Be warned. The global financial system in 2021 will face a gigantic stress test.
This follows from one of the more important lessons that emerged from the coronavirus-induced market turmoil in March last year — a lesson that is worth revisiting.
The so-called dash for cash was in part a reflection of how the big banks’ balance sheets had failed, since the 2008 financial crash, to keep pace with the growth in the stock of US Treasury securities that was spurred by the post-crisis surge in federal deficits.
Their ability to act as intermediaries in the Treasury market was thus impaired. And their readiness to provide liquidity to the market by absorbing investor flows on to their balance sheets, as opposed to simply matching buyers and sellers, was further reduced by the tougher capital and liquidity rules introduced after the financial crisis.
The stricter regulatory framework was, in one sense, good for financial stability. The banks emerged relatively safe from last year’s crisis. But their role as providers of liquidity has increasingly been filled by less-regulated non-banks, or shadow banks, such as hedge funds. These borrow heavily, often to maximise the return from trades that arbitrage tiny differences between the prices of closely related assets.
With the onset of heightened volatility and market stress last March, these non-banks faced margin calls and funding difficulties. They went from being market stabilisers to amplifiers of market stress.
Jon Cunliffe, Bank of England deputy governor for financial stability, has remarked that there is nothing new in seeing these so-called leveraged relative value trades unwind. It happened at Long-Term Capital Management, the hedge fund that had to be bailed out in 1998. What was different this time, he points out, was that the stress was systemic.
As a consequence, the world’s hitherto most liquid market — US Treasuries — saw yields rise sharply while the bid-ask spread on 30-year US Treasury paper increased tenfold. The safest global haven lost its haven status until the US Federal Reserve came to the rescue, cutting the target range for the benchmark to near zero and committing to buy $500bn-plus of Treasury securities.
What matters about this rescue for 2021 and beyond, argues Darrell Duffie of Stanford University’s Graduate School of Business, is that there is counterproductive moral hazard in relying on future Fed rescues of the Treasury market as an alternative to reforming the structure of the market so it can better handle large episodic future surges in demand for liquidity.
In a paper last year, he observed that such surges could be expected to arrive with greater frequency and magnitude, given both the historically high and growing ratio of federal debt to gross domestic product and the ballooning stock of outstanding Treasury securities relative to the capacity of dealer balance sheets.
In other words, a financial system with a morally hazardous inbuilt incentive for excessive risk taking is now subject to a rolling stress test on an unprecedented scale.
The financial fragility revealed in March 2020 highlights a fundamental change in the structure of the financial system. For much of the postwar period, it was all about channelling savings to borrowers, facilitating payments and helping people and corporations share risk.
Yet, since the deregulatory thrust that began in the 1970s, a growing share of financial intermediation — borrowing and lending — takes the form of collateralised repurchase agreements or repos where cash is exchanged for high-quality assets such as US government debt. At the same time, much of the risk-sharing function is conducted in multitrillion-dollar derivatives markets.
Michael Howell, managing director at CrossBorder Capital, points out that in this more market-based framework, the provision of liquidity depends heavily on wholesale markets. Here the players — often shadow banks — are leveraged and part of complex networks of collateralised lending relationships. Shadow banks, he adds, mainly repackage and recycle existing savings. Their funding model is based on short-term repos and they are much more exposed to interest rate fluctuations than banks.
It is a more opaque, fast-moving financial world that poses huge challenges for regulators. As for the financial system itself, the big future challenge will be how to refinance an ever-growing mountain of debt when so many banks and non-banks have flawed or constrained balance sheets. The conclusion must be that central banks’ market stabilising activities will be with us for longer than many now expect.