Fabio Natalucci on How to Think About Financial Risk Right Now

Tracy Alloway (0:10)

Hello and welcome to a special episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:16)

I'm Joe Weisenthal.

Tracy Alloway (0:18)

So this is a live recording that we are doing at the Credit Market Structure Alliance Conference. We are going to be talking about one of the thorniest, most controversial topics in financial markets, and it's not compensation, it's liquidity.

Joe Weisenthal (0:33)

Right, and so obviously, you know, it was kind of a wild year for markets overall in 2022

I guess markets have been a little bit more constructive, calm so far to start 2023 But like, I mean, I think it's still pretty clear that people are like anxious about like, what are the various risks lurking out there, particularly like coming off such a big, like repricing of interest rates and such an uncertain macro environment.

Tracy Alloway (0:59)

That's exactly right. And we have had instances where liquidity risk has reared its head recently, notably with some real estate funds based in the UK that had to suspend redemptions. That prompted a well-known question of whether or not we should actually have these illiquid assets in a liquid wrapper. So we are going to be delving into all of that with really the perfect guest. We are gonna be speaking with Fabio Natalucci. He's the Deputy Director of the Monetary and Capital Markets Department at the International Monetary Fund. He's responsible for the Global Financial Stability Report that the IMF puts out every year, previously at the Fed and the Treasury. So really the perfect guest. Fabio, thank you so much for coming on all of us.

Thanks. So maybe a very simple question. It seems like a simple question just to begin with, but it never is.

What is liquidity?

Fabio Natalucci (1:51)

So liquidity and I think we talk about market liquidity here, not liquidity on the balance sheet with banks, but essentially is the ability to liquefy in a position at a price that doesn't move the overall prices significantly. So you can do it quickly, you can do it without much market impact.

So you can essentially liquefy a position without having a major impact on the overall market.

Joe Weisenthal (2:16)

So I mentioned it in the intro. 2022 was kind of a wild year for multiple asset classes, et cetera.

By and large though, not too much broke, right? I mean, I think you'd have to, looking back, it feels like it could have been worse.

Fabio Natalucci (2:31)

Yeah, so this is the big question. If you work in financial stability now, and you say, okay, if someone told you a year ago that the Federal Reserve would raise interest rate 450 basis points, 500 basis points, do you think it would have worked smoothly or what would have broke? And I think the answer you would be looking for place in things that something didn't work, right?

Now, there were some instances, I think. So the pension, LDI, I think in the UK was a good example of a liquidity problem interacting with leverage problem. So that's a combination of two vulnerabilities that amplify each other.

Of course, the trigger of that shock was very unique. It was a fiscal policy shock that it's kind of idiosyncratic, if you want. There was some other example like Korean asset-backed securities market, but generally speaking, particularly focusing on the US., I think things have gone pretty smoothly, which if you work on the other side and you need to worry about risk, then the question is like, did I miss something or the system is really more resilient and I should feel comfortable? It's always uncomfortable to feel comfortable.

Tracy Alloway (3:42)

Well, this is something that I always like to ask regulators, which is so much of the financial stability risk seems to be in things that we don't see coming. So given that we've been talking about liquidity risk for probably eight or 10 years at this point, should we be looking at something else or do you think the problem has largely been solved?

Fabio Natalucci (4:01)

So the way, if I may for a second think about, how we think about financial stability at the fund, right? So without trying to forecast what the next shock could be. So I think I wouldn't miss all of them, right? If you think about COVID, that's not what probably was on my top list, the war. So I don't want to be in that business. I think what we can do and we try to do is to figure out what are the vulnerabilities. So think of vulnerability as an amplifier, right? So if there's any shock that hit, whatever that is. And then there are fragilities in the financial system that make the shock bigger. And so we have some sort of like matrix where we look at different sectors. So the sovereign debt, for example, household, corporations, banks, and then what we call non-bank financial institutions.