Analysing the megatrends: Fintech, China and banking transparency
Laurent Clavel, head of macroeconomic research at AXA Investment Managers and Victor Murinde, chair of the Centre for Global Finance at SOAS University of London, discuss some of the key megatrends affecting global finance today and look ahead to what might be moving the needle tomorrow…
Laurent Clavel: Your research focuses on megatrends within finance. How do you define megatrends and how do you manage to estimate these, to extract them from the everyday evolution of the economy?
Victor Murinde: We define megatrends as phenomena or exclusive patterns in global financial development. For many of these, there are a priori reasons why we think a pattern on a given phenomenon or financial indicator, or groups of financial indicators is outside of the normal financial evolution; something that represents a departure from the structural way we have observed these variables in the past. Such trends also tend to gather momentum and persist. Of course sometimes, they can mutate or change their structure. But, the rationale behind this, the intuition behind this is that while we can recognise some persistent patterns, and while we can find some highly predictable patterns, there are some we are not able to capture or predict. And, some of these have confounding effects on other variables and patterns. And, it is these ones that we are interested in; how they are affected by regional divergences for example and of course, as you examine them more closely you look at their drivers, their effects on things like economic growth or resilience.
LC: One of the megatrends that has occurred typically over the past 20 or 30 years is the rise of China in global trade. It is something you touch on in your research quite a bit. How do you see it evolving?
VM: I see this really as a phenomenal issue. In particular, China’s impact as a global investor and how this tends to transform the behaviour of financial markets, everything from financial institutions and manufacturing, to commerce. A good example of this is how Chinese investment is influencing industries and shaping trade in Africa. It is a game-changer in the sense that the investment is available in huge proportions, often well beyond the debt systems of the individual countries and, at the same time, it is rapidly dispersed. It often doesn’t require the traditional due diligence – the six to 18 month consultation period that such a huge resource usually does. And, importantly many of these funds are being directed into strategic areas, especially natural resources, oil and gas. So it is a phenomena worth watching, especially as to how it is transforming the patterns of global trade and investment, and of course the impact on the host countries especially in Africa with its high potential for rapid and sustainable growth.
The risks and opportunities of digital finance
LC: Another megatrend you identify is the digital revolution. What, to your mind are the main risks and opportunities that stem from this fourth innovation wave?
VM: I like the way you phrased the question because it is definitely a source of both. Digital finance, which is a combination of developments in technology and finance, has a lot of very promising impacts and the ability to foster inclusivity. For example, telephones have opened up the possibility of providing financial services to areas that were previously in economic exclusion zones – rural areas, hard-to-reach areas, unbanked areas, where commercial banks and other financial institutions could or would not reach before. And, because of that connectivity, payment mechanisms can then be effected and loans and repayments begin to be made.
The fact that there is great interest in some of the elements of digital finance and how they are changing life in Africa and many other low income countries is a positive. The fact that the digital revolution is changing the availability of information and reducing opacity in the financial services sector in developing countries is also a positive, as is the resultant growth in the level of interaction between the Organisation for Economic Co-operation and Development (OECD) and developing countries. For example, the rapid transfer of funds between OECD countries and developing nations and vice versa that has been facilitated by improvements in digital finance has been a boon to Africa.
But we also have to look at the other side, whereby there might be risks involved in the use of digital finance and of course, how these risks can be measured, whether these risks can be managed or pooled. That is one dimension. The other downside is that we don’t yet understand the full impact of some of the developments we have begun to see, both in terms of how they operate and what the long-term costs may be.
For example, if you take the issue of bitcoin and its potential successors, the trading of these cryptocurrencies, the users of it sit on many trading platforms, largely outside the traditional financial system. There remains a question of whether or not bitcoin is actually becoming a competitor to central banks, which traditionally have had the monopoly role of issuing and managing currencies.
In addition, for example, what are the implications of this for seigniorage, the tax and revenue enjoyed by central banks and governments for monopoly issuance of currencies. These are things that we need to understand a bit further. But digital finance is a megatrend, that is for sure, and as long as developments in technology are fused with developments in financial instruments, then we can definitely see digital finance expanding across the globe, especially in lower income countries.
LC: You recently published a paper in the Journal of Financial Stability on bank opacity and risk taking, where you use analyst earnings forecast error as a proxy for bank opacity. You empirically confirm the positive correlation that opaque banks tend to take more risk. Can you explain the implication of your findings?
VM: The question of bank opacity is one we are very concerned with. The paper, which is joint research with Dr. Samuel Fosu at the University of Birmingham, Dr. William Coffie at the University of Ghana and Professor Collins Ntim at the University of Southampton, has a fundamental underlying argument. It is the realisation that we have been living for quite some time now with complex and periodic financial crises and of course there are many explanations for these crises. But if we just take a look at the incidence of these global financial crises you will find trends. The tequila crisis of 1994 rested mainly on capital flight. The financial crisis across Asia in 1997/1998, reflected some fundamental weaknesses in the international financial system and the way banks operate. Then there was the Russian financial crisis in 1998, which involved the value of Russian currency and debt. And, of course, there was the global financial crisis of 2008.
Banks featured in all of these crises but in particular the inherent opacity of the banking system. This is an age-old problem and reflects the high degree of information asymmetry inherent within the system. While this could be measured in many ways, we wanted to use the fact that analysts actually produce forecasts as an entry point. By actually trying to break through the barriers of opacity, these analysts try to get some fundamental information from banks. We hoped that these forecasts could be fundamental in helping us understand a great deal about banks and how banking systems operate.
Our results, in a way, are shedding light on the fact that while regulators and central bankers have information about the banks, it is not always a complete picture. And, even if that information is a proximate way of trying to understand how the banks operate and a way of minimising risk, it is structured according to regulatory regime. And, these regulatory regimes have been very weak – just look at the changing nature of the Basel banking accords over time. Other systems need to play an important role and the one we put forward is analyst forecasts. Using analyst forecasts provides us with a broad understanding of bank risk taking behaviour. If you are able to combine the analyst forecasts with a better understanding of the banks’ business model, the way it operates then we are actually able to shed more light on the risk-taking incentives of these banks.
Regulation and the future
LC: I would say that the financial deregulation that began in the 1970s and ran until 2007, was a megatrend, as was the reregulation we have seen post the global financial crisis. As we enter 2018, which path are we currently on?
VM: I would argue that the next step is the lighter regulation of banks but within a specific context. It will be different from previous periods of deregulation as it will have mechanisms that reinforce official regulation. For example, the fact that the current Basel III A code has strong capital buffers is not helping banks and is resulting in a scenario where banks are shifting away from the intermediation loan-type transactions into investment in securities, such as government bonds and treasury bills. This is not a positive development.
At the same time, current knowledge would suggest that there are a number of other additional mechanisms supporting the official regulation. For example, we mentioned analyst forecasts, where you can get information about bank risk taking behaviour, which remain a good source of monitoring. Additionally, there are peer monitoring mechanisms and market discipline mechanisms being used by the banks. For example, in the interbank market, banks have a high incentive to monitor their peers to ensure they are able to both get their money back on the lending side and are able to lend funds when they need to. This need to both lend and borrow is a great incentive for banks to reduce their risk-taking behaviour. Of course, you could argue on the contrary, that these same peer mechanisms create the opportunity for banks to collude and, if they do so, could create a contagion through the interbank market. But I would argue that in general, if the interbank market is active, the tendency for collusion should be low. So we are moving toward less regulation but with more supporting mechanisms outside of central bank oversight or regulatory mechanisms.
LC: Just to conclude, we have touched on a few of the major megatrends driving change at the moment, are there any other trends that you think are on the radar that are going to become talking points in the near future?
VM: Some of the other trends are already on the radar, in particular the issue of political risk and the trend towards reversing globalisation. I think these will have a strong impact on global economic transformation and the global financial system going forward. We, the AXA Chair research team in the Centre for Global Finance at SOAS University of London, are peering into that twilight zone.