The Future of Financial Markets. June 29 July 1, 2016

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1 From the address by Governor of the Central Bank of the Russian Federation Elvira Nabiullina The policies implemented by central banks are increasingly influenced by issues of financial stability. Uncertainty in the global economy is high. Events such as the decline in oil prices two years ago and Brexit this year were not seriously anticipated by experts. That is why it is so important that central banks have a set of tools at hand to stabilize financial markets and the economy when risks of varying kinds occur. It is also very important to resist the temptation of socalled easy solutions, which would only worsen prospects for global economic growth. Brexit is an example of such an easy solution. Easy solutions have also enjoyed an increase in popularity in Russia, where, for example, suggestions have been made to boost the economy by simply printing several trillion roubles. Russia witnessed the consequences of such ideas back in the 1990s: a prolonged economic downturn accompanied by high inflation. The key global challenges facing Russia include the long-term decline of oil prices, changes in the growth model, and the slowdown in the Chinese economy. A quick return to high oil prices is not expected, so the Russian economy will have to adjust to reduced oil and gas prices. In its dealings with China, Russia must shift its focus to the rapidly growing consumer sectors and the post-industrial economy. Of particular note are the monetary policy challenges facing central banks around the world. In developed countries, soft monetary policies have helped to stabilize the situation, but alone, these

2 are not sufficient to return economies to a position of sustainable growth. While abandoning a soft monetary policy poses certain risks, refusing to normalize the economy may result in stagflation. The central banks of the world s major economies will find themselves between a rock and a hard place. The Bank of Russia has now shifted from taking active measures to prevent inflation from rising to a policy aimed at achieving a sustainable decrease in inflation and inflation expectations. We are confident that we will reach our goal of 4% inflation by the end of 2017, without negatively impacting economic growth. Seeking to help the economy by prematurely lowering interest rates may have the reverse effect. Due to the continuing high inflation rates and budget deficit, Russia does not have any leeway to stimulate economic growth through budgetary or monetary policy. In fact, such measures would not lead to sustainable growth as structural limitations are keeping the potential growth rate for the Russian economy low, at around 1.5 2%. This has led the central bank to raise the issue of structural reforms which are critical for the sustainable growth of the Russian economy. The key structural reform in Russia is to improve the business climate, which involves taking measures to foster competition, deregulate the economy, reduce the share of public and semi-public organizations, and protect property rights and the rights of minority shareholders. A medium-term programme for achieving a balanced budget is, of course, very important. Uncertainty surrounding government expenditure, the deficit, and future options for financing the deficit increases inflationary risk. A budgetary rule is required to ensure sustainable low inflation and a stable real exchange rate for the rouble against a background of fluctuating oil prices and commodity cycles. The challenges for the Russian banking system are linked both to the objective deterioration in economic conditions and to problems accumulated by banks: weak market players, the prioritization of business owners by banks when providing financing. Although the banking system is in a relatively good condition, this does not mean that the banking sector has fully recovered. The problems accumulated by banks are more significant than expected. Weak and unscrupulous financial institutions must be removed from the market. The whole oversight system for credit institutions is currently undergoing a major overhaul, with a transition from ex post facto analysis to online analysis. The mechanism for the financial rehabilitation of credit institutions needs to be changed. The

3 restructuring mechanism has not changed since it was first established, and is still based on the granting of large numbers of long-term, concessional loans to restructuring organizations. The mechanism has serious systemic shortcomings: it is costly for the state, restructured banks remain undercapitalized for years and are used by the restructuring organizations to warehouse bad assets. The Bank of Russia proposes the creation of a special banking sector consolidation fund, which will contribute to the capital of banks undergoing restructuring. The transition to this new model will make the bank restructuring process cheaper, quicker, more manageable, and generally more efficient. A need to implement proportional regulation in the banking sector has arisen, meaning that the strictness of the requirements must be in line with the range of banking operations carried out by that bank and the scope of risks assumed by it. We propose to distinguish three types of credit organization: systemically important banks (which are already distinguished), federal banks, and regional banks. For federal banks, we plan to increase minimum capital requirements to RUB 1 billion and consistently implement international standards. Regional banks are defined as banks with assets of less than RUB 7 billion operating within a single region. The business model for such banks must consist of raising funds from individuals and legal entities in a particular region and loaning such funds to people in the same region with minimal risks involved. Regional banks will be subject to highly simplified regulation and will not have to comply with technically demanding international standards. The introduction of consolidated oversight for bank holdings and for financial groups in general is required. The lack of oversight and lack of obligation for such groups to comply with prudential standards allows existing problems to be masked. We therefore need to create a regulatory environment which is tailored to the organizational structure of entities and to establish mandatory standards and management requirements for financial groups.

4 Plenary Session 1 Global economic growth and inancial stability Moderator: Elvira Nabiullina, Governor, Bank of Russia Speakers: Stephen King, Senior Economic Advisor, HSBC; Kenneth Rogoff, Professor of Public Policy, Harvard University; Marc Uzan, Executive Director, Reinventing Bretton Woods Committee; Jacob Frenkel, Chairman, JPMorgan Chase International; Guillermo Ortiz, Board Member, Chairman, Partner, BTG Pactual; Stephen G. Cecchetti, Professor, Brandeis International Business School

5 Excerpts from the participants speeches are given below: According to Mr. Cecchetti, the main task for central banks is to ensure price stability. When inflation is high, central banks tighten their monetary policy, whereas low inflation results in an easing of policy, which may be referred to as quantitative easing. The banks may also set negative interest rates, but it must be understood that this only occurs in highly extraordinary circumstances. Mr. Cecchetti believes that the aim of a soft monetary policy is to maintain price stability, rather than to ensure long-term growth, and that it is price stability that creates the basis for sustained, balanced, and robust growth. Without price stability, the economy simply will not operate efficiently. Mr. King noted that there are other factors that hinder economic growth, in spite of quantitative easing. This means that monetary policy has limited impact, and governments must take additional measures to address the structural weaknesses of their economies. This results in growth levels which are significantly lower than anticipated. Answering the question of whether it is possible to coordinate the monetary policies of different countries, Mr. Uzan said that economies could benefit significantly from such coordination, as it would minimize the impact of one country s policies on other economies. The world s economies should coordinate their efforts to prevent global crises of such magnitude. Mr. Ortiz considers that inflation expectations in most countries which use inflation targeting serve as an anchor that provides space in which to manage various kinds of economic instability. In other words, the advantage of inflation targeting is that central banks can use currency exchange rates as a buffer to absorb the effects of shocks. Mr. Frenkel said that even large economies and organizations implementing unconventional monetary policies, such as very low or zero interest rates or buying up assets on the markets, would be prepared to normalize their economies and would welcome a return to more conventional policies. What is now called unconventional monetary policy is and should be only a short-term solution. It should never become normalized in the long term. According to Mr. Frenkel, as a rule, economies with higher economic growth rates belong to countries which have been able to ensure price stability and an annual inflation rate of 2 3%. Mr. Frenkel believes that monetary policy is just one tool in the toolbox. It may be the best and most important tool for ensuring price stability, but it should be backed up with others. The effectiveness of monetary policy depends first and foremost on the flexibility of the economy. When an economy lacks

6 sufficient flexibility, it is not possible to implement such changes. Ms. Nabiullina suggested that central banks brought on the situation themselves by building expectations within society that they could resolve a large number of challenges, while in fact, some of these challenges cannot be resolved through monetary policy alone. Central banks exceeded their conventional remit by taking on responsibility for issues beyond the scope of price stability (the opportunity to buy time to implement structural reforms or boost employment, etc.). Mr. King believes that there is a certain national agen da behind every currency war, but as is usually sta ted by central bank officials, this approach does not always have the desired effect. It is good when one country seeks to devalue its national currency, but other countries do not. When multiple countries pursue the same policy, however, this may lead to these risks spilling over to other parts of the world, resulting in much quicker destabilization. According to Mr. Frenkel, history has shown us that exchange rates do not lead to economic shocks. In fact, exchange rates absorb shocks. If the market is not properly prepared, any fluctuation in the exchange rate will lead to a rise in inflation. On the other hand, if the market is properly prepared, the consequences will be much less pronounced, and exchange rate fluctuation is much less likely to result in rising infla tion, especially if there is confidence in the infla tion targeting policy.

7 Plenary Session 2 Monetary policies in a time of global uncertainty: lessons and opportunities Moderator: Ksenia Yudaeva, First Deputy Governor, Bank of Russia Speakers Boris Vujčić, Governor, Croatian National Bank; Már Gudmundsson Governor, Central Bank of Iceland; Mario Marcel, Board Member, Central Bank of Chile; Oleg Smolyakov, DeputyGovernor, National Bank of Kazakhstan; Tao Zhang, Deputy Governor, People s Bank of China; Karnit Flug, Governor, Bank of Israel; Fritz Zurbrügg, Vice Chairman of the Governing Board, Swiss National Bank

8 The session Monetary policy in a time of global uncertainty: lessons and opportunities brought together banking practitioners for a discussion of the challenges facing central banks in both developed and emerging markets. Kazakhstan was obliged to adopt an inflation targeting policy to tackle the overvalued exchange rate and help the economy adjust to falling com modity prices. It has now gone through the first stage of this adjustment. At the same time, the country transitioned to a structural liquidity surplus (10% of banking assets). The market is gradually adapting to the use of interest rates rather than exchange rates as the key means of influencing the economy. The transition to a floating exchange rate also enabled de dollarization, which was made possible, among other things, by the high interest rate. The example of Chile shows that inflation targeting is best used as a means to overcome external shocks when complemented by additional structural and budget stabilization measures (the Copper Stabilization Fund was established during the 2000s), buffers (zero external debt), sufficient reserves, policy flexibility (the option to allow a higher target on a temporary basis), and measures to develop the financial market, particularly the encouragement of institutional investors and the creation of a domestic bond market. In this case, even serious devaluation (40% since the beginning of 2014) poses no threat. The example of Israel shows that a stable and rapid decrease in inflation rates can be achieved more quickly by coordinating monetary policy with budgetary policy and effecting a rapid transition to budget consolidation after achieving price stability.

9 The main benefit of inflation targeting is the public confidence manifest initially in anchored short term, and then long term low inflation expectations. China does not pursue an inflation targeting policy, but uses quantitative measures and other measures aimed at ensuring price stability. First and foremost, it prioritizes the financial market development required for a transition to consumer led growth. The example of Iceland shows that a very small economy may sometimes find it difficult to stay afloat in the modern world without capital controls, but that these must be eased as soon as they are no longer required. They may be a necessary measure to deal with debt overhangs, high capital inflow due to high interest rates, or external shock. The conclusion reached by Iceland was that inflation targeting does not have to be accompanied by a free floating exchange rate. For the purpose of financial stability, interventions can be made and these may also be complemented by macroand microprudential regulation, and if necessary, measures to control capital flows. Switzerland showed us that interventions in the exchange rate in order to prevent the rapid appreciation of the currency are sometimes necessary to maintain financial stability. A negative interest rate policy can also be used during periods of deflation. In Croatia, de dollarization proved to be a serious problem and a time consuming process. Despite low inflation and positive interest rates, the process remains very slow. De dollarization is facilitated by a strong appreciation in the nominal exchange rate. Central banks can use macroprudential regulation to keep dollarization in check. This primarily applies to credit borrowers with no export earnings.

10 The Future of Financial Markets Plenary session 3 The banking industry: through hardships to the stars? Moderator: Mikhail Alekseev Chairman of the Management Board, UniCreditBank, Russia Speakers: Anatoly Aksakov Chairman of the Committee on Economic Policy, Innovative Development, and Entrepreneurship, State Duma of the Federal Assembly of the Russian Federation; President, Association of Regional Banks of Russia ( Russia Association) Akbar Komijani Deputy Governor, Central Bank of Iran Mario Nava Director of Financial System Surveillance and Crisis Management, European Commission Aditya Narain Deputy Director, Monetary and Capital Markets Department, IMF Alexey Simanovskiy First Deputy Governor, Bank of Russia Garegin Tosunyan President, Association of Russian Banks Adam Farkas Executive Director, European Banking Authority

11 The Future of Financial Markets Below are some excerpts from participant presentations: Since the operation and regulation of the inancial sector is affected by negative interest rates, shareholding in credit organizations is generally less popular than in organizations in other sectors. This results in investors feeling less and less willing to invest in banks, and banks inding it more dificult to attract investment. At the same time additional capital is required, in particular to comply with the new regulations. This is a vicious cycle. Banking regulation has to evolve to keep up with developments in the sector, and in the products and technologies it is using. Regulation has to be in tune with these new developments in order to effectively limit individual and systemic risk. A search is also under way for the most proportional, considered, and well-balanced regulatory solutions. Europe seeks to implement regulation based on the principle of proportionality, which is designed to meet the requirements for good prudence. This means that small and large banks enjoy the same

12 The Future of Financial Markets level of security while facing different regulatory burdens in accordance with their size. Periods of negative interest rates have historically tended not to last long, because they are anomalous. Positive interest rates are the norm. We will pass through this anomaly in the credit market and return to positive rates again. The Central Bank s key interest rate (the reinancing rate) has a clear impact on the work of credit organizations and the market as a whole. However its influence must not be overrated, because the value of money is multifaceted. While it is affected by the key interest rate, this is far from being the only factor involved. For banks (in Russia), it is not only important that changes in the key rate are directed towards reducing the value of money, but also that there is an action plan for business development. Business cannot develop without affordable loans, but this is neither the only nor the most important condition for business growth. In a dificult economic climate with a resource deicit, it is quite risky to enter the universalization of banking market. In these circumstances, banks have to ind their niche and their own unique proile. Credit organizations need to reduce their costs in order to boost their eficiency. They should look into their internal reserves, the possibility of reducing their numbers of staff and ofices, but, irst of all, into different ways of improving productivity. It is worthwhile for credit organizations to outsource some services, digitize certain processes, and introduce modern technologies. Providers of alternative services are entering the market, and banks should consider ways of approaching these technological advancements. It is critical that banks bring in these new technologies before they develop autonomously and start impeding the banking industry. New technologies present both new opportunities and new risks. Whoever is the best at eficiently utilizing the opportunities and protecting themselves from the risks will, as always, come out on top. There is a certain dilemma faced by banking sector regulators: on the one hand, it is wrong to hold back the development of new technologies, but on the other hand it is important to introduce regulations quickly enough to avoid situations where consumers are already used to a certain technology, and the new regulations cause them dificulties because they are used to a different kind of service. This is why both the type of regulatory solution and the timing of its introduction are equally important.

13 The Future of Financial Markets Plenary session 4 Major trends in Russia s inancial market Moderator: Oleg Vyugin Chairman of the Board of Directors, NAUFOR, Russia Speakers: Ruben Aganbegyan Member of the Board of Directors, Chairman of the Managing Board, CEO, Otkritie Financial Corporation Anatoly Aksakov President, Association of Regional Banks of Russia ( Russia Association) Andrey Kostin President, Chairman of the Management Board, VTB Bank Alexander Murychev Executive Vice President, Russian Union of Industrialists and Entrepreneurs Elvira Nabiullina Governor, Central Bank of Russia Anton Siluanov Minister of Finance of the Russian Federation Vladimír Tomšík Vice-Governor, Czech National Bank Alfred Hannig Executive Director, Alliance for Financial Inclusion Igor Yurgens President, All-Russian Insurance Association

14 The Future of Financial Markets Below are excerpts from participant presentations: In 2016, the Central Bank of Russia produced its first document of a cross-sectoral nature: Major Trends in Russia s Financial Market, The document considers the development not of specific sectors of the Russian financial market, but of the market as a whole. Its aim is to promote the coordinated growth of all market sectors on the basis of fair competition. The imbalances that must be corrected to achieve the coordinated development of the financial market are as follows: 1) The disproportionate development of Russia s capital and debt markets. The share of bank assets to GDP exceeds 100%, while all other forms of funding, including other non-bank debt financing and equity capital financing, are much lower. 2) The prevalence of credit financing. The bond market is developing, but the potential for further growth is significant. 3) The presence in every sector of weak players and unscrupulous practices that affect the fairness of the competitive environment and are a barrier to the development of the financial market. 4) Market structure. Big players dominate both the banking and non-banking markets. 5) Inadequate protections for the rights of financial product consumers. At the moment, the rights of consumers are not being adequately protected. 6) Unequal distribution of administrative burdens. The principle of proportionate regulation must be introduced in all sectors of the financial market. Requirements for financial institutions must depend on the volume of risk those organizations take on and on the range of operations they perform. 7) Inadequate oversight of the financial market. Oversight must be carried out in accordance with principles rather than focusing on compliance with rules. Principles-based regulation must be introduced to oversight practice. 8) The rapid development of financial technologies, new financial products, and an entirely new competitive environment with new risks of cybercrime and cyber threats. The Russian financial system does not exactly abound with resources: all the instruments are there, all institutions are functioning, but resources are lacking. The banking sector gets the lion s share of resources. Currently, assets in the banking sector exceed RUB 80 trillion, while those in the insurance sector and in private pension funds total less than RUB 2 trillion each. In line with a decision on safeguards for the insurance market similar to those available in the banking sector, the Deposit Insurance Agency (DIA) will act as guarantor for both the banks and the insurance market. One of the key ways of funnelling financial resources into the non-banking sector involves creating pension savings systems within private pension funds. Moreover, all funds should be insured and inherited. Each citizen will then be able to amass his or her own pension capital.

15 The Future of Financial Markets From the perspective of taxation, it is necessary to do everything possible to create opportunities for an influx of savings not only into deposits, but also into other financial market instruments. The market is now essentially mature enough for the introduction of motivated judgments. A key element is necessary to make this work: trust. Two factors must be present in order to establish trust: 1) Experience. Trust arises, develops, and deepens with experience, when institutions have a certain number of years of successfully implementing this approach under their belts. 2) A mechanism. We must change the mechanism, the approach itself, in order for the market to begin to feel this trust. There are already elements of professional judgment among banks on a very narrow range of issues. It is imperative to select, together with the market, those areas where trust and qualifications are already in place, to discuss all of these areas, and to begin working with motivated judgments. The challenges facing the banking sector are associated with a significant reduction in the margin and profitability of the banking business, the increased cost of capital, relatively low demand for loans due to Russia s sluggish economy, the high cost of money, and expensive funding. Today the sector s profitability is rather low while risks remain high. Technological breakthroughs in banking will proceed quickly. Non-bank institutions might be able to outpace banks on technology, but banks are capable of adopting cutting-edge technologies and retaining their primacy in providing financial services. Regulatory authorities exist not only to provide oversight, but also to ensure the stability of the market as a whole. Stress tests are carried out in order to determine the preparedness of market participants for future shocks. It is imperative to clearly inform the market of regulatory expectations. A key problem for the development of the Russian financial market is the issue of trust in financial institutions on the part of both customers and regulators. The Central Bank of Russia is currently trying to solve this problem through vigilant oversight, regulatory systems, and by purging the system of unscrupulous parties. A second element has to do with trust in the regulator. The more frank the dialogue, the greater the trust between the regulatory body and those it monitors will be, and the better and easier the Central Bank s work will be. When greater trust is present, the Central Bank will also be able to self-correct, rendering regulation more effective. A third element of trust is general trust in the authorities, which requires avoiding a situation where the rules of the game are constantly shifting. Large resources are enabled by a long history of stability, a long history of financial institutions working as they should. In France, there are 200 types of mandatory insurance, while the Russian Federation only has two. It is quite difficult to develop an insurance culture with only two types of mandatory insurance. Access to financial services really is important for development. There is a relationship, a certain correlation among per capita GDP, median household income, and access to financial services. Expanding access to financial services is very important for maintaining financial stability.