Recipe for doom: The next big threat to the financial system

By binding banks in a suffocating straightjacket for the last 14 years, the regulators have pushed lending off books and helped create what may or may not prove to be a systemic monster.

The Financial Stability Board (FSB) says the shadow nexus – or non-bank financial intermediaries – has mushroomed to $US239 trillion ($355.4 trillion) and displaced traditional lenders ($US183 trillion) as the main source of global finance. Much of this is benign and helps to keep the global economy growing.

Risks without guardrails

The “core” shadow component that keeps regulators awake at night amounts to $US67 trillion. These are investment vehicles and funds that pose “bank-like financial stability risks”, but without guardrails. The FSB says they are susceptible to “margin call dynamics” and act as “amplifiers of liquidity stress.”

We had a taste of this when [one-month UK Prime Minister] Liz Truss blew up the British pension system.

A spike in gilt yields exposed the hidden interest rate risk of “liability driven investments”, setting off a £1 trillion ($1.85 trillion) margin call.

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The Bank of England had large enough shoulders to stabilise the market with emergency purchases of gilts.

What happens if the next blow-up happens in a country such as Ireland, host to the world’s fifth-biggest shadow banking industry, with exposure tripling in a decade and now surpassing 900 per cent of Irish GDP under the FSB’s core measure? Some argue that the ratio is even higher.

The Irish state may not be big enough to stand behind this edifice in a crisis. Nor can it safely wash its hands of the problem on the grounds that shadow banks operate outside the normal Irish payments system.

That became clear last September. Gabriel Makhlouf, the governor of the Irish central bank, said contagion from the Truss episode spread to Irish-domiciled funds with £267 billion in holdings of UK gilts. It threatened to spread into a broader financial crisis. Any spark, from any source, can set off a brush fire that spills across borders instantly.

Dublin is a well-regulated hub, but the pace of expansion has been torrid for a decade, and the QE-driven shadow boom has the character of a bubble.

I do not wish to overstate parallels with the Lehman crisis, but the liabilities of the Irish financial system were 800 per cent of GDP in 2008 when the music stopped. Ireland found itself in the invidious position of being deemed “systemic” for the whole of Europe.

it would be a miracle if nothing bad happens as the Federal Reserve and the ECB ram through the most aggressive monetary tightening in the working lifetime of most traders in the market.

The ECB threatened to cut off liquidity to the Irish banking system (in the secret “Trichet letter”) unless Dublin swallowed the bad debts of lenders operating from its soil. The Irish government took a bullet for the team. What seemed at first blush to have nothing to do with the Irish people ended up in their laps.

Can we say with any certainty today that the eurozone’s bailout machinery would immediately deploy all means to put out a raging fire in any country within EU jurisdiction if the source of the problem was in shadow banking? Or would perennial arguments over moral hazard intrude? Would the fractious politics of Europe’s half-formed monetary union again allow the problem to fester? We do not know.

Shadow banks could get into trouble in any number of jurisdictions, including the Cayman Islands or Luxembourg, which host even larger shadow liabilities than Ireland. Or skeletons could emerge in some of the more exotic corners of the cross-border market.

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Professor Philip Turner, who used to track shadow lenders at the Bank for International Settlements, said: “I am convinced there must be large losses on bond holdings of all sorts of funds which are being disguised.”

We can be sure of one thing only: it would be a miracle if nothing bad happens as the Federal Reserve and the ECB ram through the most aggressive monetary tightening in the working lifetime of most traders in the market. Rates have spiked; less understood is that the abrupt switch from quantitative easing (QE) to quantitative tightening (asset sales) amounts to a $US2 trillion reversal in annualised liquidity flows, and this in turn is causing the money supply to contract at record post-war rates.

Such tightening operates with a long lag. Central banks will not know how much damage they have done until months later.

Since shadow lenders are largely outside their field of view, they can only guess what level of pain will tip the financial system into a destructive vortex. By then it will be too late.

The Telegraph, London

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