BBH on the impact of increased regulation and low volatility on the financial markets

Transcript

The dust has settled somewhat in financial markets as low volatility hits the US and UK financial sectors. But is this good news, and has increased regulation in the banking sector brought about more stability? World Finance speaks to Scott Clemons of Brown Brothers Harriman and Company to find out.

World Finance: Scott, the Federal Reserve and the Bank of England laid out plans to raise interest rates based on jobs figures as well as inflation. Now, do you agree with delaying an increase to the rates?

Scott Clemons: You know, central bank policy is always a matter of balancing risks. On either side of the pond the question is how much risk of inflation do you want to take on, while you are addressing the risk of deflation or stagnation in the labour markets.

I think both central banks, the Bank of England as well as the Federal Reserve here in the US, have opted to focus on the risks of stagnation on the labour markets – that’s causing the delay in higher rates.

They’ve basically decided to accept a higher risk of inflation down the road in exchange for combating fragility in the labour markets today. It certainly prolongs this era of very low interest rates, but it’s a balance of risk that I think both central banks are wise in making.

World Finance: Now let’s talk about how this delay is impacting the property sector in the US.

Scott Clemons: Well there’s no question that low interest rates for the past five or six years now really, since the financial crisis, have been a support for both the commercial as well as the residential real-estate markets.

It’s allowed for a recovery to take place in both markets

It’s allowed for a recovery to take place in both markets. However the impact on the residential real-estate market in particular isn’t as great as you might think, simply because access to credit has been constrained.

As banks have tightened lending standards, fewer people are able to take advantage of those lower rates. So there has been support for the housing market. But the support hasn’t been as great as you might think, if all you knew was that mortgage rates had been at all time lows for four or five years now.

World Finance: Now Scott, how are people turning to investing in currency markets in the US, considering that we are in a low volatility period?

Scott Clemons: You know Kumutha, we haven’t really seen that among our client base. There’s no question that investors here in the States have grown frustrated with very low interest rates, and they long for a more normal era in which they could earn a reasonable rate of return on safe assets, such as money market assets or very short duration, short maturity treasure bills or municipal bills.

We haven’t seen a whole lot of movement into currencies as a way of dealing with that. What our clients have done so far is opt to remain short duration fixed income, preferring the liquidity that it provides over any sort of return that they might get in other asset classes.

World Finance: Now Scott, let’s take a look at how some of those issues are affecting the banking sector. Officials are hoping to bridge the financial regulatory gap with proposals being tabled at the G20 Leaders Brisbane Summit in November, which addresses the kind of too big to fail argument that we have heard over and over again in the news. How do you think that the banking sector in the US is going to react?

Scott Clemons: Kumutha, I think the banking sector in the US was actually pretty quick at even pro-acting to enhanced banking regulation, even in the early days of the recovery from the global financial crisis.

The Brisbane Summit, the G20 Summit that’s coming up is only the latest step, and it will not be the last stop, in enhanced banking regulation. So I don’t think the impact on the US banking sector is any greater than that which is already anticipated, and to which the banks have already begun to respond.

There’s no question that it is the desire of regulators to have better insight and better control over the exercise of capital creation

There’s no question that it is the desire of regulators to have better insight and better control over the exercise of capital creation. If you think about what really went wrong in 2008, in sort of 20 seconds or less, the regulatory environment was designed to provide oversight to the creation of capital. The problem in 2008 is that so much of credit creation took place outside of the banking sector, and therefore outside of the regulatory environment.

So filling the gaps as you phrase it, and I think that’s the right way to think about it, it’s certainly taking place, but it’s taking place at such a slow pace, it’s giving the US banking sector the opportunity to get ahead of the regulatory curve, and I think they’ll continue to do that.

World Finance: Now the US of course has had successive bailouts in place that have supported the resurrection of the banking sector. Scott, do you think that banks have learnt from their past mistakes and do you think the US government is being tough enough?

Scott Clemons: It’s almost a truism of human nature that innovation paces out regulation. So forgive a slightly cynical response to your question, but there’s no question in my mind that the regulatory steps that being taken, by various government agencies, will prevent banks from making the same mistakes that they made in 2007 in the run up to the 2008 crisis.

But that doesn’t mean that the banks won’t make all new mistakes the next time around. So investors in particular shouldn’t take too much confidence in an enhanced regulatory environment, but should conduct their own due diligence on the banking sector in particular, as an area for potential investments.

World Finance: Very interesting, thank you so much for your insight Scott.

Scott Clemons: Thank you Kumutha, it was nice chatting with you.