insurers, you do it at your peril, because as you get towards low rates and move into the Alice in Wonderland world of negative rates, the credit transmission simply becomes much less effective. And I think that's really something which, you know, policy makers need to way up as we think about confronting the global slowdown, I certainly, for my vote, would be hardly against any further moves more negative. And I think also what really struck me doing the review is, you know, tech is really important, but also cyber defence. European banks,

particularly Eurozone banks, are spending almost half the proportion of their tech budgets on digital transformation than their US colleagues. Now, some of that is being subscale, and, you know, we can debate whether there should be more M&A in Europe. But, some of it is just the lack of profitability and of which negative rates is a key component. So I think it's a tough experiment. And that's before we go on to people storing cash in deposits and being disincentivized. So I think it remains a high-risk experiment here three or four years on. But just on this point, this is one thing that I don't understand because central banks must

know that banks are important transmitters of monetary policy. So if banks are structurally unprofitable, doesn't that worry the central bank? I think it does, but I think that what you've put your finger on is a key difference between probably the Anglo-Saxon world and some of the other systems where I think the Anglo-Saxon world firmly believes in a positive interest rate, even if it may be low. I think second is because macroeconomics have just assumed this way, there is very, very little in the literature that central bankers are relying on to understand how this works. And I think it's fair to say negative rates work in, quote, a myriad of ways. You know, they obviously impact net interest income margin for the banks like the top line. But in some cases, as markets get revalued up, commission income, the sale of asset and wealth

management products could increase. Low rates clearly are suppressed bad debts, and that's been a key defence of ECB and others in support of the policy. But when you really dig deep, it's probably more QE than negative rates who've done that because it's more about tackling the bad debt problems in Spain, Portugal, Greece, Iqli, and arguably QE would have been more effective than negative rates in suppressing it. But as you and I and your listeners know, that's already priced in. So at this point, you know, lower bad debts is priced in. It's much more about what the next step is from here. And a very unprofitable system is one which is more brittle. So I think that's definitely a concern. One, you know, Larry, someone's recently came up with the great analogy about black hole economics.

The one that I've debated more with a bunch of academics I've been working with is it's more like steroids. Steroids and short blasts can be very effective in repair, but long-term dependence. on steroids starts to dissolve your bones and makes the patient more brittle and maybe negative rates are more like steroids than other analogies. So just to continue that analogy, if you have banks that are sort of reliant on the steroids of easy monetary policy and we're reaching the limits of that potential monetary policy and at the same time payments is a space where you can still make money as a financial intermediary but you're getting a lot of tech firms encroaching on it. And in the meantime, lending out money doesn't actually earn you any interest. What does that

mean for the banking business model? Is there a future for banks in their current form? I think there, no, I firmly think there is, and I think we go back to this, that it's first technology, at one level, allows many new entrants, but also provides real scale economies. And in a world where, let's say, large corporates are obsessed, rightly obsessed about their security their money, the firms who've got the single best cybersecurity should win out. So number one, there's a, I think tech is becoming an arms race for the winning financials, I'm sorry, winning banks. So I think that's one aspect which is really important. I think two, what flows from that is scale is more important. And so it may well be that actually the combination of low rates

and tech actually accelerates more M&A, which is, you know, let's be not, let's be honest. has been somewhat on hold in recent times. And you can see that with a couple of, you know, recent US transactions, which have really been around payments and the tech space. And I think third is, it really will be about becoming a low-cost manufacturer. And so I think there is going to be relentless hard work for bankers in making sure they've got a lean and a very effective platform. Because, you know, throughout my professional career,

let's take sort of, when I used to sit on an equity trading floor many, many years ago, before we got moved into the research box, the commissions have gone down through thick and thin double digit year by year. And I think that banks have been able to confront that through becoming more efficient and more scaled. So I think there's a lot of industrial logic which needs to flow from this, but they'll probably need a bit of luck as well. Is there space for regulation to play a role in this? Could payments companies, big tech companies entering the payment space, could they be regulated like banks? And one of the reasons I ask this is because one of the outcomes of your review

was the BOE starting a consultation on opening access to its balance sheet to payment providers, which, you know, it's kind of controversial in many ways. Yeah, I mean, so I think the way, the present I see this through is having a level playing field. It's not the job of the bank to pick winners or losers, but provide a, the infrastructure and set of rules and standards to ensure that there is just a great suite of financial services which are safe and secure for society. So I view this much more about the leveling the playing field. So on one hand, if there are some really high quality payment firms who pass some pretty high hurdles of security, cybersecurity and resilience, then why shouldn't

they potentially have access to park money at the central bank overnight and help foster to competition. But the other aspect of a level playing field is the payment firms or the big techs have to be held to the same standards as banks. So whether that be with knowing your customer and anti-money laundering controls, whether it be cybersecurity, whether it be resilience. And that's why the other part of my report was to argue for updating payments regulation. Now within the UK, that's obviously a role for the government and they're kind of busy at the moment with other things. I can't imagine what. But the former chancellor, you know, did commit the Treasury to looking at a updated payments regulation.

As I said, I think what the Singaporeans have done of introducing a third category of, you know, large, important payment firms, which are held to high standards, is at least an intriguing idea, which, you know, many jurisdictions, I'm sure, must be looking at. And the other bit is about reciprocity of data. So one of the big challenges is if the banks are asked to share their data with big techs, what do they get in return? or at least how do they get compensated for that? And so a level playing field information is probably just as important as having really high standards. So I'm going to ask you a very broad question now for which I ask your forgiveness in advance. But when you look a decade into the future, what exactly does the financial system look like to you? Who is dominating and how are central bankers responding?

Well, look, I have the humility to know that I thought about, to try and think about scenarios because none of us are clever enough to be able to forecast the future. So let me turn it around saying the scenarios that I think policy makers really must think through. So one would be that if we have a two by two of the rate environment and had the degree of disruption, the one where we have negative or low rates and high disruption is very challenging for the banking system. So thinking through what does that mean then for scale, their budgets to respond, what can they be allowed to do in response to these competitive challenges, potentially changing what market shares they can have to try and have more scale.

That's something I think is really important to weigh up. A second is, if big tech, in a scenario where big techs become really important, or at least even FinTech, a much broader range of players are skimming the cream, what standards do we hold them to, particularly knowing that the network effects are so powerful that when a firm is large, like let's say the Chinese payment firms, it's very difficult to row them back. And so, you know, one reason why I think the bank talked about in making sure they want to get ahead of Libra rather than just respond when it's out is to try and think through firms which could become systemic and get further ahead. I think the other aspect, Tracy, which is slightly more,

you know, basic, but I think is really important, which is the central bank needs to have the capabilities and the kind of know-how of the tech world. You know, most central banks around the world are dominated by outstanding public servants who have got PhDs and economics. And I think that's an important skill set, but we need to make sure that they also have much richer understanding of cyber, of technology, and, you know, the tools. And so, you know, one scenario is that the regulator of the future is more like on the Star Trek enterprise, you know, with the data coming in automatically to, you know, screens and understanding. So they can get their finger on the pulse much more quickly and what is quite frankly a complex and

challenging world. Right. So what's the technology aspect of your research? Was that difficult when you were at the BEO? Did you, you know, for instance, have to, I guess, tap specific expertise or ask specific people to help you on technological issues? Yes. I mean, I was blessed that everyone was very happy to help out. And so I met with over 300 entrepreneurs, techies, CEOs, cyber experts, many other policymakers around the world lent they had too. So I was able to dig deep. I mean, obviously, I have the humility that even in a year I could only scratch the surface of some of these important questions. I think that, you know, one thing that I put my finger on is that it's still

quite a paper-based world. And so if you're sitting there as a regulator, I calculated that the average bank regulator is receiving the complete works of Shakespeare twice a week in terms of data. Now, you simply can't comprehend that without modern technology. And if, you know, going back to my life as a research analyst, you need to automate feed, you need to create alert screens, you need to completely rethink the way you run with hypotheses and make sure we get the appropriate data. And the other thing is regulation is blooming complex. So the UK rulebook is longer than the complete works of the Old Testament. And unfortunately, it gets updated regularly. And so, you know, this is no one individual can keep on top of that data. So it's not just

the regulator. It's the people at the banks themselves who are trying to keep on top of a gargantuan amount of data. So without embracing technology and quite frankly embracing cloud technology, so banks and regulators communicate their data more cheaply, more effectively, I think is going to be part of the secret source of an effective central banker in the future. What was the most interesting part of working at the BOE on this project? Did you go searching for the BOE's gold reserves, for instance? Well, I think I mentioned that, you know, Bill Winters, who had previously done a review, said I should get access to the gold vaults on my security pass.

But then I realized that was a joke. And when I tried to get in, there were people with guns. So I'm afraid I never found out how much of the gold Gordon Brown sold off. But no, I think it was two things. One was we hosted a large roundtables and to try and keep them bouncy. We had typically, you know, four or five people from the incumbents, four or five attackers and then a few, you know, clients to ground the conversation. so it just didn't become sort of finance babble.

And it became really crystal clear to me that some of the fintechs not only are challenging the status quo, they didn't even know where some of the rules are. And I think that's a very odd environment for regulators to comprehend. And therefore, you know, the natural Pavlovian reaction to that is to sort of close up. And yet, you know, the world is developing and is moving at a pace. And so you do need to keep very open alert and engage. And I think that was one aspect. I think second was this sort of international comparisons and understanding what we can learn, whether it's from China, from Sweden, from other industries about how to respond.

And certainly it was I thought about what the bank regulator of the future should look like. I was probably spending more time thinking about data analytics, digitization of data taxonomies, quite frankly, data science than I was thinking about PhDs and economics. All right, Hugh, I think we'll have to leave it there. but thank you so much for coming on Odd Lots. As you know, I've been following your work for so very long, including when you were a star analyst, really, over at Morgan Stanley. And it's been great to chat with you again. Thanks so much.

Thanks. Well, this has been another episode of the Odd Lots Podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Allaway, and you can follow Joe Wisenthall on Twitter at The Stowart. You can also follow Our Podcast. producer Laura Carlson at Laura M. Carlson. And finally, make sure you're following Bloomberg Podcasts on Twitter at Podcasts. Thanks for listening. You can get the news whenever you want it with

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