With Global Markets at Stake, Why is an Ounce of Prevention So Hard?

Finance ministers and central bankers should already be hard at work addressing the market’s systemic vulnerabilities.

Boring visits to the doctor or the auto mechanic are always the best visits, and investors should be thankful that the finance ministers and central bank governors gathering in Riyadh later this week appear unlikely to generate big headlines. But we might wish for more serious efforts at preventive care from the most important stewards of the global financial system.

Investors spend an inordinate amount of effort trying to time the next recession, when the real risks to their long-term returns actually come from the potential of the next financial crisis. This may not come soon, but the group that will surely be convened when it does is making little discernible progress on what are increasingly clear vulnerabilities in the system.

When the next crisis does hit, the headlines will likely follow one of these lines:
 

“Chinese Bank Collapse Roils Global Markets”

We are long past the days when China’s woes stayed in China. If the last two decades were the story of the country’s integration with global trade flows, its integration into global financial markets is well advanced. Chinese money funds everything from U.S. treasuries and multi-national corporate debt to Silicon Valley venture capital and Greek ports. If there are capital controls, there is also growing leakage. So far, the government has had both the money and the skill to manage any hiccoughs as the numbers rise, but the risks are growing with the flows. Recall also that the last crisis involved enormous trust and transparency among market regulators primarily in the United States and the United Kingdom. A crisis with roots in China will strike in any number of jurisdictions where trust and transparency may be in short supply.
 

“Cyber Attacks Shut Trading”

Long before the risks from cyberspace, it should have given us all pause that so much of the world’s financial infrastructure grew more from hodgepodge bank merger activity than anything that remotely resembled planning. Worse now, these computer systems are a juicy target for any bad actors looking to make a point or inflict a lot of damage at a relatively modest cost. We are a long way from developing norms that countries should follow for operating in cyberspace, but we’re even further from a strategy that will deter non-state hackers from disrupting market operations or large financial transfers. And much like the actual infection that investors are watching this month, computer viruses spread rapidly and unpredictably. Markets react violently when they have literally no idea what to expect next.
 

“Shadow Banks Trigger Financial Shock Waves”

Banks without enough capital and mortgage borrowers without enough income lay at the root of the last financial crisis, but regulators have been all over that problem. What has proven more difficult is trying to get a handle on all the financial flows that have sprung up outside the banking system since then. Pension funds, asset managers, endowments and insurance companies are just some of the largest pots of money reaching for a little more yield in a world of low and negative interest rates. Notionally, much of the lending is committed and cannot be pulled at the first sign of trouble, as banks often must. Still, market regulators are the first to admit that they don’t have a complete picture on who is lending what to whom, which makes everyone nervous about exposures and correlations that could trigger large losses and market gyrations.
 

“Banks Collapse Under the Strain of Negative Interest Rates”

Central banks have turned on the spigots since the last crisis, which helped support the global economy through a period of weak but sustained recovery. Negative interest in Europe and Japan, as controversial as they are, have even boosted credit growth, some studies say. Questions mount, however, about the long-term corrosive effect of negative rates on savers, lenders and investors. We know that they hurt bank profits, but at what point are bank deposits converted to cash to avoid negative returns? When might pension funds be unable to credibly match assets to liabilities? Will there be a day when worried savers stop spending? As those forces build gradually, might not an institution of considerable size suddenly find itself in enough trouble to spook investors?
 

“Stranded Assets Sink Major Bank as Climate Risks Mount”

This one may take a while to emerge because we are still in the early stages of grappling with the rising costs of climate change. Just how these costs will flow through financial markets remains difficult to predict, but regulators are already sounding the alarm. They are urging lenders and insurers to start assessing the risks they may bear from weather damage, crop failures, coastal flooding and more. Oceanfront real estate may lose value precipitously. Large reserves of oil, coal or gas may need to be written down as “stranded assets.” The pressures may build gradually and invisibly inside the financial system until some lender breaks and sends investors scrambling to identify the next weakest link.

The next financial crisis may still be decades away, but more likely than not it will trace its roots to one of these systemic weaknesses. Coincidentally, all of them will take just as long to address. What better time to start in earnest than now?