Structural changes in the global financial system and the transmission of financial conditions
Presentation slides by Mr Hyun Song Shin, Economic Adviser and Head of the Monetary and Economic Department of the BIS, at the 4th Annual Lecture in honour of Charles Goodhart, London School of Economics, 19 May 2025.
The Great Financial Crisis (GFC) was a watershed event that set in motion two related structural changes to the global financial system. Those changes define the state of the system today. The first is the shift in the underlying claims from those on private sector borrowers (especially mortgages) to claims on the government in the form of sovereign bonds. The second structural change is the shift from banks to non-bank financial intermediaries. The GFC was essentially a banking crisis where (mostly) regulated banks were the protagonists. The post-GFC financial system has, instead, cast portfolio managers and other non-bank financial intermediaries as the main actors to take centre stage.
Even as expansive fiscal policies have meant that sovereign bond issuance has outpaced the growth of private sector debt, portfolio managers of all stripes have absorbed the rapid issuance of sovereign bonds. The global nature of sovereign bond markets means that currency choice is an integral part of the investment decision. Pension funds and life insurance companies from rich economies that have obligations to their beneficiaries or policyholders in domestic currency nevertheless hold a globally diversified asset portfolio in several currencies. Currency hedging is therefore a key theme, and the system has evolved to allow such hedging. In this process, the banking system has played a crucial role. Banks enable the market for foreign exchange (FX) swaps, allowing investors to hedge currency risk. When boiled down, an FX swap is a collateralised borrowing operation. A euro area pension fund, for example, borrows dollars to invest in dollar bonds by pledging euros as collateral, with a promise to unwind the transaction at a pre-agreed exchange rate. In this sense, FX swaps make money fungible across currencies. The outstanding stock of FX swaps stands at $113 trillion, having increased rapidly since the GFC. Accounting convention allows not including FX swaps in debt, even though they are collateralised borrowing arrangements. In this respect, the apparently smaller footprint of the banking sector after the GFC is more an artifact of accounting conventions, rather than the underlying economics. Most of the time, the FX swap market lies out of view, but it is thrust into the limelight from time to time. The eventful first few months of 2025 are a good example.
This lecture takes the audience through the operation of the FX swap market and how, with the greater role of global portfolio investors, it has served to intensify the transmission of financial conditions across borders. Portfolio decisions involve gross positions and are only loosely related to current account imbalances and associated net positions. As sovereign bond markets are set to grow even larger with expansive fiscal policies in key jurisdictions, this lecture aims to highlight how the sovereign bond market and exchange rates are two sides of the same coin. The banking sector plays the key linchpin role in connecting the two, even if the accounting convention allows them to keep a smaller footprint.
