 You're listening to the ECB podcast bringing you insights into the world of economics and central banking. My name is Katie Ranger. Europe is slowly emerging from the third wave of the coronavirus pandemic. Although lockdowns are easing, many parts of the economy still can't open as they used to. Policy support by governments and the ECB remains in place to ensure that people keep their jobs and firm state afloat. But there is hope. Vaccinations are progressing and there's optimism that the economy will bounce back. In today's episode, we'll be looking at how financial stability has fared during this third wave. And we'll be exploring some of the challenges that lie along the road to recovery. My first guest today is John Fell from our Financial Stability Department here at the ECB. John, thanks for taking the time and welcome to the podcast. Thank you. Now, you were last on the podcast at the beginning of the second wave back in November 2020. And you talked about what financial stability is and how it affects the economy by using this idea of a bicycle and a cyclist. And you said that if one part of the bicycle breaks, it creates instability that could cause the cyclist to basically fall off. And the same is true of the financial system and the economy. So if one part of that system doesn't work, it creates financial instability that could also affect the economy. Now, since then, we've been through the second and also the third wave of the pandemic here in Europe. John, how has the financial system fared during these last six months during the third wave? I suppose what I'm asking is how is the bicycle doing? So, Katie, the good news is the cyclist remains on the bicycle and the bicycle is moving forward. But an important reason for that is the bicycle has been supported with what we call in British English or indeed Hiberno English stabilizers. Americans call them training wheels. As long as they are clamped onto the bicycle, the cyclist should remain balanced. Now, you will remember that at the outset of the pandemic, there was an unprecedented broad based policy response in the Euro area. Many macro potential policy authorities around the Euro area also released capital buffers and fiscal authorities made loan guarantees available to firms while also introducing statutory moratoria on existing loans. Now, together, these measures were highly complementary. The monetary policy measures combined with loan moratoria addressed the immediate liquidity strains that resulted from a collapse of firms revenues. And government loan guarantees addressed solvency risks, shielding banks from the rise of credit risk. Together, these measures ensured that credit kept flowing and prevented the economic crisis from escalating into a financial stability one. So, financial stability was preserved. That said, over the course of the past six to nine months, the COVID-19 shock has evolved and it has evolved from a source of liquidity stress to a source of solvency risk. Initially, the economic and macro potential policy responses were geared towards containing the immediate economic fallout. And as you mentioned, many countries are now reopening after a third wave of COVID-19 infections. The pace of vaccination is speeding up as well, by the way, and all of this provides grounds for optimism. And it's time to think about removing the stabilizers from the bike. In fact, some countries are already doing that with statutory moratoria and government guarantee schemes coming to an end. Our view now is that more targeted policy responses are required while risks from cliff edges will need to be carefully balanced. Specifically, what do I mean by that? We know that phasing out of government loan guarantees and statutory moratoria will reveal vulnerabilities on non-financial sector balance sheets. And that needs to be balanced against the risks of a misallocation of capital if those measures were to persist for too long. So, for our cyclists, as those stabilizers come off, we cannot exclude some shaking and wobbling on the road ahead. Okay, so you mentioned the vaccination campaign, and indeed here in Europe it's progressing a lot faster than it was perhaps at the beginning. And with that, we can hopefully look forward to the next phase, which will be the recovery. Is there anything that we need to be aware of for that, any risks that you've got your eye on at the moment? So, the first point is that we witnessed very differentiated impacts of the pandemic at the beginning, both globally and also across Euro area countries. And as we come out, countries are also recovering at different speeds, and that has created new sources of risk. So, for instance, in the U.S., the combination of a sizable fiscal stimulus package together with optimism about the pace of vaccine rollout in the U.S. caused bond yields to rise abruptly in February and March, as investors started to worry about inflation. It was actually the worst quarter for investors in the U.S. Treasury market since 1980. And the spillovers to other asset markets served, you could say, as a wake-up call about the vulnerability of stretched asset price valuations to low discount rates. Also, within the Euro area, we're seeing wide differences in economic performances. While some countries are expected to have growth rates close to the very rapid growth rates that are expected for the U.S. this year, others are recovering more slowly. And the result has been a clustering of vulnerabilities in some countries. Also, within the financial system, as the COVID-19 outlook has improved, investor sentiment towards Euro area banks has become distinctly more optimistic. Now, we have a more cautious view, especially given uncertainties about the adequacy of provisions in the banking system to deal with an expected rise of non-performing loans. So, while we are more upbeat about the financial stability outlook than we were six months ago, we are cautiously so, because we still see challenges ahead. In the Financial Stability Review, you also talk about divergence across sectors, and you mentioned already the divergence across countries. Could you tell us a little bit about the divergence across sectors, specifically where we're seeing that, and perhaps what's behind it? So, well, I mean, there is a link between the sectoral divergence and the cross-country divergence, actually. And it's depended on several factors, including differences in economic structures across countries, as well as health and economic policy responses. So, COVID-19 was a shock that hit all Euro area countries more or less simultaneously. But the health policy responses, so lockdowns, social distancing primarily, they had differentiated impacts on economic activity, depending on the sector. For instance, manufacturing, which is highly automated, recovered quickly, whereas the recovery of services has been taking much longer. And this partly explains the country differences as well with the contribution of manufacturing in some countries being more important than it is in others. Even within services, there has been great divergence. As some activities continued virtually, thanks to video conferencing, think of education or professional services, for example, while others ground to a complete halt. Think of restaurants and bars, or tourism more generally. Again, countries that are more reliant on tourism and travel suffered more, so differences in economic structures really have been key, even when health policy responses have been exactly the same. Not only has divergence been apparent in measures of economic activity, but we also see divergence in the performance of banks last year. In some countries, banks reported profitability performances that would have been considered decent before the pandemic, but others endured sizeable losses. Again, differences in economic structures appear to explain much of those differences across banks. And unfortunately, the ones that suffered the most were ones that were most affected by past financial crisis. So economic divergence poses a risk for financial stability as it has affected financial system performances and it has affected financial system performances unevenly. But maybe Katie, the short and simple answer to your question about what is behind the divergence is bad luck. Few were prepared for this COVID-19 shock. So going forward, it's clear that certain countries and certain sectors are going to need more help than others to come out the other side of the pandemic. What exactly can we do to help them? Are there specific policies that are good at targeting this divergence? So this is really a task for fiscal policy, which has the capacity to be very targeted towards the greatest need. Right from the start, Euroarea countries activated a range of fiscal measures and those included measures to increase expenditures on national health care and on measures to tackle the economic crisis. But the result was that after March last year, all member states saw increases in their public sector deficits and their debt. And a key source of concern we flagged it in the Financial Stability Review last year was this rising indebtedness was taking, the largest increases were taking place in already highly indebted countries. And that comes back to the economic divergence and the bad luck that I was speaking about, but it also had the capacity to raise sovereign debt sustainability risks. Now while the EU Council Agreement in March last year to initiate a general escape clause from the Stability and Growth Pact helped those countries that were running into the constraints of the Stability and Growth Pact, it didn't really solve the debt sustainability issue. And that is where the next generation EU agreement comes in by establishing an instrument of fiscal support within the EU budget for those countries that have been most affected by the crisis. And that was really an unprecedented demonstration of European solidarity, which should not only bring the economy back to potential, but it should also put economies back on a path of convergence. Thanks a lot, John. Really nice to talk to you. Thank you very much, Katie. Let's zoom in now on two specific areas of financial stability. And I'd like to look at the markets and particularly at the big risk appetite that we've been seeing from investors at the moment. And the other thing I'd like to look at is zombie firms. Now for that, I welcome my next guest, Tamara Shakir, who also works in the ECB's Financial Stability Department. Tamara, welcome back to the podcast. Thanks, Katie. Now, one of the big building blocks of the financial system is the markets. And we've seen some extreme highs and lows over the past year, specifically in March 2020 when we saw quite big losses after the onset of the pandemic. Fast forwarding to today, how have investors been behaving during the third wave? What kind of sentiment have you seen there? Well, globally in terms of the big financial markets, what we've seen actually not just in the last six months, but even in a period preceding that since those troughs of the pandemic that you mentioned, quite a lot of optimism in financial markets, particularly in the big global equity markets and rising prices in equity markets. There's been a bit of a shift in some periods of that. So whereas maybe in the middle of last year, a lot of that, those price rises were being driven by, for example, big technology firms driving the US equity markets and spillovers from that. Lately, I mean, John talked a bit about the rise in US interest rates. When that happened, it also led to broader shift in market sentiment towards a broader range of firms. So for example, firms that would also do well just as the economy recovers. And that really reflected, I think, as people cemented ideas that the pandemic was coming to an end, vaccinations were coming into place, stimulus the packages were still there, particularly in the United States. And they looked ahead to the recovery, which is what markets are supposed to do, and a pricing for that. Some corporate earnings have also been relatively positive in recent months. And so markets were picking up on that. So that's been pretty broad based improvement in market sentiment or continued strength in market sentiment, which is somewhat explicable. I think that maybe we'll come on to the vulnerability part where underneath that is actually the return of something we were worrying about before the pandemic, which a lot of this vulnerabilities have been, I think, in terms of search for yield, we call it, where you've got investors who want to make returns and they seem to in some quarters be pricing at a very optimistic view of the world. So that's the idea that, I mean, until now they've been, for example, buying bonds, which are generally seen to be safe and stable. But they're looking for more money. Basically, they want more return on their investment. And so they're moving into more risky, into riskier areas. Yes. So you might get investors who traditionally bought corporate bonds, for example, but of a certain quality. So big save companies or companies have got well established reputation for having a certain level of return. But that's not going to generate enough investment yields. So they start exploring into riskier segments of the market and we see bits of that. And that shows up for us. And we pay a lot of attention to corporate bond markets, the distinction between what we call investment grade and high yield debt. And you get a whole load of firms are priced right on the cusp of that. And it makes a big difference to investors, which technical category their bond sits in. And the concern there is if you do get a disappointment in the earnings, how exposed are those investors? Or if the companies move from that investment grade to a high yield category? How exposed are they going to be? So that's an area of risk that we're seeing that we're concerned about? Yeah, I mean, that's the return of a theme we've had. Like I say, I think it's a restarting of a theme we were talking about before the pandemic and it reflects optimism. The other thing which we have seen in the last six months, it's a bit more novel is other pockets of exuberance. A lot of it around equity markets, actually, but also link to episodic episodes and equity markets where we've seen big volatility in subsectors of the equity market. So I talked a bit about the rise in broad-based equity markets, but say whereas you might have had like a 15% increase in the US, the big US S&P index, which everyone follows, you've actually got sub-indices of that, which are the riskier end or more uncertain indices where you've had 30% or 40% price rises in the same period. And that's reflected people craving a search for higher returns, but on something that is riskier and more uncertain. So you mentioned risk-taking and I think one area where it's safe to say there's quite a lot of risk-taking going on at the moment is Bitcoin. Could you tell us a bit about what you've seen there? So over the last six months, we've seen a lot of action in Bitcoin and cryptocurrencies and something that a lot of people have been calling a bubble. Huge price rises followed actually by quite a big correction recently as various announcements came out about how it would be treated. It's not the first time with Bitcoin that we've seen this in the last few years. So we have seen these episodes of very large increases in price followed by corrections and then it starts again. And I think that does link to a general sense of exuberance so you can see a line from people looking for places to make money in financial markets and then exploring what we would think of as riskier asset. We pay more attention to it from a financial stability perspective isn't necessarily when some people individually or with small amounts of money are investing and then losing money. It's when we're watching signs, we're getting signs of professional investors, more establishment institutions that are looking at these price rises and then we hear that they're beginning to explore making investments in this area because that's giving us a signal of something we need to understand more about shifts and risk appetite and behaviour from these firms. So we're seeing a different kind of investor starting to look into Bitcoin as well. We've had signs of that when the price is rising. I suspect in recent weeks people have been thinking again have been reminded of the volatility of this asset so they need to think really carefully about what they do then. Now the other topic I'd like to ask you about is something that you wouldn't usually associate with the economy and that's zombies, well specifically zombie firms. And critics have raised the question of whether the fiscal and monetary policy support that's in place at the moment put in place by governments and central banks has actually had a negative effect in that it supports and provides a lifeline to these zombie companies. Now it's worth explaining quickly what they are. Zombie firms are firms that aren't profitable but still keep their operations running because they're often propped up artificially through loans and credit and they're called zombies because they're kind of neither alive nor dead. Tamara, what's your take on this claim on what the critics are saying and perhaps do you see zombie firms as a risk for financial stability? Now that's been a debate about the extent of those firms and how many of them they really are what their impact is and there's a lot of people have different views about that. Okay. So when we then think about the pandemic context, the debate got reinvigorated a little bit exactly as you say because people were observing policy measures that are really broad based and generous all done in the immediate crisis around the pandemic and trying to handle that. And the question is, are those, is there a side effect of some of those policies that might be benefiting these firms and what does it mean if so? We did a bit of work looking at this in our latest financial stability review and we aren't able to examine the question in full partly because we really just started by looking at what do we think with the scale of zombie firms going into the pandemic and then try and ask question about how many of them may have benefited from policy measures. And the conclusion are is there probably have been firms that have been able to benefit from these measures but overall we don't find a really big scale of an issue. The question I think looking ahead goes back to what John was talking about in terms of policy going forward in terms of it's all fine if these measures are relatively temporary then they fall away. Many firms will stop benefiting from them including any less profitable firms or non viable firms that have been benefiting from them. But if the policy measures go on sort of for too long and we get too scared about removing their training wheels then there is a chance that these firms will benefit for a long time and why do we care about it? Two reasons, one isn't more an economic reason than financial stability which is these firms are holding onto resources that could be used for doing something else whether that's in the form of capital or labour of people. The other thing for a financial stability perspective is as you hinted one of the reasons that zombie firms have always been kept alive is usually credit which means someone's been lending to them and typically it's banks. And so the question from us for financial stability is if you were to get a wave of failures of firms including these types of firms down the road what's the impact going to be for banks? And how much worse would it be for banks than if banks had actually just let them go earlier on in the process? And so that's the reason that we pay attention to this but as I said our early investigations are not painting it as a top priority issue yet but it's definitely worth reminding ourselves of what are the side effects from policy measures that go on too long or in a too broad based way. Thank you Tamara. Before we wrap up there is something I ask all of our guests here on the podcast. If you had to recommend one must read or must watch about today's topic financial stability what would that be? What's your hot tip for our listeners? John would you like to go first? Can I have a must read and a must watch? You can have as many musts as you like. So must read I mean I think the best book that has ever been written to really understand what gives rise to and what the consequences are of financial instability is many as panics and crashes written by Charles Kindleberger. The book has been through many editions and I think it's an absolute must read. For most watches I would recommend Highly Margin Call. So this is a movie that tells the story of a roughly 24 hour period at a fictional investment bank on the eve of the 2008 financial collapse and I think it really helps to understand what happened in 2008 that caused ultimately the global financial crisis. Great two good recommendations thank you John Tamara. So my recommendation in terms of a book is more to think about why it matters financial stability and what the consequences can be and I think still the biggest event for financial stability was the Wall Street crash in 1929 in the Great Depression that followed Tickey United States. So me John Steinbeck has some great literature then particularly Great Separat which tells you a story driven by the consequences of this and what it's meant for people moving across the United States and the fallout really from doing that. So I think that's a kind of good reminder of why we why we do this why we care and what can go wrong. I didn't have a must watch exactly but just remembering it the film I think of as a kid particularly that has probably my earliest themes of financial stability was remembering trading places which is there. I think in 1980s classic with Eddie Murphy. And if you want to learn about Orange Futures and insider trading with a dose of chaos around it. Okay so that's my summer watching and reading sorted thank you so much both of you for the discussion. And thank you too Katie it was a pleasure. Yes thank you very much and have a nice summer. Thank you you too. Well that brings us to the end of this episode do check out the show notes for further reading on this topic. You've been listening to the ECB podcast with Katie Ranger. If you like what you've heard please subscribe and leave us a review. We'd also love to hear from you so do share your feedback and ideas with us via social media. Until next time thanks for listening.