Cautious optimism: The Davos outlook for financial and monetary systems

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Matthew Blake, Head of Centre for Financial and Monetary Systems; Executive Committee Member, World Economic Forum

• Discussions at Davos 2024, this year’s Annual Meeting in Davos, Switzerland, saw relief that central banks had achieved a delicate balance between maintaining economic growth and taming inflation.
• Three strategies for building greater resilience in financial and monetary systems took centre stage at the Meeting: inclusivity, sustainable finance and catalyzing economic growth.
• Technological change is accelerating so quickly that regulators and the private sector must find new ways to partner to ensure that communities are protected without stifling innovation.

The mood at Davos 2024, this year’s Annual Meeting in Davos, Switzerland, fell between exuberance and doomsday.

Emerging from 2023, leaders reflected on last year’s high-profile bank failures, high inflation and geopolitical uncertainties. But many leaders in finance and policy expressed tentative relief that central banks have, by and large, navigated a delicate balance between maintaining economic growth and taming inflation.

The consensus among industry leaders was that the playbook for flexible inflation targeting and safeguarding the banking system worked. But 2024 is no time for complacency, leaders warned.

“I’m holding my breath as much about 2024 as I was about 2023,” said Ronald O’Hanley, chairman and chief executive officer of State Street. Ongoing geopolitical tensions, the uncertainties associated with the 2024 elections around the world, climate risks and technological disruption were just several reasons financial institutions must resist complacency.

Three strategies for building greater resilience in financial and monetary systems took centre stage at this year’s annual meeting.

Inclusive finance

Fighting inflation is one of the most basic ways that financial leaders can help promote inclusivity.

“Poor people are the ones who pay [during] inflation,” said Laura Alfaro of Harvard Business School. By prioritizing lower inflation, central bankers can help prevent lower-income people from bearing the brunt of macroeconomic challenges.

Emerging technologies – from fintech to credit algorithms – can also help individuals participate in the gains of economic growth. Digital payments, for example, can transform a small business in the developing world into a provider of global goods and services.

Fintech services for underserved and unbanked communities have also emerged, including in China, where hundreds of millions of Chinese citizens have accessed mobile financial services from start-ups. While risks in terms of fraud, data protection and systemic biases can’t be ignored, pioneers were optimistic that partnering with regulators would allow improvements and expansion of the tools to outweigh risks.

Employers and financial institutions can lead in expanding access to financial markets through education and rethinking retirement offerings. By 2050, the global population over 60 will double, requiring preparation for the longevity economy, as ageing populations could outlive their retirement savings by up to 20 years.

Employers can help by educating workers, simplifying retirement options and offering access to stock ownership in employee compensation packages to promote financial inclusion. One pension fund leader observed that simply changing the plan’s default offerings – enrolling savers automatically into target-date funds rather than cash accounts – increased members’ returns and diversified their portfolios.

Financing the green transformation

“Effectively, the world is being rewired. Trade routes are being rewired… Energy systems are being rewired,” said Mark Carney, UN special envoy for climate action and finance. This “rewiring” – to meet net zero targets, respond to geopolitics and incorporate new technologies – requires investments and financial institutions to have a tremendous role in helping stakeholders worldwide address the challenges and opportunities with the net zero transformation.

Moreover, climate risks pose direct threats to financial institutions. Banks hold trillions of dollars in fossil fuel assets on their balance sheets, and investors and customers increasingly demand greater access to sustainable finance.

One challenge facing sustainable finance investors has been access to reliable data. While counting carbon molecules might sound straightforward, attributing emissions and tracking environmental impacts reliably is a tremendously complex and fraught enterprise.

Many industry leaders agree that carbon emissions should come with a tax; however, voluntary carbon markets have faced challenges. New measures to enhance data integrity could help restore investors’ confidence and revitalize trade in offsets, which has struggled to scale.

The financing gap to decarbonize emerging markets is particularly large: nearly $6 trillion will be needed by 2030 to reach net zero targets. Meeting this demand will require financial institutions, the public sector and philanthropies to find new ways to collaborate. While demand for sustainable investments has grown, the structure of sustainable infrastructure investing could be better suited to private investors’ short-term needs or fiduciary requirements.

“It’s quite complicated to exit a sustainable finance project,” noted Bill Winters, group chief executive of Standard Chartered Bank. The gap between developing-world demand and investors’ needs has complicated the growth of sustainable financial products.

Multilateral development banks can bridge the divide. For example, the European Bank for Reconstruction and Development recently partnered with Egypt to develop renewable energy sources, pairing donor financing with private sector investment.

Multilateral development banks can promote investment in industries and regions where private-sector investment alone is not enough by structuring investments to offset first losses and minimize political risks and exchange-related risks to borrowers by lending in local currencies.

Financial leaders cited progress towards sustainability in the methane reduction pledge at the 2023 United Nations Climate Change Conference (COP28). Moreover, worldwide, financial institutions have embraced the urgency of climate risks and the imperative to create resilience. Turning these promising developments into concrete action will take sustained partnerships and ongoing commitments by the public and private sectors.

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Effectively, the world is being rewired. Trade routes are being rewired… Energy systems are being rewired.”— Mark Carney, Special Envoy for Climate Action and Finance, United Nations

Catalyzing growth

Traditionally, the core purpose of financial markets has been to promote value creation and economic growth. In the past, high leverage ratios allowed banks to generate high returns for investors; however, such returns have become increasingly elusive, given regulatory requirements on banks to reduce leverage.

Most experts agreed that the new requirements have improved the banking system’s resilience since the 2008 financial crisis. However, the requirements will likely yield lower returns for the banking industry in the coming years.

By contrast, the non-banking sector has evolved tremendously in recent years, such that private equity and venture firms play an increasingly important role in capital markets, especially in the United States. Non-banking institutions have been vital in providing credit and accelerating growth in areas overlooked by traditional banks.

For example, regional banks often cite the difficulty of accessing reliable credit information to justify lending to small businesses. Fintech, by contrast, and AI-savvy financial institution tools fill unmet credit demands because new technologies lower the barriers to analyzing diverse sources of credit information.

Financial institutions have been early adopters of new technologies such as generative AI. “In our estimation, it’s going to be one of the most transformative technologies that we’ve seen in a couple of generations,” said Robin Vince, president and chief executive officer of BNY Mellon.

While long-term forecasts are promising, the short-term outlook for AI’s impact on finance is muddier. The tendency of large language models to “hallucinate” poses acute challenges for banks, whose operation depends on precision, accuracy and reliability. Financial institutions are increasingly developing tools that help audit results and train models on trusted data sets.

Moreover, new technology tools exacerbate the threat of cyber-attacks. One bank reported hiring more software engineers than Amazon or Google to ensure it had the in-house expertise to protect its financial operations and maintain its technological edge.

The future of partnerships

Technological change is accelerating so quickly that, now more than ever, regulators and the private sector must find new ways to partner to ensure that communities are protected without stifling innovation. Industry leaders cited a need for designating in-house policy liaisons to work with governments to educate regulators about industry perspectives and better understand regulators’ goals.

Such partnerships could help regulation move beyond imposing rigid standards, which become obsolete and constraining and instead focus on achieving social outcomes. One model gaining traction involves regulatory sandboxes for policymakers, technology leaders and financial players to develop AI tools or introduce new fintech products.

Another model involves creating a task force – around cryptocurrency, blockchain or other emerging technologies – where regulators and industry can ensure mutual understanding of social objectives and pain points. Fintech and banking sector leaders wanted clearer guardrails around using emerging technology and common standards to allow cross-border use of new tools.

The financial outlook for 2024 remains hazy, as more than 60% of the world’s population will go to the polls. In the short term, technological transformation remains as much a threat as an opportunity to many in the financial sector. However, a steady focus on resilience has many leaders looking to the year ahead with cautious optimism.