A stress test looms for the financial system in 2021

Be warned. The global financial system will face a gigantic stress test in 2021.

This stems from one of the most important lessons that emerged from the coronavirus-induced market turmoil in March of last year – a lesson worth revisiting.

The so-called race for money was in part a reflection of how the balance sheets of the big banks had failed, since the 2008 financial crash, to keep pace with the growth in the stock of US Treasury securities that has been stimulated by the post-crisis. soaring federal deficits.

Their ability to act as intermediaries on the Treasury market is thus impaired. And their willingness to provide liquidity to the market by absorbing investor flows into their balance sheets, instead of just matching buyers and sellers, has been further curtailed by the stricter capital and liquidity rules introduced after the financial crisis. .

The stricter regulatory framework was, in a sense, good for financial stability. Banks have emerged relatively insulated from last year’s crisis. But their role as providers of liquidity has increasingly been fulfilled by less regulated non-banks, or shadow banks, such as hedge funds. These borrow heavily, often to maximize returns on transactions that arbitrate tiny differences between the prices of closely related assets.

With the onset of increased volatility and market tensions last March, these non-bank institutions faced margin calls and funding difficulties. They have gone from market stabilizers to market voltage amplifiers.

Jon Cunliffe, Bank of England Deputy Governor for Financial Stability, have noticed that there is nothing new about these so-called leveraged relative value transactions taking place. It happened to Long-Term Capital Management, the hedge fund that had to be bailed out in 1998. What was different this time around, he points out, was that the stress was systemic.

As a result, the world’s most liquid market so far, US Treasuries, saw yields rise sharply as the bid-ask price spread across 30-year US Treasuries. multiplied by ten. The world’s safest safe haven lost its safe haven status until the U.S. Federal Reserve came to the rescue, reducing the benchmark’s target range to near zero and committing to buy more. $ 500 billion in treasury securities.

What matters about this rescue for 2021 and beyond, according to Darrell Duffie of the Graduate School of Business at Stanford University, is that there is counterproductive moral hazard in relying on future rescues of the Fed’s Treasury market as an alternative to reforming the market structure so that it can better handle future episodic surges in demand for liquidity.

In a paper last year, he observed that such surges could be expected to occur with greater frequency and magnitude, given both the historically high and growing ratio of federal debt to product gross domestic product and the swelling of the stock of treasury securities in circulation relative to the capacity of brokers’ balance sheets.

In other words, a financial system with an inherently dangerous incentive to take excessive risk is now subject to a sliding stress test on an unprecedented scale.

The financial fragility revealed in March 2020 highlights a fundamental change in the structure of the financial system. For much of the postwar period, it was about funneling savings to borrowers, facilitating payments, and helping individuals and businesses share risk.

Yet since the trend towards deregulation that began in the 1970s, an increasing share of financial intermediation – borrowing and lending – has taken the form of guaranteed repurchase agreements or pensions where cash is exchanged for assets of high quality such as US government debt. At the same time, much of the risk-sharing function is performed in multi-billion dollar derivatives markets.

Michael Howell, Managing Director of CrossBorder Capital, points out that in this more market-oriented framework, the provision of liquidity relies heavily on wholesale markets. The actors here – often shadow banks – are leveraged and part of complex webs of secured loan relationships. Shadow banks, he adds, mainly repackage and recycle existing savings. Their funding model is based on short-term repos and they are much more exposed to interest rate fluctuations than banks.

It’s a more opaque and rapidly changing financial world that poses enormous challenges for regulators. As for the financial system itself, the big future challenge will be how to refinance an ever-growing mountain of debt when so many banks and non-banks have bad or limited balance sheets. The bottom line must be that central banks’ market stabilization activities will be with us longer than many now think.

john.plender@ft.com


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Don F. Davis