The impact of geopolitics and regulatory uncertainty in securities markets

Geopolitics and regulatory uncertainty can have serious repercussions on markets at large; investors become more conscious of the risk of losing money and start to move their investments from riskier to safer assets. How does these impact financial institutions? What do they need to do? How can they better manage this uncertainty and maintain a competitive edge while tackling other important challenges?

In its April 2017 World Economic Outlook, the International Monetary Fund (IMF) clearly emphasised the impact that geopolitical risks, as well as the uncertainty in terms of regulatory issues, could have on economic growth in general and on the financial sector in particular. The subsequent July 2017 update from the IMF observed an uptick in economic growth worldwide which, while modest in 2017, potentially will be moderate over the longer term and diversely distributed amongst countries. This is a source of optimism for the future, with the report pointing out a promising outlook for the financial markets. But at the same time, it raises concerns about “the considerable risks that continue to darken the outlook over the medium term…”

The IMF identified many risks, including international tensions and a wide range of uncertainties. These include the political situation in certain countries and regions (notably Europe with the UK’s withdrawal from the European Union). In addition, there are uncertainties related to the economic policies of advanced economies, particularly whether protectionist measures will be introduced that could lead to trade wars and damage to international trade relations. There are also vulnerabilities in the financial sector in some countries such as credit controls in China and fragile balance sheets in the banking systems of some European countries, which could lead to a downturn in profits due to fears about financial stability.

The IMF also voiced concerns about the impact that a generalised reversal of the tougher regulations and financial supervision could have on financial stability, including reduced equity, liquidity resources, weaker supervision, to which can be added markets fragmentation, regulatory arbitrage and unfair competition between stakeholders. A sudden tightening of financial conditions (for example, following the change of administration in the US) could have an impact on emerging and developing countries. All these risks are interdependent and can mutually reinforce each other. As the managing director of the IMF, Christine Lagarde, declared, if action is not taken, the issues could comprise a recipe for a “brutal financial crisis”. Such a crisis could include a correction to the current high valuations on markets, notably stock markets, and greater volatility. These shake confidence and weigh on expenditure and therefore growth. And we know that an economic crisis usually follows such a crisis.

Based on these alarming observations, it is normal for investors to worry about the risks to their investments and to seek an asset allocation strategy that will enable them to protect themselves. And yet, we mustn’t lose sight of the fact that investors are also looking for yield and, for now, it is hard to find any without a minimum amount of risk-taking. So, it is difficult for investors to position themselves in this context.

In the face of this, financial institutions must exercise prudence and selectivity. This prudence should be demonstrated in several ways. For example, care must be given to monitoring these potential risks to be able to foresee their occurrence and the resulting impacts. It would be a pity to be taken by surprise, as was the case in 2008, and to be lulled by the current optimism connected to the economic recovery which, once again, remains modest. Also, banks must be prudent in achieving compliance with the many financial regulations issued during the past ten years – notably those aimed at strengthening their resources and their balance sheets. By doing so, they will be in a better position to cope with a sudden downturn in the economic environment. For this, reconsidering the regulatory measures taken after the crisis of 2008, notably in terms of prudential rules, would be a mistake. Some measures can indeed seem excessive: they are an illustration of the public authorities’ regulatory overreaction and need to be corrected. But the underlying principles are sound and it would be dangerous to call them into question. Prudence must also be displayed in the geographical and sectoral diversification of financial institutions’ business, although this is not necessarily a guarantee of security when faced with a major crisis. Finally, must pay attention to the quality of customer support for investments of all kinds, these being a risk for the customer but often for financial institutions themselves as well, either through the granting of credit, or through advice and other financial services. A poorly assessed or ill-advised customer represents a significant risk for a financial institution.

Confidence renewed through sound regulatory and financial compliance, quality of the advice and services provided to customers and a close relationship with them, but also with the regulatory authorities and supervisors, and adaptation to the rapid technological changes that will shape the customer experience in the coming years, are potentially differentiating factors that will ensure the sustainability of those financial institutions that take inspiration from them.

Eric de Nexon
Head of Strategy for Market Infrastructures

In an environment as uncertain as that described in the IMF’s report, financial institutions need to reassure themselves that what has been accomplished since 2008 to restore confidence in the financial system in general and then in each establishment is an effort that must go on. They must avoid the questionable behaviour that led to the 2008 financial crisis and not sacrifice short-term profitability in terms of the risks taken on customers, but also by the customers themselves.