LSE: Public Lectures and Events Podcast

Episode: Fiscal threats in a changing global financial system

Date: November 27, 2025
Speaker: Pablo Hernández de Cos (General Manager, Bank for International Settlements)
Host: Prof. Silvana Tenreiro (LSE)

Overview

In this lecture, Pablo Hernández de Cos examines the growing fiscal threats in a rapidly evolving global financial system, focusing on the surging levels of public debt and the increasing influence of non-bank financial intermediaries (NBFIs). He explores how these trends are interwoven, the risks they pose for global financial stability, and discusses a comprehensive policy response involving fiscal, monetary, and prudential tools.

Key Discussion Points and Insights

1. Setting the Scene: Two Major Trends

[02:24]

• There has been a significant global increase in public debt relative to GDP in both advanced and emerging economies.
• A simultaneous rise in the importance and activity of non-bank financial intermediaries (NBFIs), such as investment funds, hedge funds, pension funds, etc., especially in sovereign bond markets.

Quote:
"If you just try to measure the total debt at the world level... there is a significant increase in the weight of public debt over total debt."
— Pablo Hernández de Cos [03:05]

2. The Facts: Debt Dynamics, Demographic Pressures, and NBFIs

A. Debt Evolution and Simulations

[05:00-08:14]

• Public debt as a percentage of GDP now at historic peacetime highs.
• Simulations using 2024 deficits and IMF projections indicate public debt could reach 180% of GDP in advanced economies and 170% in emerging economies by 2050.
• Additional pressure from aging, health and pension expenditure, and rising defense outlays.
• Interest rates are critical: keeping current rates would increase interest payments significantly as governments refinance maturing debt.

Quote:
"The levels of public debt measured as a percentage of GDP have now reached historical peacetime heights in many advanced economies."
— Pablo Hernández de Cos [05:17]

B. Changing Financial Intermediation: Shift from Banks to NBFIs

[09:37–13:00]

• Since the global financial crisis, stricter banking regulations pushed some intermediation away from banks toward NBFIs ("balance-sheet light" forms).
• All segments of NBFI sector have grown, especially investment funds and hedge funds.
• Central bank quantitative easing originally absorbed much of new sovereign debt, but with tightening and decreased official appetite, private NBFIs—primarily investment funds and hedge funds—now fill the gap.

Quote:
"The recent increase in advanced economies public debt has been primarily absorbed by NBFIs, which took center stage from banks in sovereign debt markets."
— Pablo Hernández de Cos [12:37]

C. NBFI Segmentation and Strategies

[14:00–21:00]

• Long-term investors ("real money" NBFIs): e.g., pension and insurance funds—seek diversification and hedge currency risk mainly via FX swaps and forwards.
  • FX swap market now at $130 trillion (as of June 2025), with most contracts under 1-year maturity.
  • However, these institutions aren't fully absorbing the increase in sovereign issuance, partly due to concerns about fiscal trajectories and reduced hedging benefits.
• Highly leveraged NBFIs (hedge funds):
  • Use strategies like the "cash-future basis trade," exploiting small price discrepancies between cash and futures markets via heavy leverage.
  • Hedge funds' activity significant globally, not just a US phenomenon.

Quote:
"Hedge funds have played a key role in filling the gap between the rapidly increasing supply of government bonds and the demand from banks and other NBFIs."
— Pablo Hernández de Cos [20:17]

3. Financial Stability Implications

[21:42–34:50]

A. Nonlinear Risks and Amplification Channels

• Traditional debt sustainability analyses may underestimate risks by ignoring NBFIs' risk-bearing capacity and constraints.
• High public debt levels, combined with the nature of NBFI involvement and leverage, can lead to abrupt market adjustments—well before theoretical 'limits' are reached.

Quote:
"Such financial constraints could precipitate the 'sudden stop' in markets well before the theoretical limits of sustainability are reached."
— Pablo Hernández de Cos [24:34]

B. Channels of Amplification (Summarized)

• Duration Matching:
  Example: 2022 UK gilt market crisis—pension funds' hedging led to sudden selloffs.
• Liquidity Risks:
  Money market and open-ended funds using government bonds as liquidity buffers, risking fire sales during redemptions.
• Currency Risk and Portfolio Outflows:
  Foreign NBFIs holding local bonds—exchange rate shocks can trigger exits.
• Leverage-induced Market Fragility:
  Heavy NBFI reliance on short-term repo funding, often at "zero haircut" (i.e., no lender protection, raising vulnerability).

C. Critical Nexus: Banks, NBFIs, and Sovereigns

• The traditional “bank-sovereign” risk loop has evolved into a broader nexus including NBFIs.

Quote:
"The traditional bank-sovereign nexus... has now evolved into a broader nexus linking bank and non-bank financial institutions and sovereigns."
— Pablo Hernández de Cos [34:16]

4. Policy Responses

[34:56–40:15]

A. Prudential Regulation & Supervision

• Reduce excessive NBFI leverage
• Pursue congruent regulation—similar risk, similar rules—while noting differences in business models and risk profiles
• Key Tools:
  • Greater use of central clearing (for both cash and repo markets): improves resilience but not a panacea.
  • Imposing minimum haircuts (mainly on leveraged trades, with targeted application).
  • Stronger data and reporting requirements: substantial opacity in both FX and repo markets impairs risk monitoring.

Quote:
"An important part of the problem is coming from fiscal... we need to work in the three dimensions... regulation and supervision, monetary policy, and fiscal."
— Pablo Hernández de Cos [35:01]

B. Monetary Policy

• Maintain price stability and central bank independence, as this underpins fiscal sustainability.
• Central banks may need to intervene (including through swap lines) to stabilize markets during systemic stress—but must manage moral hazard.
• Design interventions (like incorporating penalty fees, clear exit conditions) to limit distortions.

C. Fiscal Policy

• Fiscal consolidation is essential, but must be credible, gradual, and well-composed to minimize negative growth impacts and maximize sustainability.
• Fiscal rules and independent councils helpful for credibility.
• Consolidation should begin when growth is strong, and target reforms with positive long-term effects (e.g., productivity, pensions).

Quote:
"One of the main tools to guarantee financial stability should come through fiscal consolidation—to basically putting the house in order on the fiscal side."
— Pablo Hernández de Cos [39:30]

Memorable Quotes

• On the broader risk loop:
  “The traditional bank-sovereign nexus... has now evolved into a broader nexus linking bank and non-bank financial institutions and sovereigns.”
  — Pablo Hernández de Cos [34:16]

• On necessity of coordination:
  “Financial stability is a global public good... It doesn't solve the problem if you solve it in one jurisdiction but you don't do that in another...”
  — Pablo Hernández de Cos [41:30]

• On the challenge of fiscal consolidation:
  “The political economy of fiscal consolidation is very complex... there's a financial literacy element that is absolutely critical...”
  — Pablo Hernández de Cos [45:10]

Q&A Highlights

1. Global Coordination & Role of BIS/IMF

[41:13]

• Regulatory coordination at the global level is required; piecemeal, national solutions invite problems, as risks cross borders easily.

2. Central Bank Swap Lines

[43:45]

• Expressed high confidence in ongoing US provision; acknowledged their critical role in stabilizing global markets.

3. Political Economy of Fiscal Tightening

[44:05, 44:54]

• Recognized the challenge of convincing voters to accept fiscal discipline; stressed importance of financial literacy among the public.

4. Bank Buffers & NBFI Linkages

[46:24]

• More research needed on buffer usability; the countercyclical capital buffer has shown promise as a stabilizer.

5. Fiscal Dominance & Central Bank Independence

[47:41, 47:44]

• Central bank independence is crucial to avoid fiscal dominance; this framework must remain intact.

6. Aging, Pensions, and Debt

[51:25]

• Population aging will sharply increase pension expenditure (dependency ratio to double), putting more strain on fiscal sustainability unless reforms are made.

7. Fiscal Threats and Globalization

[54:09]

• Not answered in detail; topic acknowledged for its complexity and importance.

8. Fiscal/Monetary Coordination

[54:33–55:50]

• While explicit coordination is inappropriate, some implicit alignment may be beneficial in crises (e.g., the pandemic), but central bank independence must be preserved.

9. Financial Stability & Climate Change

[59:03]

• Growing overlap between climate risk and global financial stability; harmonization of related policies likely to increase.

10. Banks vs NBFIs: Macro Stability

[59:18–60:03]

• Rise of NBFIs is not inherently bad, but demands greater attention to the new risks; bank regulations have improved stability, now it’s time to address NBFI vulnerabilities.

Important Timestamps

• Introduction & Talk Structure: [02:24]
• Debt Simulations & Projections: [04:50–08:14]
• Shift to NBFIs & Market Dynamics: [09:37–14:00]
• NBFI Segments & Cross-Border Activity: [14:00–21:00]
• Risk Amplification Channels: [21:42–34:50]
• Policy Recommendations: [34:56–40:15]
• Q&A - Global Coordination: [41:13]
• Q&A - Political Economy of Fiscal Consolidation: [44:05, 45:10]
• Q&A - Bank Buffers & Usability: [46:24, 48:36]
• Q&A - Aging & Dependency Ratios: [51:25]
• Q&A - Fiscal/Monetary Coordination: [54:33–55:50]
• Q&A - NBFI Stability: [59:18]

Conclusion

Pablo Hernández de Cos provided a comprehensive and nuanced analysis of the intertwining fiscal and financial stability threats in the current global context. While acknowledging some resilience improvements post-financial crisis (particularly among banks), he highlighted the new vulnerabilities posed by record-high public debt and the increasing importance of NBFIs—especially those using leverage and short-term funding in sovereign debt markets.

He called for a tripartite policy response:

• Fiscal discipline and well-timed, credible consolidation
• Robust, targeted prudential regulation (including better data and minimum haircuts)
• Monetary policy independence coupled with preparedness for targeted interventions

Above all, international coordination and improved public understanding will be essential to manage the emerging risks.