HomeOpinionThe financial crisis is not finished

The financial crisis is not finished

There’s an old investing adage that says bull markets continue longer than you anticipate and bear markets strike harder than you believe. This is one of the reasons why investors should be optimistic most of the time. Nonetheless, it pays to be careful every eight to ten years. The recent wave of bank collapses shows that such a time has arrived.

Authorities are trying to show that these bank failures are isolated events that are not likely to lead to a larger systemic disaster.We’re not persuaded. First, we disagree on the nature of systemic risk. Second, a decade of low interest rates and cheap money has skewed capital allocations, increasing the likelihood of a systemic disaster.

Financial disasters have shown that systemic risk is cumulative. A minor entity’s failure may have serious ramifications for the whole system. Faultlines tend to appear at the weakest connections in systems, not the biggest. Despite this, authorities continue to focus on bigger institutions as being systemically significant, only to be caught off guard by smaller actors that are less well capitalised and less rigorously regulated.

The recent wave of bank failures in the United States is also a manifestation of what we term quantitative destruction: the systematic unravelling of the institutional structures that arose and flourished over a decade of near-zero interest rates and cheap liquidity. The greatest, quickest, and most widespread tightening of policy rates in 40 years, along with the contraction of central bank balance sheets, is putting pressure on the financial system. Many company operations, finances, and default models have not been thoroughly road-tested for such a quick transition. We witnessed this last year when bitcoin and UK pension fund plans were under scrutiny.

And, while 2022 was about capital repricing, 2023 is likely to be about capital reduction, as “quantitative destruction” puts alternative assets and non-bank financial institutions to the test following their recent fast expansion.

Willis Towers Watson’s Thinking Ahead Institute says that a decade of negative interest rates made people want to find other ways to make money. As a result, pension fund portfolio allocations to commercial real estate and alternatives will rise from 15% in 2007 to 23% in 2022.In 2023, real estate might be a major flashpoint. Higher interest rates have already had a significant impact on residential property values, and now commercial property prices are also decreasing. Asset owners and lenders will eventually need to reprice their property assets. With smaller banks funding almost 60% of the $2.9 trillion in commercial real estate loans in the United States, anxiety is expected to escalate.

Private debt and equity had higher returns and less reported volatility, since their prices aren’t always adjusted to the market.Private enterprises could readily access finance and equity markets when liquidity was available. This gets more difficult when interest rates increase and liquidity vanishes.

When asked, owners of assets may have to keep their promises to invest in funds.To do this, they may need to sell publicly traded assets, focusing on what they can sell rather than what they want to sell (as happened in the UK pension fund crisis over so-called liability-driven investment strategies). A recent New York Federal Reserve Bank study emphasised how asset sales by non-bank financial entities, which now represent $60 trillion in global assets, might reinsert systemic risk into the banking system.

Increasing financial risks are also a sign of overall debt deleveraging. The growth of central bank balance sheets resulted in a substantial increase in borrowing between 2008 and 2021. Over that time period, world non-financial debt increased from 182% to 257.5% of GDPof

Once central banks started to tighten their policies, non-financial debt went back down to 238 percent of GDP. This was the first time since the early 1950s that US non-financial debt kept going down as a percentage of GDP.Although central bankers may perceive balance-sheet reduction as primarily a technological process, the financial industry sees it as traditional debt deleveraging.

Financial failures are often labelled as idiosyncratic at the onset of any systemic crisis. When the rate and scope of financial disaster increase, that story becomes more difficult to sustain. A decade of low interest rates and cheap liquidity laid the groundwork for a systemic collapse, with fast asset development and financial innovation driving new entrants into poorly regulated sectors. We think that “quantitative destruction,” fueled by a toxic combination of rising rates, debt deleveraging, and inflated market values, has the potential to amplify idiosyncratic financial risks to systemic levels.

Aryan Jakhar
Aryan Jakhar
Aryan Jakhar is an Indian Journalist with over two years of active working experience. Aryan is currently working as editor-in-chief at BusinessHeadline.in and he is reachable on contact@businessheadline.in
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