Interest rate cuts may be coming: What lessons can we learn from the recent turmoil?

2023 ended with some welcome news – potential rate cuts by the Federal Reserve – and a resulting enthusiasm by markets, particularly in the United States and parts of Europe. The recent good news can cloud memories of some of 2023’s more challenging episodes and their attendant lessons for investors and market participants.

As we turn a corner in the current phase of central bank policy, leaders will be meeting in Davos as part of the World Economic Forum's Annual Meeting 2024 to discuss how to accelerate economic growth and prosperity.

A necessary part of that conversation must be resilience: How can we learn from the events of 2023? And how do we build a more resilient financial system to promote more sustainable and widespread growth? Here are three areas to consider:

Economies are beginning to make the transition to more normalized conditions and prepare for stronger growth in 2025. In fact, in the latest Alta Report, BNY Mellon economists’ consensus on rate cuts is a matter of “when, not if”. Yet, as they adjust and risk appetite returns, particularly in the US, it remains the responsibility of global financial institutions not to be complacent.

Risks abound, and a smooth transition from the abnormally low-rate conditions and high inflation of recent times is not an assured outcome. Global banks, in particular, must take the necessary steps toward building the robust foundations required for success through different market conditions.

In the era of zero rates, a few market participants forgot the basic tenets of sound asset and liability management, and the turmoil we saw in the first quarter of 2023 swirling around some weak banks served as an unpleasant reminder of the consequences to the industry. The problem was not systemic but reminded us that quality and management matter. Nonetheless, the episode generated sufficient fear that the contagion could spread, and it demanded some intervention from the US government and central banks worldwide.

In the US, resolving the conflict depended on quick action by the federal government and central banks, as well as the strong capital and liquidity positions built by the eight US Global Systemically Important Banks (GSIBs). These actions were critical to preventing the turmoil from spreading and underscored the commercial value proposition of financial resilience and healthy large banking institutions to the broader economy.

While not all banks can meet the capital and liquidity requirements of GSIBs, the success of their response revealed the benefits of taking more proactive measures to uphold and protect the strength of the banking sector at large.

To promote stability in the long run, any institution, whether privately or publicly held, must calibrate its balance sheet with an appropriate risk calculus adjusted to the external environment. Taking these steps to proactively build resilience will benefit both banks and non-banks.

Despite their name, GSIBs are not the only institutions with systemic importance. As we look across markets in 2024, we still see risks in the non-bank sectors of the financial system, such as private markets, real estate and more. The private credit market has grown from approximately $875 billion to $1.4 trillion over the past three years, and a recent survey by BNY Mellon of traditional and alternative asset managers predicts more growth on the horizon: 43% expect to increase their firm’s offerings of private credit over the next one to two years.

Given the significant amount of capital investment bound up, a failure in this segment could still carry contagion risk to the rest of the financial ecosystem.

The Basel III endgame debate about banking capital requirements in the US is a good example of the importance of setting the right incentives and ensuring the right balance. When policies drive capital and liquidity levels so high within the banking system that activity critical to economic growth is chased away or relegated to less resilient parts of the system, it’s important to step back and remember what problems we are trying to solve.

Healthy economies create growth and jobs, benefitting society at large. They require vibrant financial systems, and these systems, in turn, need strong banks and liquid markets. Solving for the primary objective must remain our shared endeavour.

New technologies offer exciting possibilities for banks around the world. Whether they involve faster real-time payment methods, innovative ways to streamline wealth technology or AI, emerging technologies are a key driver of growth throughout the industry.

But these developments pose unique challenges and must work safely and for society at large. Risks and challenges posed by cybersecurity and AI are often complex, carrying risks not only for institutions and their clients, but also markets and the broader economy. As a result, robust systems and information-sharing – and the cooperation between and across public and private sectors – will be essential to ensuring financial resilience.

We are just beginning 2024, and while there are a number of risks to this year’s economic outlook, I am optimistic that the banking industry will remain strong and stands ready to support economies around the world, leveraging measures we have in place that allow us to stay resilient during times of change.

It is our responsibility to join policy-makers in helping to advance financial markets proactively, instead of reactively.

While there is no one-size-fits-all solution, we can each do our part to ensure that resilient institutions continue serving the world’s economies, creating prosperity for society at large.