The International Monetary Fund’s latest Global Financial Stability Report October 2017 has raised concerns about the profitability of nine “Global Systemically Important Banks” (i.e. the ones that are too big to fail). Among the nine are two UK banks – Barclays and Standard Chartered – which the IMF lists as “weak” and potentially unprofitable in the near future. Two other UK banks – HSBC and Royal Bank of Scotland are considered to be “challenged,” and only just avoided falling into the “weak” category. However, the biggest concern is with the health of Deutsche Bank, which the IMF lists as the weakest of all of the major banks, because of its position at the centre of the global banking system – if Deutsche Bank crashes, the whole house of cards will likely follow.
According to the IMF, some of the risk to profitability is due to “legacy issues” from the 2008 crash, such as the UK banks’ PPI insurance fraud. However, the report hints that the regulatory measures introduced since 2008 may not be sufficient to prevent another global financial meltdown in the event of one or more of these too big to fail banks crashing:
“Regulation and supervision of global systemically important banks have been considerably tightened in recent years… [But] There has been less progress in making a resolution framework for international banks operational. Challenges include the need for further strengthening national resolution regimes, the development of crossborder resolution plans with adequate loss-absorbing capacity to make them effective, and close coordination between home and host-country regulators and resolution authorities, providing sufficient comfort for host countries that a centralized resolution strategy would protect their interests. Only with such a framework in place will it be possible to avoid the potential negative consequences that can flow from the imposition of capital and liquidity requirements for GSIBs on a market-by-market basis.”
As with 2008, however, the important question will be just how valuable the “assets” that the banks hold on their books actually are. There is good reason to believe that their value is greatly inflated, as they include several “bubble” asset classes including, especially, government bonds.
In order to artificially lower interest rates, central banks have driven up the price of government bonds (the price is always inverse to the interest rate). They have done this through quantitative easing (creating new currency and using it to buy their own bonds and create a shortage). Low interest rates allowed so-called “zombie” companies, households, banks and even countries (like Greece) to limp on by servicing (paying the interest) their debts even though they have absolutely no prospect of ever paying back the loan itself.
The fear is that in the event of bonds no longer holding their high value; interest rates will rise dramatically, plunging households, companies, banks and countries into bankruptcy. Were this to happen, there is a high risk that we will experience an even bigger cascading collapse to the one seen in the wake of the Lehman Brothers collapse nine years ago; as banks that were too big to fail then prove to be too big to save today.
Is this an unfounded fear? Not according to bond trader Bob Michele, interviewed in the Financial Times:
“The next 18 months are going to be incredibly challenging. ‘I am not an equity investor, but I can just imagine how equity investors felt in 1999, during the dotcom bubble,’ he says, referring to the bubble that emerged in technology stocks in the late 1990s and burst spectacularly at the turn of the century. The Nasdaq Composite, the index, lost 78 per cent of its value in the 18 months after the tech bubble collapsed.”
The reason for similar concern with the bond market is that central banks are about to attempt “quantitative tightening.” As the Michele explains:
“Right now, central banks are printing money at a rate of around $1.5tn per year. That is a lot of money going into bonds. By this time next year, we think this will turn negative.
“That will be a huge difference. What happens between now and then is the big question for investors to resolve. As long as money is being printed and prices are going up, you want to be involved. But you also want to be able to get out quickly.”
Since quantitative easing had never been tried prior to 2008, nobody knows how quantitative tightening will turn out; although “badly” is a word that comes to mind. A recent Bank of England simulation raised the risk of a “corporate bond market dislocation, threatening the stability of financial markets” in the event of a run on bonds as traders sought safer places to invest. This, in turn, would render so-called “assets” – including those held on bank balance sheets – illiquid (i.e. nobody would want to buy them).
The other big unknown risk factor today is the growth of algorithmic trading. As another Bank of England paper explains:
“Algorithmic trading, in which computers interact directly with electronic trading venues, and typically without human intervention, has grown rapidly over the past decade. This growth has occurred alongside various other developments. For example, a greater proliferation of trading venues lends itself to automated decision-making to choose between them. And when many investment banks are shrinking, staff cost savings have been another driving factor.”
This may be good for the short-term interests of banks, but it introduces an entirely new and not well understood risk into an already risky global banking and finance system. Trading algorithms are self-learning and, in certain situations, can act in irrational and unpredictable ways. There have been several “flash crashes” in which algorithms create runs on shares, bonds and currencies. So far, these have been dealt with by, in effect, hitting Ctrl-Alt-Del and restarting the system. But this has only worked in normal trading situations. And as the Bank of England warns:
“Information collected to date suggests that risk management and controls around algorithmic trading are still not fully and consistently embedded within financial institutions’ governance processes.”
One of the things that trading algorithms have “learned” since 2008 is that whatever else happens, some combination of the Federal Reserve Bank, the European Central Bank, the Bank of England and the Bank of Japan will always be on hand as the “buyer of last resort” – happily doling out $tns per year to prop up the markets. The result is that those same algorithms have pumped up bubbles across a range of asset class in bonds, shares, property, fine art and collectables. For now it would seem that the only way is up.
But what happens when all of those quantitative easing dollars, euros, pounds and yen are taken away? Indeed, what happens to bond prices and interest rates when the central banks begin to sell all of those bonds back into the market? One very likely result is that the algorithms all head for the exits at the same time. Interest rates shoot up to levels not seen since the 1980s. Households, companies, banks and non-sovereign governments go broke overnight. And this time around, simply restarting the system won’t work, because by the time it restarts, everyone will be attempting to sell – and the algorithms will take their cue from this. Nothing short of a complete reset of the global currency system would work – and that is not something anyone knows how to do in an emergency.
It may not happen, of course. But the handful of economists who have been critical of central bank policy since 2008 have all warned that when it comes time to unwind quantitative easing and to begin raising interest rates, there is a risk of t