Banks are much stronger and more stable than before the 2008 crisis, as I have already written. But they remain directly exposed to the market-based version of finance that has exploded over the past decade. And that exposure can be far more dangerous than expected when a very large fund or group of funds quickly runs into big trouble, as evidenced by the collapse of Hwang’s Archegos Capital Management, or the turmoil caused by pension funds in the UK government bond markets triggered by unfunded Truss funds. tax reductions.
First, let’s take a step back. Market finance – often called shadow banking – covers all the ways in which companies or households obtain financing from investors on the capital markets. These investors include insurers, pension funds, hedge funds, and a myriad of vehicles known by obscure acronyms. Financial Stability Board global supervisors call these non-bank financial intermediaries.
NBFIs or shadow banks(1) controlled $225 trillion at the end of 2020, nearly half of all global financial assets, according to an FSB report last week. This is an increase from $102 trillion in 2008. They have overtaken banks, whose global assets were $114 trillion in 2008 and have grown to $180 trillion in 2020.
This outcome was a deliberate goal of post-crisis rule changes that aimed to make the financial system safer and reduce the need for future bank bailouts by keeping depositors away from more racy financial areas. But growth has been spurred by monetary policy: major central banks have created trillions of dollars to pull government bonds off the markets and encourage investors to buy corporate debt or mortgages, for example, at the square. Quantitative easing was more of a market-based stimulus than a boost to bank lending.
People have been worried about shadow banking for years now, but most of all they worry about liquidity risks, i.e. the problems caused when many people all try to withdraw their money from funds with hard-to-sell assets. The FSB and other regulators have been working on ways to improve the liquidity management of various types of funds to make them, and the markets in general, better able to deal with any rush of money from investors. .
However, the collapse of Archegos in 2021 and the recent extreme volatility in UK government bond markets have revived another ghost from the past: hidden leverage and the damage it can cause to shadow bank counterparties. . We have already seen this disaster film in the failure of Long-Term Capital Management in 1998, for example.
Leverage is any method you can use to amplify the power of your bets. You can borrow money to increase your stake – and thus increase your potential winnings and losses. Alternatively, you can use derivatives such as swaps, which allow you to place a large bet while only pony up a fraction of its total notional value.
The problem with derivatives is that counterparties such as banks or clearinghouses have a harder time tracking the true extent of leverage their use creates. The more counterparties the same investor uses, the more the leverage effect can be hidden. And the more concentrated the bets – either because one investor makes the same bets multiple times, as Archegos did, or because many similar investors all make the same bets, as happened with UK gilts – the more dangerous it can be for the counterparties. to unwind losing trades. In either case, a collateral sell-off to close out the bet can destroy the value of the very security that is meant to protect the counterparty.
Banks are protected against losses by collateral – the cash or bonds that investors put up for their transactions. If the bets go against the investors, the bank asks for more money or bonds. When collateral is easy to find or easy for banks to sell, things work out. Even in stress tests, the losses suffered by banks in the event of default by investors on derivatives bets are relatively small. In the Federal Reserve’s 2022 test, counterparty default losses are aggregated with all other trading desk losses and the combined hit was still only 16% of total banking system losses. For a large universal bank like JPMorgan Chase & Co., the trading and counterparty loss was 17% of the total.
But these tests can be misleading: hidden, concentrated leverage can hurt a lot more. Archegos was just one fund, but it cost a group of banks about $10 billion in losses.
During the UK government bond sell-off in October, the Bank of England said it stepped in to protect market stability, as gilts are key to pricing everything else. British financial blogger Frances Coppola believed at the time that the Bank could also have acted to avoid large losses to banks as counterparties to pension fund derivatives transactions. I think she was right. Sarah Breeden, the Bank of England’s executive director for financial stability, warned of hidden leverage and how it can hurt big banks at the heart of the financial system in an incisive speech on the debacle in the government securities market last week.
Breeden’s conclusions were that banks need more information from shadow banks about the full extent of their positions and the leverage involved, and that banks should be more creative in crafting scenarios in which shadow banks could default and their collateral could also lose value.
Markets will remain much more volatile than they have been for the past decade. Hidden leverage is hard to quantify, obviously, but it has certainly increased among shadow banks over the long years of ultra-low returns. We will see more episodes where certain corners of the markets run into a stomach air pocket. The banking system is much safer than in the past, but it is not immune to market finance or its disasters.
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(1) Personally, I don’t like the term “shadow bank”: it sounds too interesting for what it represents, and its meaning has changed and expanded since economist Paul McCulley uttered the term for the first time in a 2007 speech. It covers just about anything that isn’t a bank, central bank, or public financial body. But it’s so much easier to read and write than all the official terms.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.
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