To me, it’s not surprising that governments, policymakers, analysts and market participants devote considerable time and energy to predict the possible damage of the current crisis. Financial crisis are very costly, as become evident in the aftermath of the global financial crisis (GFC) of 2008-2009. Typically, crisis hit countries lose 5-20% of GDP and the growth path falls. So, the loss is permanent. Therefore, trying to handle the current crisis is a dangerous game – not least because doing so has feed a sense of panic – and that obviously fuels a crisis. You, me, we all know that certain institutional arrangements pose greater threats than others, and there is a role for regulatory policy in trying to channel financial innovation in ways that leave the global economy less vulnerable to financial collapse.
And financial crisis are likely to be less costly in a stable macroeconomic environment for financial markets, especially in an increasingly interconnected global economy. Monetary, fiscal and regulatory policies have in my opinion a key role here.
In the decade following the GFC, we have seen meaningful reforms to the financial regulatory environment, and particularly the role of banks. Many commentators believe the reforms have fundamentally improved the resilience of the financial system.
So, are we in a better position to understand potential causes of the current and next crisis – and thereby avert or reduce the damage of it?
Yes and No! The current crisis has not been triggered initially through a financial collapse like Lehman in the time of the last GFC.
But both financial markets and the broader financial system are much more interconnected – and therefore interdependent -, and we are in a new era of financial innovation. This leads me to my next question:
Does the political will exist to fashion regulatory policy to channel that financial innovation in ways that leave the global economy less vulnerable to financial collapse?
Looking at the macroeconomic side, the potential sources of crisis that are external to the financial system – political uncertainty in parts of Europe, South America, and possibly even China and Russia, escalating trade wars and protectionism, and cyber security – it is in my opinion difficult to conceive how they may be amenable to regulatory policy, given that the origins of ten lie in the rise of populism and the intentional actions of government.
And macroprudential regulation at the international level such as carried out by the European Systemic Risk Board (ESRB), established in 2010 to oversee the financial system of the EU and prevent and mitigate systemic risk relies on non-binding recommendations. It might be policy, but that does not mean it is practice.
Now consider the potential sources of crisis from within the financial system. We have had an extraordinary environment since the GFC, with interest rates at or close to zero for a decade – great for those of us with variable – rate mortgages, but not great for financial stability.
This low interest rate (LIR) era has led to an unprecedented build-up of debt in the corporate sector, among households (especially in the UK), and of most important sovereign debt, coupled in Europe with a sovereign bank nexus, leading to a potential “doom-loop” scenario.
If the credit worthiness of sovereign debt holdings of the banks comes into question and their prices fall, this hits bank balance sheets and may lead them to fail, with the government having to pick up the tab and a consequent deterioration in its fiscal position. This pushes its bond prices down still further. This can become a vicious circle, ending in bank and sovereign defaults.
Low interest rates lead to a search for yield, whereby assets managers look for higher-yielding assets. But higher yield comes obviously with greater risk, so the search for yield leads to more risk taking. This could see now rising defaults on loans on the current crisis and the return of complex securities like those that were so dangerous in 2008.
Other vulnerabilities stem from some equity and EU commercial real estate markets reaching historic highs; the largely unregulated shadow banking sector; liquidity risk and risks associated with leverage among some types of investment funds; and – there it is again – greater interconnectedness, creating risk of contagion across sectors and within the non-bank financial system, both domestic and through cross-border linkages.
A sudden collapse of asset values that generates a credit cycle could lead to a “Minsky Moment”, whereby a period of stability encourages risk – taking, leading in turn to a period of instability when risks are realized as losses, leading in turn to risk-averse trading or deleveraging (as seen last month) restoring stability – and setting up the next cycle.
In the boom part of the cycle, long periods of prosperity and profitable investment as seen in the US over the last few years lower the perception of market risk, leading to more use of borrowed money instead of cash (leverage). A rise in asset prices then leads to collateral values rising… which leads to more borrowing… which pushes asset prices up further.
Then, debt-leveraged financing of speculative investments may lead to a cash flow crisis. This could begin with just a short period of modestly declining asset prices. Following this, the cash generated by assets is no longer sufficient to pay off the debt use to acquire the assets and loan collateral declines in value, leading to losses on speculative assets and lenders calling in loans.
Next, asset values collapse and leveraged investors are forced to sell even their less speculative positions to cover their loans. But potential buyers now fear a further decline in prices – a scenario we currently face -, so they don’t bid which causes a major sell-off as seen last month.
The fire sales then trigger a deep collapse in market-clearing asset prices and a sharp drop in market liquidity. And market participants fear that any counterparty might become insolvent at any moment, so markets freeze.
The collapse in asset values may bring down banks, whose asset values collapse, too, so depositors want to get out (look at Lebanon). Then foreign investors may pullout, so the exchange rate crashes as seen in Turkey last year.
There will always be crises in the world. Capitalism thrives on risk-taking the source of innovation, investment and productivity growth. Some of those risks will go bad. If enough do, in an interconnected financial system, we have a crisis. That is today, we have reached!