This low interest rate (LIR) era has led to an unprecedented build-up of debt in the corporate sector, among households (especially in the UK), and of sovereign debt, coupled in Europe with a sovereign-bank nexus, leading to a potential ‘doom-loop’ scenario. If the creditworthiness of sovereign debt holdings of the banks comes into question and their prices fall, this hits bank balance sheets and may lead them to fail, with the government having to pick up the tab and a consequent deterioration in its fiscal position, which pushes its bond prices down still further. This can become a vicious circle, ending in bank and sovereign defaults.
LIR leads to a search for yield, whereby asset managers look for higher-yielding assets. But higher yield comes with greater risk, so the search for yield leads to more risk-taking. This could see rising defaults on loans and the return of complex securities like those that were so dangerous in 2008.
Other vulnerabilities stem from some equity markets and EU commercial real-estate markets reaching historic highs; the largely unregulated shadow-banking sector; liquidity risk and risks associated with leverage among some types of investment funds; and (there it is again) greater interconnectedness, creating risk of contagion across sectors and within the non-bank financial system, both domestic and through cross-border linkages.
A sudden, major collapse of asset values that generates a credit cycle could lead to a ‘Minsky moment’, whereby a period of stability encourages risk-taking, leading in turn to a period of instability when risks are realised as losses, leading in turn to risk-averse trading or deleveraging, restoring stability… and setting up the next cycle.
In the boom part of the cycle, long periods of prosperity and profitable investment lower the perception of market risk, leading to more use of borrowed money instead of cash (leverage). A rise in asset prices then leads to collateral values rising… which leads to more borrowing… which pushes asset prices up further.
Then, debt-leveraged financing of speculative investments may lead to a cash-flow crisis. This could begin with just a short period of modestly declining asset prices. Following this, the cash generated by assets is no longer sufficient to pay off the debt used to acquire the assets and loan collateral declines in value, leading to losses on speculative assets and lenders calling in loans. Asset values collapse and leveraged investors are forced to sell even their less speculative positions to cover their loans.