How long before we confront a new financial crisis? Usually a severe shock to the financial system damps risk appetite for some considerable time. Economies have to recover, bank capital has to be substantially rebuilt and debt workouts, which can take 10 years or more, have to be far advanced before trouble brews anew.
However, if the core ingredients of a financial crisis are boundless optimism, excessive leverage and overpriced assets, then we are already in dangerous territory less than three years after the collapse of Lehman Brothers.
Consider the state of asset markets. Commodities remain overblown despite the setback that recently overtook silver and subsequently spread to other markets. Developed world government debt markets look seriously overpriced in the light of the slow response to spiralling fiscal deficits in the US and elsewhere. While US house prices have collapsed, those in the UK look far too high in relation to earnings.
In equities, we have a new internet bubble with shares in the likes of Facebook, LinkedIn and Renren trading on absurd multiples of revenue. As for credit markets, lending standards are falling and covenant-lite lending has staged a comeback.
This is largely the work of developed world central banks, whose monetary policy response to the last crisis threatens to sow the seeds of a new crisis, just as Federal Reserve policy did in the US after the dotcom bubble burst. Meanwhile, the banks remain vulnerable. While modest progress has been made in deleveraging, the capital regime proposed by Basel III looks inadequate to anyone other than a boundless optimist and banker.
The developed world is still crippled with debt and the response to the European sovereign debt crisis has been a case of simply muddling through. As I said here a year ago at the time of the first rescue package for southern Europe, policymakers are offering a liquidity solution to a solvency problem. They continue to do so and a lack of realism has marked the handling of successive stages in this fiscal debacle, culminating in the absurd denial that the recent finance ministers’ meeting in Luxembourg was taking place.
Equally striking is the inadequate regulatory response to the last crisis. Any attempt to assess the state of the reform effort should start from the point that a disproportionate share of the burden is being carried by the increase in capital ratios. While an increase is desirable, it has the disadvantage of giving banks an added incentive to shovel business off balance sheet. While the UK is pursuing the tougher line of trying to ringfence retail banking operations, I fear politicians will be unable to resist the temptation to bail out the investment banking arms of universal banks that run into trouble.
In the US, Republican politicians seem determined to unwind the Dodd-Frank Act and ensure that the Securities and Exchange Commission and the Commodity Futures Trading Commission are deprived of the resources to carry out their duties under the new legislation. Furious lobbying by the investment banks is also eroding the thrust of the Volcker rule, which is supposed to put a stop to their own-account gambling.
Perhaps the biggest concern is the increased concentration of wholesale and investment banking business among a handful of systemically important financial institutions, including those that dominate the opaque derivatives business, parts of which are highly toxic. Moves to put more of this business through a central counterparty make sense. Yet as Peter Norman points out in a new book on this aspect of risk control, putting central counterparties into a front-line role in absorbing systemic risk raises the question of what would happen if the central counterparties themselves failed.
He quotes Patrick Pearson, head of the financial market infrastructure unit at the EU Commission, as saying that a clearing house failure could unleash “financial Armageddon”.* So the too big to fail problem could be raised to another level. At the same time, the attempt to establish resolution mechanisms to permit the closure of a bank’s operations on a cross-border basis is likely to remain intractable.
A paradoxical feature of all this is that while the reforms do not add up to a coherent programme, so much of the structure of banking regulation is being changed in one go that the risks in implementation remain formidable.
It is, of course, impossible to predict the timing of a financial crisis or its trigger. Yet it is disquieting that when there are so many obvious vulnerabilities in the system, there is so little left in the monetary and fiscal policy locker with which to address another financial maelstrom.
* The Risk Controllers: Central Counterparty Clearing in Globalised Financial Markets, John Wiley and Sons, Ltd.
The writer is an FT columnist
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