With So Much Liquidity, It’s Time to Double-Check the Plumbing
As markets power higher on government support and expanding access to vaccines, enthusiasm seems to wobble only when a slight whiff of inflation hits the air. But investors should spend less time worrying about a sustained price surge in a world of excess capacity and more time checking their portfolios for land mines. This is also a time for regulators to re-assess any “macro-prudential risks” that may be building up in the system.
The next crisis could still be years away, but its seeds are surely growing silently deep in unsuspecting and apparently unrelated balance sheets. Leverage has ways of lashing together the fates of distant investors, when the bets are hidden or misunderstood. Easy loans to overextended Arizona homebuyers in 2008 ultimately took down Greece a couple of years later—by way of complex U.S. financial engineering, a flood of German savings, and some poorly capitalized French banks.
It’s impossible to know what will tip-off the next chain reaction of defaults, but it will almost certainly be a story that involves opaque lending practices, overextended balance sheets, and mispriced risk. With so much liquidity now coursing through the system, this is precisely the time to double-check the plumbing and tighten the fittings.
The recent woes of Credit Suisse seem contained so far. Mistakes were made, heads have rolled, and the stock price has plummeted. But is this the only major bank that is financing large and concentrated bets for a hedge fund? It was certainly not the only one to take losses on lending to what should have been a safe supply-chain finance business, but turned out to be something far riskier.
“It’s impossible to know what will tip-off the next chain reaction of defaults, but it will almost certainly be a story that involves opaque lending practices, overextended balance sheets, and mispriced risk.”
Fortunately, the bank and its competitors have large capital bases that were mandated after the last crisis to absorb these losses without setting off broader systemic ripples. Also, their interdependence through a web of derivative exposures in 2008 now operates with far more transparency thanks to clearinghouses that keep risks from spreading. But the recent headlines should leave investors wondering “what’s next?”
A very different set of risks may be building across a wide swath of countries from Sri Lanka to Zambia, which have tapped into the expansive lending of China’s Belt and Road Initiative (BRI). Beijing insists the financing is intended to lift troubled economies that desperately need infrastructure to grow, while critics see more nefarious motives to spread Chinese geopolitical influence.
China’s true intentions aside, the real problem for global financial stability is the lack of coordination and poor visibility. A path-breaking study just released by a consortium of scholars finds worrying patterns in a review of 100 BRI loan contracts painstakingly collected from borrowers’ official registers and parliamentary databases. The common thread is China’s insistence on secrecy and preferential terms outside cooperative restructuring mechanisms like the Paris Club. At best, this complicates additional loans to these needy countries. At worst, it sets the stage for contagion and cascading defaults.
More broadly, the stress of pandemic lockdowns has surely embedded plenty of surprises in corporate balance sheets everywhere. “Unprecedented policy support may have unintended consequences,” concludes the IMF’s most recent Global Financial Stability Report. “Excessive risk taking in markets is contributing to stretched valuations, and rising vulnerabilities may become structural legacy problems if not addressed.”
None of this suggests we are on the verge of market collapse; careful analysts will always find good opportunities in firms that have built resilient business models as the economy recovers. But even as they have upgraded forecasts, the IMF’s economists stress outcomes will be highly differentiated across countries and sectors with pockets of elevated risk, even amid the global rebound.
This is where fresh vigilance from central banks and market regulators will be especially important to ensure macro-prudential oversight that minimizes the systemic damage from inevitable bad choices. Is there plenty of loss-absorbing capital? Are the haircuts on collateral realistic? Can there be more clarity among the inter-connected and diverse collection of banks, brokerages, investors and sundry market players? The Basel Committee on Banking Supervision is hard at work on the implementation of its newest standards, Basel III (and IV!), but the job is never done.
Sometimes, financial markets look majestic in the efficiency with which they deploy capital to create jobs and prosperity. Sometimes, however, they look more like quirky Rube Goldberg contraptions that use a bucket of water to light a candle, by way of a pulley, a ramp and a line of dominoes. If you don’t see and understand all the interconnections, you will never imagine the many ways things can go wrong.