Fabio Natalucci on How to Think About Financial Risk Right Now

for markets overall. In two I guess markets have been a little bit more constructive calm so far to start, 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 pricing of interest rates and such

an uncertain macro environment, That's exactly. 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 liquid 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 natal Lucci.

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 i m F puts out every year. Previously at the Fed and the Treasury. So really the perfect guest, Fabio, Thank you so much for coming on. Thanks. Um. 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're talking about market liquid here, not liquidly on the balancial banks, but essentially is the ability to uh liquid by in a position at market prices they know, at a price that doesn't move or dual ow prices significantly, so you can do it quickly, you can do without much market impact, so you can essentially refi a position without having a major impact on the overall market. So you know, I mentioned that in the interio was kind

of a wild year for multiple asset classes, etcetera. Why and large though not too much broke, right, I mean I think like so you have the looking back, it feels like it could have been worse. So this is the big question, right, So if you work in financials a bility now and you say, okay, if someone told you a year ago that the Federals are would raise interest rate four under fifty business points under business points, Uh, do you think he would have worked smoothly or what

would have broke? And I think the answer you would be looking for praising things that they were something didn't work right now. There were some instances, I think so the pension l D. I think in the okay, it was a good example of liquidity problem interacting with leverage problem. Right, so that's a combinational to vulnerabilities that amplify each other. Of course, the trigger of the shock was very unique. It was a physical policy shock that it's kind of

US incretic if you want. There was some other example like a Korean as ber securities market, but generally speaking, particularly focus in the US, I think things have 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? All the system is really more resilient, and I should feel comfortable, and it's always uncomfortable.

Feel comfortable. So 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'm at for a second thing, how we think about financial stability of the fund right, so we don't try to forecast what the next shock could be. So I think I would admiss all of them. Right if you think about Cowvid, that's not what probably wasn't my top lists 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. I think of vulnerability is an amplifier that 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 metrics where we look at different sectors, so the sovereign debt for example, household corporations, banks, and then when we call non bank financial institutions, and then we look at different vulnerabilities. So liquidly it's one

of them, or lack of liquidity leverage. Financial leverage is another one. Effects exposure or interconnections between the system and then we try to fill the metrics based on the data we have and we do this for the twenty nine time important countries and we track them over time. So liquidit it's one of them. Again, there were example like the Dash for cash in was a good example and involved the specific entity in the non bank financial intermediation sector. There was the l d I in the UK.

It's a combination of liquidity and leverage. There was Archegos is another example. I think more of financial leverage perhaps interconnectness. So those are the things we're looking at. But again, um, the thing to me the biggest puzzle now is financial leverage. There's a lot of talks of leverage position being unwound and resolates more higher volatilitarizes, but you don't really see

the system breaking. So again it's see that because it's been the financial egolators have done a great job for financial crisis, or maybe we're missing something they're like, think of the l d I in the UK. Maybe this is like a tramore 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 two, if you had sent to someone, Okay, the FED is going to hike for your fifty basis points, and by and large things would be would like I think that would be surprising for a number of reasons. Everyone had become used to zero de facto zero interest rate. It was 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 that's certainly an aspect of that. Right, So the financial post financial crisis regulation, in my view, most certainly made the system the core

of the systems. So the banking sector more rezilient, right, the more liquidity, the more capital, the resolution plans a bunch of feature that made like, if you want the fortress of the financial system safer, there is can move away from there. And they moved towards we called the

nba FI or non bank Financial Institution. I think of that as hedge funds, investment funds, solving wealth fund, pension insurance um and part of it, I think it's okay because they have different risk profile, the different investment aizing, 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 would 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 liquid it.

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. You can absorb it doesn't create a financial stability even f X, Yeah, in some sense. And then the other part is like, is there a feedback though into the banking sector right that we have

no considered right? So Archegos. I think the example there was yes that the entity per se perhaps was not systemic, but there was so much feedback into the back door of the banking sector to prom brokerage for example. Right, so that that's kind of with think about it, um, I think the reform there are some unfinished business in the nonbank financial intermediation performed agenda. Some of it it's holds and not being called by their form agenda somewhere

that to implementation. UM I don't want to just say that it's all bad though, and their advantaging positive of activity and risk moving to the non bank financial intermediation right there again different risk profile, different lendings UH, funding structure, different investment horizon UH. And they provide to growth to the financial system, provide lending, provide financial services, so that part is good. Other reason, and it's not just financial regulation.

Activities 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 is there too structure they're non nimble enough.

There are also conjunctual aspect right. So for example, when you are at zero interest rate for all ten plus years, it's normal and some of the risk cree shuffles around their way from the banking sector and then the last one, perhaps especially in advance a Gono, the center banks that played an important role, people may say too large a role in a number of markets, and so that's an impact on pricing itself. So there's a number of factor I think that contributed to this. Some are positive, some

are still I think open for assessment. You know, you mentioned Archagos, 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 Archaicos 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 excess in the market means for financial stability. So there's two aspects of this, right, So I want us to do that if you want to call it like price misalignment or financial conditions are

too easy compared to the fundamental values. However you measure fundamental values, that's one piece. I think that if there are is no leverage employed, if there is no major liquidly mismatch. No, it's not necessary systemic per set. Someone will lose money, someone will make money, but let's not part of my job. The concern is when that unwinding of financial condition interact with vulnerabilities liquidity or in case of our chegos, is financial leverage, right, because then that

vulnerability becomes a major amplifier. So it's not just that risk as surprise risk risk as a reprise is that the de leveraging in the case become an amplifier of the reprise and I fire yourself. 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 the realtives, through prime brokerage, and the other weak link there was that that was provided by banks, right, and so there was an entry point into 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 of back in some formal shape somewhere along the chain hits the Boden set of

the bank. So part of it it's a risk, but it's it's an opportunity for the regulativity should be able to see it once it touched the bond shield bank. You know another thing that I think when I think about the last year, maybe the last two years, is uh sitting aside the market volatility. There was a lot of growth, I mean, and maybe it's just nominal growth. But of course with if you have a debt, like

the most important thing is you get it paid. How much does just that maintaining a growing economy, unlike say what we saw in the second half of two thou eight, how important does that in terms of butchersing 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 corporation. So usually um, the one this is how we used to look at the FED. Growth.

To me, it's a precondition for financials to build it. Right. You cannot have franchis debate without you need growth. So growth it's really important. And so that growth that came off the if you want the procession if you want to called the way of the COVID was in part because Center Bank stepped in majority. Right, So the FED here at a major central bank and ended up back

stopping the full financial system. If you compare that with two thousand and eight, back stopping was faster, more aggressive, and wider. U. The other difference with two thousand and seven two dosan A was fiscal policy. Right. So if you remember the size of the ABAN administration physical plan and think about the number of physical measures they've been taking the US during COVID and the size of those, right, the combination the two easy financial condition plus physical policy

as turbosh are essentially the economy now. Downside of that is I think perhaps we as a community in general, policymaker, maybe market so we have been slow to recognize is the inflation problem? Right, So because growth was going fast and because physical policy and be using that size for a while, Um, that's where I think the concern is now, and this is why we went into the Tilaning Morning, Repolis and so on. So the flip side of that fast growth has been inflation at levels that we haven't

seen since the plate seventy early eighties. Is inflation? How does inflation manifest itself in financial stability risks? Yeah, So that's that's the risk here, And I think That's why priced ability is so important. Is that if you don't tackle inflation now, So if you don't let prevent inflationary pressure from becoming entrenched into the infression dynamics, so core inflation wages and you'll let inflation expectation and more from the target is going to be way more expensive to

bring inflation down. So in sometimes the personally I don't think. I think there is in a symmetryn cost here, right, So if you say, okay, what's the cost sire? If I am tithening not enough for if tithing I'm not tithening too much, that's when I think the cost society

if you're not aggressively approached this. Do you think of the late sevent y earlieries in the US, It took a lot of high any more other policy bring in freshtion down, right, So being proactive and preventing the entrenchment and increasing frention in pressing expectation, I think it's crucial because you can control it, then you can bring invent eventually you can bring race down to a rather I'm supposed to go now. Of course, if you do this

space on which this is done, financial condition tied. If anything. Now, the puzzle is why they haven't tied more than otherwise. Right, any model that we you run, if you say, okay that the frisk free rate moves by four and fifty basis point, I think example, at least based on historical relationship, will tell you the financial condition should be way tighter.

I mean, we had merged. It was just the FED, you know, in addition to the massive stimulus and or a couple other rounds of stimulus afterwards, and then the Fed just you know, opening up one acronym after another trying to backstop the market. And maybe you know, retrospect

that contributed to inflation. But was that a sort of like you know, from your perspective, it is like this is an example of we saw what happened in two thousand and eight, two thousand nine when we go slow and we let growth collapse, when we've let nominal income collapsed, and sort of a successful lesson learned. I have no doubt that was successful. I mean the alternative would have been like fall into a creator of growth right in

the Great Procession story. Um. The issue is that that response and the easing of financial condition and the build up of some of the vulnerability highlighted. Some of the reform agenda that you mentioned before has now been addressed. Right. So the chapter that we pulled out in last October, it was about open end investment fund and that's an example.

I think a sector where there are liquid in mismatch, right, particularly those open and investment fund to have daily redemption for a liquidous right think about high you know, corporate bond for example, That's where I think there is case and that's what we have seen. In March twenty the outflows from those open ended funds was about five percent of assets. That was larger than during the financial crisis.

Um and the camera faction of the FED not stepping in very quickly and starting to backstop not just quei or supporters by back stopping current market would have been a much larger decline. A surprises, right. So what we show in that chapter, it's one that there is a link between the liquidity of the funds and what they hold, right. So assets that are held by liquid funds tend to drop in prices much more and that there are much

more volatility in return. So for example, once and the deviation shock in the liquidity or some sort of what you saw in March twenty increase volatility of return by which is a large, significantly large number. And that's where I think you need to think about doing what what do we need to fit fit in terms of policy agenda, is there a whole we need to think about the

regulatory emiter, what tools do we need? So, just on the snow, there is that inherent tension between you know, offering someone liquid 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 fund's view

on the best way to deal with that risk? And also given what we saw in when the FED effectively came in and back stopped 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 endgame problem solved? Central banks back

stop this and liquidity risk is no longer an issue? No, So my personal view is that if you want to live in a world where every X number of years the center banks needs to step in and back stop the financial system and every time push the line one more, I think you need to rethink the regulatory perimier. Then, right, if you want to be on the perceiving end of the financial sector back stop, then the perimer need to be different, right, So you need to be within the periment.

They're not outside the perimid obviously, but there's a different way of thinking about financial stabilities because systemic risk at that point it right. So the issue here is that you're providing dare liquidly when there is underlying a liquid US. Now, of course they all liquidly buffer and so on, so that'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 liquidly buffer. Therefore,

to sell us right, you face redemption. You sell, you generally fire yourself. And because of the structure, there is an incentive to run first because you're not bearing the transaction cost when you get out the way this is designed, and so I want to get out the first before the market's price are going down essentially the enemy, so

that generate the 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 this of these fissures are now so what we look at. We look at a bunch of possible solution there measure and we did some work across countries. Usually, what the most common tools in terms of liquidly risk management tools are either suspension obviously or redemption gates or

redemption fast. Those are pretty much widespread. What is much less common is either what because swing prices so essentially the ability to incorporates in the price you pay to exit of the externality or if you want the transaction cause the impose of those sustained the fund. Those are not common or not the in in DUS for sure, and even in Europe or in some sense they're voluntary. And then this open debate of what do you do with

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

actually use them actively. So I'm gonna sell the most liquid stuff, use my ready lines and hope for the best if you want. Others don't want to touch it because they don't know what's coming nest and so they start selling 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, tend to grow the relear butter. 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 example incentive to run right, it doesn't prevent that. Swing prices are mostly used in Europe. Again, swing prices the ability a century to correct the price which you take money out based on this transaction costs they impost on others. The problem is 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 from to the liquid of the underlying right. So you mentioned the real estate one, they're the liquid. It is not daily, right, you only a specific period where you can withdraw. Um. If you go into landmark in duance and you go back decades, there was no daily liquidity. They used to be if I remember correctly,

intermitted funds or there were quarterly, monthly quickly. You need to give advance and then when it comes time you withdraw. That allows you to I think, manage liquidly better. I think there's a lot of controversy and whether you should restrict liquidity that can be given based on the underlying but that 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 priced risk and the risk that you're going to see a big drop when you try to sell. How do you just aggregate those two things? And also there there is an argument to be made that UM, if you're holding a liquid assets and if you can get away from marking them to market. UM. 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 less I would deliquately one UM. I think they take the treasury market here, the kid market in the UK, right, um. And the issue was that in some cases it was really hard to sell that you couldnot find a bit.

Right even if this are supposed to be the most liquid, the most liquid fund, so you should not see those in the most liquid markets. That's supposed to be the risk for assets, right, you should be able to sell um. The issue with liquidly, I think has to do with the fact that often also interact withies. Right. I made the example of leveage, right, that's what we called liquid is spiral at least and in the in the in the profession, that's where liquidity and leverage interact with each other.

My personal view is getting rid of market to market. It's kind of like hiding a little bit um. I want investor to be able to price risk and not mark into market. And I can see the argument of saying, 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 provide disclosure,

more disclosure. I'm only favor of disclosing trade for example, because in the end, yes, you will take a loss, but your price markets where they're supposed to be past experience during the financial crisis, and 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 your price market. Yes,

sometimes it's gonna overshoot. You know, both of you talked about the l d I situation in the UK, and of course in March we had that big dislocation in the treasury market, but it was sold fairly quickly in terms of the Central Brank step in and was a buyer, and then the prices returned to normal and then subsequently to March, and the FED is set 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 degreetion more is, would you 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 in the business of managing data equally, right, so I

can see it all. What the central bank is the blendard of last result of the proliquidity provider of last resort. What the standing rip of facilities meant to do. It's meant to cap in some tense rates, right, So they don't want to see what you saw in September nineteen where when they would normalizing the balance, it preparate. That's what the facility is meant to be. That is not meant to be a day to day a normal way of providing liquid liquidly. It's in the market. There are

buyers and seller. That's how the systems should work. What's changing 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 is done by firms. They are not part of the trade shop banking system and they're not within the traditional regulatory perimeter. That it's technology evolution. I think the question is where the perimeter should be.

There are also a major discuss again have to do with transparency of trades, so disclosing trades and whether you should use central camera party to net some of this position out then reduce some of the plosure, whether they would free up balance it effectively to provide liquidly. I don't think that daily to day job or a center bank should be provide liquid in the markets. To me, that's a lender of last resort function that I think

it's super important. Uh. That is a question though that if you have access to the lender of last resort function of a center bank, how to where the perimeter of the regulations should be. You can't be just receiving a check and then the central bank should be completely out the 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 All 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 regulators view on that topic. I think liquid it is a

financial service and like any other financial service, surprise. The problem, I think after fifteen years of zero interest rate, zero volatility, pre fat tightening, was that liquidly was no properly price. That was a big problem. So you get used to a place where liquid it is abundant, it's essentially free,

and you don't price the risk. Right, So that's a think about price of li quickly break it down two pieces, right, they expected liquidly and there is premium how much you want to pay for insurance if you or if you're providing it. I think that part that's where it was miss priced. There was a quickly de premium was not paid. You are not paying for that. They were not willing to pay for. Situation where go away and I think

the normal interest rate normalizing, volatiality rising eventually. The hope is that people will start to price liquidly. They should be liquid is not free. Liquickly there's a financial service that you should probably pay for and provision for. I want to go back to some of these funds that

occasionally have issues with redemptions. There's the real estate one. Recently, I think it was after the energy crash or sixteen 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, etcetera. But even some of the recent stuff that didn't seem

like they're a huge spillovers. What is the scenario in which something some stress that emanates from some fund or some class of funds, because it becomes something that we would regulators should be concerned as systemic risk. So it's a question about mutual opening the fund or ETF or both either one. Howeveryone, Well, let me start with the

first one that we do open in the funds. I think there is because again what I was this described before the pop You run for the door because I want to come after you, and because they are incentive to do that, and then by going out, you generate the spiral where you get fire sale because they need to weak me they to pay you, and the price moves much more than it should have. I would argue, if you take twenty when he as an example, that's 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 for reserve based of the entire francial system. Right, So if I give a counter factual where instead of them Monday with another month, my expectation is that the system will have cracked in a different places um DTFS. I think my views change over time. I think I was trying and to look for place what could go wrong there. I think they provide an important liquidity function.

Um you can get out, you just sell you share with the FS, and in some sense they do sell the price. Right. The concern that I have there is more the opaque world of the other ICE participants. Right. So the dealers that create and redeem shares, particularly in fixed income where inequities, I think it's easier if you have the SMP five. The bucket that you use is

more or less than index. With fix income, the basket you used to create and reallym is way smaller than that, and there is a lot of opacity exactly what's in those baskets is provided to whom. If they don't provide the function any breaks down, then the creation redemption can break. Now, whether that's systemnic or not, I don't know, But to me, that's where one question marks. Just on March specifically, it's like, okay that that situation required enormous support from the FED

and other central banks. But I think with the point that you know, we talked to Josh Younger, who's then the JP Morgan out the New York FED, like, should regulators be optimizing for the type of crisis that emerges from a once in a century pandemic? Like I don't know, Like is this is it worth like having the system be robust or should we say, okay, once in the century pandemic, it's not so bad if that requires the

FED to step in and start spraying money everywhere. The first of all, it's two times in a century now because it's from the GFC to to UH to COVID, right, so it's kind of close to each other. Um, I agree, I don't think you should calibrate too financial disaster every time, but I think there is something in the middle between caliber in like that and what is done now. I think there are steps that can be taken to fix

some of these liquidity mismatch. Whether this is um swing prices for example, and utilization of those So regulator can for example, provide guidance of the implementation or some of these liquidly tools. They can consider whether there some of these liquid it would should be mandatory. The problem is there's no alignment between the incentives of the individual manager of the funds and the system financials to be objective, right,

If you align those then the system works better. So whether this is again guidance, mandatory use of some liquid tools, where this is stress testing, whether this is disclosure, I think you can find a combination of this. It's gonna be a functional country by country, depend on the institutional set up, the legal setup can some things can work better than others. And again or minimizing the gap between the liquidity you provide and the deliquid of the end

of line. One last point, there is another aspect that often it's not discussed in the US, but some of these players are made of this open and the funds are major players in emerging market 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 boarder systemic aspect to list. And maybe it's not just us focus, but at least from me working at the fund for some countries,

those are large, large molers. Yeah, I think that's a good point. Um, 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 marnaging liquidly right. One was trying to understand what is your definitional ligue? But fore wou do you use? Is the cash is the lines of credit, is the most liquid leverage loans, your whole treasury security? Is how big the buffer is?

I mean there's a trade off between Yeah, of course you can alde a huge li quickly buffer, but it's going to hit your return at some point, right, So if I want to invest in the average loans, I don't want you to hold twenty indiqudity. 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 right from I'm gonna start using and selling the if I have some liquid liquid a like securities after cash, then maybe use my lines of credit. Then progressively moved to the rest LIEPID stuff, and then others they would tell you I would never at touch it now that even if you shoot me, I just because I don't know what's next year. I need that as my insurance. So I don't think the ARELA should tell

you exactly whether you should manage this personally. I think they should provide some guidance. My sense now that it's too much left to the individual manager that does not internalize what the system in implication of the behaviors are. So one of the things that happened on this podcast of doing it for seven years is we've seen this evolution in the type of things that we talked about, and we used to have, you know, 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 risks, 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 Medals 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. So if the maths sticks that were describing before energy trading, we're not there obviously, right So and those were not the entities were following clothesly for

we did. So there was one lesson I think learned through in the February episode. I think it's important to follow for a number of reason one because they are they are important players in the financing of the physical assets, right, so they provide colorized lending to shipments of various commodities.

So that's one important piece. So they're very much linked to the physical asset too, because they are crucial players in the dri of this market, the deriv markets used by producer as a dge, and so they play a crucial role in the middle. Obviously there are banks involved and so so they play a function that is important for the smooth operational the market commodities, a global market um.

The financial the risk from a financial stability perspective one that we quickly scored that they were not data and so if you want to say, I'm gonna have a chart, and I don't know what chart to show. Some of these entities have publicly ready bonds, So that's what we were showing. That was for US proxy of investor concern

about these firms. But that was pretty much it, right, not stability into their leverage position, who they were playing, what market that was huge and sense of opacity in terms of where there is where that was the big question. I think the big flag, right 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 these is one to to have conversation with. Glencore doesn't want to talk to you. I can't imagine they

see the easier conversation without people. Um. You know you mentioned cross borders village 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 I m

F 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 of China is added or taken out, it triggers all the flows. Okay, So again there's positive. It's like everything right, opportunities and risks right. So I think opportunity of being added to the risk. It means the country opens up to capital flows. So

capital flows are important for growth, for financial transaction. So that's the positive of coming with it. The risk are that the behavior of passive investor of benchmark investors very different from SAM dedicated funds right am dedicated fund It's really about going in and picking that I count re picking the right credit, doing more the credit work if you want, or solign work. Benchmarking is just following index.

And what we found is that the behavior of investors that just benchmarks are much more linked to global financial conditions. So when financial condition change and they tire and globally di guid tends to leave. And so by being in the index, yes you get more cavial, but you are much more exposive before if you want to the risk capiti change of the global investor. That's the downside of of being in the index. So that's where I think

then it's important for the local Now there's another oportunity. Actually, they often tend to deepen the liquidity of the local markets, right, so their benefits. That's where though the local regulator I think they need to play a role in terms of like regulation that it's appropriate for those kind of flows because those investors are not the typical em didy get investors that sticks there. Those are investors that moves with global financialries capitalize and we have seen that over the

last past few years. I want to go back to something you said there at 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, or like two separate things, and that there's enough managing the banks making sure this and then also like making sure

they hit their inflation and unemployment goals, etcetera. Isn't that the case of my misperception? Or do like should central bankers should regulators recognize the interlinkages between maintaining robust growth said financial stabuilding more than they currently do. I think of like the banking sector, right, the best ingredient for success of banks growth right because they have healthy balance, the PLT cabital position, liquidity position. So to me, if

without growth the system is much more fragile. The way we think about financial stability in terms of our framework, we take if you 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 of the left tail. If you're on the downside risk, that's for us. The link between financial conditions would not

abil is and growth. What do what policy meg are trying to do when they think about financial stabilitia, trying to minimize the downside the tail. That's to me, it is the link between growth and financials ablity. That's the framework we use in the financial Ability 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 um and as evidenced by this interview and many of our questions. But it is because I am reluctant to embrace this idea that we made the system more residient and this is work 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. The coronover time that they became systemic, either because of size or because they use leverage informed that they're not apparent or I don't have data, or I don't understand the dynamic. Right. So the l d I was a good example. People knew about LDI. This is not a new thing that was learned, right, It just happened. The combination of that business model with a liquid in the guild market, with the policy shock

that perhaps no one it was difficult to forecast. But the combination will this fact or create a situation where what was going on in the UK had tremors across the globe, You have reprising or create risk in the US, you're reprising all asset execurities in as far as Australia because people were selling across asset. 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 legal model, because a lot of these are created with the lens of the past, right on the lens of the last crisis, that crisis tends to be different. So I'm reluctant to be too comfortable that we managed to to handle financials to be it's good not to be complacent if you're a financial stability person, the regular

financial they should 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 two financial stability risks. So that's a really good example. Shall we leave it there? Show? All right? This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and I'm Joey Isn't that You can follow me on Twitter at the store. The Year E