LSE Events Host (0:02)

Welcome to the LSE Events podcast by the London School of Economics and Political Science. Get ready to hear from some of the most influential international figures in the social sciences.

Silvana Tenreiro (0:16)

Good evening, everyone, and welcome to the London School of Economics. Hello. So, my name is Silvana Tenreiro. I'm a professor of Economics here at the lsc. And I'm delighted to welcome our speaker today, Pablo Hernandez Cos, who will deliver today's lecture on fiscal threats in a changing global financial system. As many of you know, Pablo became General Manager of the bank of International Settlements this summer, following a distinguished term as Governor of the bank of Spain. His international experience also includes membership in the Financial Stability Board, the Group of Governors and Heads of Supervision, the European Systemic Risk Board, the European Union Economic and Financial Committee, and the European Union Economic Policy Committee. Alongside his policy work, Pablo has been a Professor of Economics at Esse Business School and a Fellow of Bruegel and the Peterson Institute for International Economics. In his. In this lecture today, Pablo will examine the evolving landscape of sovereign debt and its implications for global financial stability. So, a little bit of housekeeping. Please put your phones on silent now. For those on Twitter or X, the hashtag for Today's event is LSCEvents. The lecture will be recorded and will hopefully be made available as a podcast, subject to no technical difficulties. As usual, there will be a chance for those in the room and those online to ask questions to Pablo after his lecture. But for now, just join me in welcoming Pablo with an applause.

Pablo Hernandez de Cos (2:24)

Okay? Good afternoon. Thank you very much, Silvana, for the nice introduction. Introduction, thank you very much for the. For the invitation. Let me just recall that one of my last, if not the last speech that I gave as governor of the bank of Spain was precisely here at lse. And it's not by chance that we also choose the lessee to do. I would say that my first, at least European speech or speech in Europe. Well, it's simply a testament of how happy, how well treated we are in this institution. Well, the quality of what you do in this university. So I will try to explain very, very briefly at the beginning what the talk is about. And of course, then I will go through the details. Well, the staff of the BIS has been working in the last years on financial stability, identifying two main dimensions that they observe. They have observed that there is being a significant increase in public debt. If you just try to measure the total debt at the wall level and you distribute it between private and public, what you observe is that there is a significant increase in the weight of total debt of public debt over total debt. That's the first trend. And the second is looking at the financial sector, the weight of NBFIs, what is called MBFIs, non bank financial intermediaries is also gain significant momentum. And the weight of this MBFIs, the role that they play in intermediation has also increased. The truth is that these two trends are interlinked, meaning that basically what we have observed is that MBFIs are now playing much more significant role in bond sovereign markets. And what I'm going to claim is that these developments create some financial stability challenges, financial stability challenges that are both important at the domestic level and also very important at the international level. And then in the last part of my talk, I would also emphasize that in order to mitigate the risk that are associated with these developments, we need a combination of policies, a combination of tools that spans from fiscal policy, of course, monetary as well, and very important prudential policy. So I will structure my talk precisely first talking about the facts, then about how we see at the BIS these facts in terms of the implications for financial stability. And then later in the third part of the talk, I will focus precisely on, on the, on the policy, on the policy implications. So let's start with the facts. And well, here what you have in the chart on the left is precisely the evolution of public debt, government debt over GDP for, well, for the last century. And well, it's very obvious that the levels of public debt measured as a percentage of GDP have now reached historical peacetime heights in many advanced economies. That's of course already a concern. But what I would claim is that there are even some factors that might lead to even higher pressure on public debt in the future. And this is what it is illustrated in this chart, both for advanced economies and on the left and for emerging market economies on the right. The exercise that we've tried to do here is to do a simulation of what the debt to GDP rat ratio would evolve. First under the assumption, and this is the red dashed line under the assumption that we keep primary deficits constant as they were in 2024. And what you observe is that, well, the deficit would increase for sure and this would lead to a debt to GDP ratio that will be close to 120% from 100, that it is the current level more or less in advanced economies and close to 85% in the case of emerging market economies that you could claim that is a relatively optimistic scenario. We have added a second scenario on which we've tried to incorporate. These are estimates by the imf, what the implications of aging will have for health expenditure and also for pension expenditure that we know. And there are many other institutions, OECD, European Commission, etc. Etc. That have made similar estimates. And the implications, as you can see in terms of the trajectory, the expected trajectory for debt to GDP ratios is that we will be adding debt to around 180% for advanced economies and 170% for emerging economies in a horizon of 2050. On top of that, you could also claim that energy transition on the one hand, are more visible in the last years. Rising defense spending will further increase government expenditure. We know that there are many governments across the globe that are planning to increase defense spending. And what we have basically here is added a new simulation to the previous ones on which we have basically had a rise in public spending by 2% of GDP, which in the end, as you can see, it would add by about an additional 40% of GDP by 2050 for both advanced and emerging economies. You can also play a bit with the different assumptions that you need in order to simulate the dynamics. And of course two variables that are critical is the interest rate and the growth assumptions that you use. And here what we've done is basically to play a bit with one of them, which is the interest rate assumption. First in the chart on the left is very interesting to see that the current interest rates are already putting pressure on fiscal accounts. For instance, and this is the blue line on the chart on the left. Among OECD countries with relatively high interest payments, average payments have risen from 3% of GDP in 2021 to levels of around 4% in 2024. So this means 1 percentage point higher. That's the blue line. You can also make the simulation that it is illustrated in the chart on the right, which is basically keeping the current levels of interest rates constant. Since the governments will have to refinance bonds that were issued at much lower rates, this would increase interest rates over GDP even further. And this blue dot that you see on the chart on the right is precisely trying to illustrate the effect of this additional burden that will be given by simply keeping the current levels of interest rates. And of course you can even think of more extreme scenarios as the yellow dot that it is in the chart on the right, on which basically we assume that the rates go would return to the post pandemic peak and the median debt service, as you can see, will Spike to around 4%. Well, of course the main message from these slides and from this analysis, of course fiscal consolidation is of the essence in many countries. But of course at the same time we know. We also know that the political economy of fiscal consolidation is very complex and of fiscal sustainability more in general. So this is the first fact. The second fact is the one that it is illustrated in this slide. So this increase in government debt levels has been accompanied by major intermediation patterns in the global financial system away from banks towards non bank financial intermediaries. And this is exactly what you observe in the chart on the. On the left. Basically what has happened after the post global financial crisis and of course also linked to a tighter bank regulation is that banks retrench from certain activities and move towards more more balance sheet light forms of intermediation as the balance sheet space became more costly. You could ask MBFI is a very broad concept which are the subsectors of MBFI that have increased? Well, all of them as you can see. Now I'm moving to the chart on the right. But there are particularly two segments of the MBFI sector that are behind these trends. One is investment funds, which is the columns, the first columns which you can see the level in 2008 and the level in 2023, you can see the very significant jump there. And then also if you move to the last columns and you focus your attention on the hedge funds, you can also see a very significant increase. Although you can also see for pension funds, insurance corporations, of money market funds, there is also been an increase. One aspect that it is also interesting to analyze and starting to try to merge the two trends is to look to what has happened with the sovereign debt holders. And here what we have observed is the combination of this surging government bond issuance on the one hand and this retrenchment of banks. It has given a steadily growing wedge between the supply of government bonds and bank dealers such as underpinning the termination capacity in this market. Well, how this gap has been covered, as you can see in the chart. Well initially during the global financial crisis and later during the COVID 19 central bank quantitative easing absorbed a significant share of the increase in government debt, helping ease the pressure on yields. However, of course we also know that subsequent quantitative tightening combined with the decline in official reserve managers sovereign debt appetite increase the amount of government debt that had to be absorbed by the private by the private sector. And this is basically the pink area in the chart on the left. It is basically against this fact that the recent increase in advanced economies public debt have been primarily absorbed by MBFIs by Nonviolent Financial intermediations which took center stage from banks in sovereign debt markets. And this is very clearly seen in the chart on the right. We are basically comparing holders of our bank's economy, government debt for non banks, banks, domestic central bank and foreign official. And as you can see between 2021 and 2024 is basically the non banks, those who are absorbing this gap that I was describing. I was emphasizing that MDFI sector is a very heterogeneous sector. And I wanted for the rest of the talk to try to distinguish two broad segments of the mbfi. One is what I would call the real money mbfi. So long term private investors, this is for example pension funds or insurance companies and then what I would call highly leveraged MBFIs. And in particular you will see that I will be focusing on hedge funds. The truth is that both the long term investors and the hedge funds have increased their presence in government bond markets. But the interesting thing is also that they have done so using different approaches and strategies. And this is what I want to describe now. So let's start with the long term private investors. In the case of the long term private investors, they have expanded their government bond holdings considerably as I was mentioning before. And this expansion, the interesting thing is that has had a very significant international dimension which has manifested in a considerable rise in MBFI's cross border holdings, which is what it is illustrated in this, in this chart across major world regions over the past decade. Why is this the case? Well, this expansion has been mainly driven by long term investors need for diversification. These institutions tend to have obligations in domestic currency, but they hold a globally diversified asset portfolio in several currencies. And of course this immediately leads to the need for these institutions to hedge. And hedging is indeed a key thing for long term private investors. And the system has evolved to allow such hedging how? Mainly through FX swaps and forwards. And here you can see precisely in this chart how the market, this FX swap market has grown over the last year. It has grown very, very rapidly after the global financial crisis. Now is very large. Just to give some numbers, outstanding FX swaps, including forwards and currency swaps reached $130 trillion in June 2025. The largest, as you can see on the chart on the left, on the right area is that the largest and fasting growing segment of this market are contracts for financial use and mostly again vis a vis and BFIs, which is a segment that has basically tripled since 2009. Very important. This is an aspect that it is illustrated on the chart on the right. Most FX swaps are short Term. And just to give you a number, 3/4 of outstanding contracts have maturities shorter than one year. This is precisely what it is illustrated in the blue bar in the right hand chart. And this is basically primarily because these instruments are provided by banks which mainly deal with short term claims. While long term private investors have increased their presence in government bond markets considerably, they have not fully absorbed rising government debt issuance. This has been at least in part driven by rising concerns about the sustainability of fiscal trajectories. In addition, it's also true that the hedging benefits of government bonds have declined due to weakening stock bond correlations. And this is for example reflected in in lower convenience deals on US Treasuries. Meaning the convenience deal is the premium investors place on holding these securities for their safety and liquidity. How then this gap has been covered? Well, through leveraged MBFIs and in particular through hedge funds who have played a key role in filling the gap between the rapidly increasing supply of government bonds and the demand from banks and other MBFIs. How this has been done? Well, this has been primarily incentivized by hedge funds utilization of relatively valued trading strategies such as what it is called cash future basis trade that well, they seek to exploit small price differences between related financial instruments and precisely to boost the returns on these very small price differences. Relative value hedge funds heavily leverage their positions and as you can imagine, this is an issue that I will emphasize later when analyzing the financial stability implications of these developments. If you look at the chart of the right hand chart, what you see is that they do so by borrowing in the repo markets. Also on the chart on the right to finance the purchase of the cash security and profit from the small price difference between the security and its corresponding future contracts. One interesting aspect is that of course this is happening in the US but it's relatively across the board. And here what you have is a chart for the euro area and also for Canada on which you can see that in both cases the role that it is played by hedge funds in the government bond markets has significantly increased. So it's not a US specificity, but it's global. So let me move from the facts. These are the facts to now to try to understand what the challenges for financial stability these developments generate. I should start by emphasizing that there are some positive elements behind these developments. It has diversified funding sources for borrowers and strengthen the overall resilience of the banking sector with no longer engages in many of the risky activities pursued before the post global financial crisis tightening of bank regulation the partial migration of some of those risky activities to real money MBFIs has also decreased the likelihood of large price swings resulting in widespread deleveraging pressures. But what I would be claiming in the rest of my talk is that there are also significant new financial stability challenges. And here let me link again the debt sustainability analysis that I was offering at the beginning with the developments of the MBFI sector that I also made when describing the facts is true, and probably you are already learning about this, that higher public debt levels can be sustainable if you have very strong economic growth, for example, and of course also if you have low interest rates. And there are also a very important literature that put the emphasis that predicts a strong demand for safe assets driven for example by population aging, which of course if this is true, this would suggest that there might still be room for further increases in debt. However, the point that I wanted to make is that this traditional analysis of sovereign debt dynamics or debt sustainability more in general, do not factor in the risk bearing capacity and balance sheet constraints of the financial intermediaries, which are those that are providing credit precisely to the government. Such financial constraints could precipitate the state in markets well before theoretical limits of sustainability are reached. And we know historical data shows that adjustment in the interest rate growth differential have been abrupt and unpredictable and especially when government debt levels are high. The other point that I want to make is that the greater presence of MBFIs in sovereign bond markets increases the likelihood of sharp nonlinear deal spikes. And there are several amplification channels that could work through the MBFI sector. Some of them are very well known. I just mentioned them, but I will not enter into the details of them. So for example, the first one is related to the role of duration matching by pension funds and insurance companies. And the 2022 UK Guild was an example of this. Then we have a second of those channels linked to the way that many money market funds and open ended funds use government bond holdings for liquidity management, which can lead to fire sales of those assets if there is a need to raise cash in response to a spike in redemptions. And then a third channel that is also relatively well known is related to what it is named original sync redux. When foreign MBFIs hold bonds denominated in the local currency of the issuer, exchange rate movements generate valuation losses which can trigger portfolio outflows, raising government bond yields as well. I would focus instead on another channel, which I would say is a more novel one, which is related Precisely to the MBFI's heavy reliance on leverage and short term dollar funding. And I will be using this chart to illustrate at least one of the channels that could precipitate this behavior. The first of these challenges stems from hedge funds leveraged trading strategies, which are facilitated by the ability of repo financing on very favorable terms. And as you can see in the chart, in recent years hedge funds have been able to borrow amounts equal to or higher than the market value of the collateral, provided that is without any discount or haircut, protecting the cash lender from market risk. The numbers are very striking. Around 70% of bilateral repositories taken out by hedge funds in US dollars and 50% in bilateral repos in euros are offered at zero haircut, as you can see in the chart on the left, meaning this basically means that the creditors are not imposing any constraint on leverage using government bonds. Now we move to the chart on the right. You can also see that large hedge funds are especially prone to receive such favorable terms from the dealers relative to their smaller peers, so that there is maybe also an issue of competition behind these developments. Of course, this also means that as a consequence of these developments, hedge funds relatively relative value strategies are highly vulnerable to adverse shocks in funding, cash or derivative markets, as evidenced by the way by the episodes of the March 2022 turmoil. And also of course at a lower scale and with of course more orderly and one day in early April this year. This is one channel, a second channel which is related to this time not to hedge funds, but to long term private investors. Again, asset managers, pension funds, insurance companies. Despite these institutions not being highly leveraged, these intermediaries also face considerable short term dollar funding rollover risk related to their use of FX derivatives. The certain nature of FX swaps that I was mentioning also before and illustrating implies that investors who use these instruments to hedge currency risk for long dated securities are taking on maturity mismatches between long term assets and short term financing. So in other words, by using FX swaps, they are de facto transforming currency risk into maturity risk. That's basically the point that I want to emphasize. And the third element of this stress amplification channel is precisely or stems from the fact that the repo market and the FX market are closely linked to each other. It's the combination of the two that in the end could have implications for financial stability. We know that the major dealer banks are the key suppliers of short term dollar funding in bond markets. It was also in one of the charts that I saw before. And while FX swaps are off balance sheet instruments that do not count towards total assets. Both repos and FX swaps are forms of collateralized lending and count towards the rigs budget of major dealing banks. So the issue here is that if a stress in the repo market lower banks risk taking capacity or disrupts their funding, they are likely to pull back also from the FX market. In other words, stress in the repo market could quickly spread to the market and by the way, vice versa could also be the case. I can put it in a relatively simplified way. The traditional bank sovereign nexus, what was one of our main worries during the global financial crisis has now evolved into a broader nexus linking bank and non bank financial institutions and sovereigns. So this is about the illustration of the facts and the channels on why we think that it is important to analyze these topics from the financial stability perspective. Let me now move to the last part of the talk which is about the policy implications. So what do we do with this? And I will stress that we need to work in the three dimensions that are relevant for this. One is of course regulation and supervision. The second is related more to monetary policy. And then finally I will also make some considerations related to fiscal. In the end, an important part of the problem is coming from fiscal on regulation and supervision. One potential avenue that we think it would be very important is precisely to limit the MBFI leverage because it's there that it is giving rise to the financial stability concerns that I was describing. The guiding principle here should be to pursue congruent regulation. When the vulnerabilities are similar across different type of institutions, then of course they have to be treated equally. Of course taking into account that banks and non banks have different business models and also the potential financial amplification risk are also different. Very important. The regulatory framework has also needs to be sufficiently granular as I was emphasizing before. I mean the MDFI sector is very heterogeneous and we have to take into account that heterogeneity when regulating and supervising these institutions. Precisely, if we want to address adequately what is the origin of the systemic risk behind each of the type of institutions there are a number of activity and entity based policy tools that can be used. Let me mention a few then that we think that could be particularly effective. First, one, greater use of central clearing and this is for cash and for repo markets which we think that this would enhance the resilience of government born markets. We know that the central clearing addresses what was mentioned before as an asymmetry presented bilateral markets. We also see some additional benefits including the elimination of counterparty risk and risk reduction through netting of exposures and very important. Last but not least, central clearing frees up balance sheet space for dealers as they are only exposed for a clearinghouse which boosts their intermediary capacity. Also very important here, central clearing is not a panacea. There are important challenges also associated with central clearing and this include of course increased systemic risk of central counterparties and procyclicality of margins. There are also unresolved questions around client access to CCPs. And moreover, while clearing allows netting within a market, it reduces the netting across markets, so meaning that more netting within government bonds but could be associated with less netting between government bonds and FX swaps. Okay, so that's one policy implication and one tool that could be used. The second is imposing minimum haircuts. That again we think that it would enhance the stability and resilience of the system. Some market participants argue that haircuts should be set at the portfolio level rather than at the trade level. However, it is unlikely that this can be done effectively because dealers often lack a complete view of their clients exposures. Also because correlations within a portfolio could break down in response to market wide factors or stress episodes, leaving counterparties much more exposed to than they originally anticipated. Again, one caveat that I want to emphasize here, minimum haircuts should be applied in a targeted manner. In many repo transactions, haircuts are intended to protect not the cash lender but rather the collateral provider so the cash borrower. A uniform application of minimum haircuts could therefore inadvertently favor one side of the trade cash lenders or collateral lenders, while failing to effectively address leverage build up in the most critical areas. Third, potential tool that could be used is related to banks. We think that regulating the banks is very very important because as I've been trying to illustrate, the more we highlight MBFI risk, the more we circle back to the importance of bank risk. And this again underscores the critical importance of banking regulation for the stability of the MBFIs due to the bank MBFI nexus. Bank regulation can be in fact an important tool to ensure bank financing to MBFIs, and this is provided on a prudent and sustainable basis. Here I should recall that in 2025 the financial stability Board issued a framework for healthcares on non centrally cleared financial transactions and the reality is that today the implementation of this framework continues to face significant delays in most jurisdictions. And then last but not least, I think it's very important to also emphasize that to properly oversee, regulate, supervise MBFIs, we need to have more data and more high quality data. Unfortunately, there is considerable opacity in many of the key markets in which MDFIs are active, thereby preventing a consolidated global view of the size of these markets and the key sproces. And this works both for the FX swaps market, but also for the repo market. In the case of the FX swaps, for example, there are very clearly many significant data gaps. We need to have data with directional positions by currency. We need also more information about the geography of payment obligations stemming from FX derivatives. And similarly, there are important blind spots in repo markets, despite the fact that there have been very good new studies on various key dimensions based on new data collection. And here I should of course mention that the BIS and the FSB have been actively working in trying precisely to fill in these data and data apps. Let's now move to to the second policy that should be involved in mitigating this risk, which is of course, monetary policy. And here the first statement I want to make is of course that price stability, which is the main objective of monetary policy in most countries and most central banks, remains the key goal for monetary policy and the most effective way to support the sustainability by reducing the inflation risk premium. In a context of deteriorating sovereign credit worthiness. The need for a credible monetary policy on central bank independence is, I would say, stronger than ever. And while monetary policy credibility does not fundamentally address the fiscal problem, it is critical for diminishing the associated inflationary risk. And this of course also implies that higher inflation, we know, cannot sustainably ease public debt burdens. So that's one element related to monetary policy. The second is related to the effects of central bank emergency interventions. And we know, we've observed it in many, many occasions. In order to fulfill their obligation as the ultimate guardians of financial stability and the financial system, central banks may have to occasionally intervene in a target manner to preserve market functioning and contain systemic risk. And in this context, in the context of the risk related to internationally active MBFIs, significant reliance on effect swaps by these intermediaries. Again, central bank swap lines remain critical to stabilize the global financial system at times of acute distress. Yes, we have to recognize that emergency intervention by central banks have drawbacks and these are related to potential generation of moral hazard. And sometimes these interventions may even conflict with other policy objectives. And this, for example, happens when turmoil arises, when a flail up inflation calls for monetary policy to be tightened. Just to give one example. Well, I think it's also clear, and there is also evidence of very specific episodes in the last years, that the central Banks have tools to deal with with these drawbacks of emergency central bank interventions. The most of course appropriate way precisely to reduce the or minimize at least the moral hassle associated with central bank emergency intervention is to ensure that MDFIs are well prepared to withstand high levels of stress in their own. So again, ex ante financial regulation is probably the best tool to minimize the moral hassle. At the same time, we also know that the design of the intervention could be particularly relevant to can incorporate penalty fees. Conditions for exit and expiration are also absolutely critical in order precisely to minimize some of these drawbacks. And let me end with a comment on fiscal policy. Well, in the end I was trying to claim at the beginning of my talk that the origin of this is the very significant increase of public debt and of course also how the sustainability of public debt to date related to the potential evolution of interest rates, the impact of aging on pension and health expenditure. Also additional pressures on expenditure, on public expenditure coming from defence, et cetera, that some of the dynamics of the sustainability are of a concern. Therefore, one of the main tools precisely to guarantee financial stability should come through fiscal consolidation to basically putting the house in order on the fiscal side, how to do that is important. According to the literature, graduality would help also in terms of the political economy that it is behind fiscal consolidation. At the same time, to be gradual you have to be credible. And for this we also know that having fiscal rules, having independent fiscal councils could help precisely on that endeavor. Timing of fiscal consolidation is very important. It's precisely very important idea that fiscal consolidation is started precisely when growth is above or around trend. And then finally it's of course very important to take into account the composition of of the adjustment. We know that there are some budgetary items that are more prone, more effective in also having positive effects on long term growth. And of course we know that growth could be particularly important not only for the welfare of our citizens, but also precisely to help a better dynamic of debt sustainability. And of course if this composition of the adjustment is done in a proper manner, and you add to that to structural reforms more in general in the economy, that could boost potential output growth in our economies, then of course it could also help very much to reduce the effort in terms of the fiscal adjustment itself. So let me end here. Thank you.