Prepare for unpleasant surprises in the financial system

The tremors were so strong that they were felt in the ultra-liquid US Treasury market. Calm was not restored until the Bank said it would step in as a buyer of last resort. It was a timely reminder that risk can never truly be eradicated, only parceled out and shipped to another part of the system.

The question is where? Part of the answer is: not the banks. Since the financial crisis, lenders have rightly faced a deluge of new rules regarding capital, liquidity and the types of risk they can take. They have also been “stress tested” by central banks to see if they can withstand various painful scenarios.

Supervisors also monitor how banks trade with each other by requiring most derivative contracts to go through clearinghouses. These institutions are designed to deal with the fallout in the event of the failure of one or two of the largest counterparties in the market.

This is all well and good and makes banks much safer. The possibility that a government will have to step in and bail out a bank at enormous cost to the taxpayer is greatly reduced.

But it’s not free. If banks have to hold more capital to do certain types of business, they will of course charge their customers higher fees. This is why there is a constant tension between security and, the major concern of the moment, the promotion of growth.

Moreover, it creates opportunities for non-banking financial institutions to undermine lenders and steal their business and customers. Welcome to the world of shadow banking.

By definition, since this activity is not performed by systemically important banks, it is not as tightly regulated or closely monitored. The concern, as expressed by Gordon Brown, is that pockets of potentially risky activity may have accumulated that no one really knows about or properly understands.

LDI strategies, for example, have shielded pension plans from interest rate fluctuations to the point where they have not.

We know this activity exists. Immediately after the financial crisis, non-bank financial institutions held similar asset values ​​to banks. Now their collective balance sheets are about 25% bigger. Much business and consumer credit, for example, has been pooled and held by private equity firms and hedge funds.

Do these alternative investors have the appropriate risk management skills and controls to deal with losses if businesses and consumers start to default en masse amid rising borrowing costs and a stronger dollar ? Here is the hope.

And, if not, can we be sure that no individual company is so large or so closely linked to others that it sets off a chain reaction? Crossed fingers.


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Don F. Davis