Can we escape boom and bust?

Richard Portes explains how risk in the financial system can escalate and how you might avoid disaster

It’s not surprising that governments, policy-makers, analysts and market participants devote considerable time and energy to trying to predict the possible causes of the next crisis, then try to forestall them. Financial crises are very costly, as became evident in the aftermath of the global financial crisis (GFC) of 2008-09. Typically, crisis-hit countries lose 5-20% of GDP, and the growth path falls, so the loss is permanent.

But trying to predict the next crisis is a dangerous game – not least because doing so can feed a sense of panic… and that fuels a crisis.

We know that certain institutional arrangements pose greater threats than others, and there is a role for regulatory policy in trying to channel financial innovation in ways that leave the global economy less vulnerable to financial collapse.

And financial crises are less likely in a stable macroeconomic environment for financial markets, especially in an increasingly interconnected global economy. Monetary, fiscal and regulatory policies have a key role here.

In the decade following the GFC, we have seen meaningful reforms to the financial regulatory environment, and particularly the role of banks. Many commentators believe the reforms have fundamentally improved the resilience of the financial system. 

“Are we in a better position to understand potential causes of the next crisis?”

So, are we in a better position to understand potential causes of the next crisis – and thereby avert it?

Both financial markets and the broader financial system are much more interconnected (and therefore interdependent), and we are in a new era of financial innovation. This leads to the question: does the political will exist to fashion regulatory policy to channel that financial innovation in ways that leave the global economy less vulnerable to financial collapse?

Looking at the macroeconomic side, the potential sources of crisis that are external to the financial system – political uncertainty in parts of Europe, South America (and possibly even China), escalating trade wars and protectionism, and cyber security – it is difficult to conceive how they may be amenable to regulatory policy, given that their origins often lie in the rise of populism and the intentional actions of government.

And macroprudential regulation at the international level (such as carried out by the European Systemic Risk Board (ESRB), established in 2010 to oversee the financial system of the EU and prevent and mitigate systemic risk) relies on non-binding recommendations. It might be policy, but that does not mean it is practice.

Risks from within the system

Now consider the potential sources of crisis from within the financial system. We have had an extraordinary financial environment since the GFC, with interest rates at or close to zero for a decade – great for those of us with variable-rate mortgages, but not great for financial stability.

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.

“Indeed, it could be a ‘triple crisis’: banks, sovereign debt and exchange rate”

But potential buyers now fear a further decline in prices, so they don’t bid – which causes a major sell-off. The fire sales then trigger a deep collapse in market-clearing asset prices and a sharp drop in market liquidity. And market participants fear that any counterparty might become insolvent at any moment, so markets freeze. The collapse in asset values may bring down banks, whose asset values collapse, too, so depositors want to get out. Then foreign investors may pull out, so the exchange rate crashes.

That’s a financial crisis. Indeed, it could be a ‘triple crisis’: banks, sovereign debt and exchange rate.

What can be done?

There will always be crises. Capitalism thrives on risk-taking – the source of innovation, investment and productivity growth. Some of those risks will go bad. If enough do, in an interconnected financial system, we may have a crisis.

So how should businesses prepare, when monetary and fiscal policymakers are constrained in their responses to crises, because interest rates are already low, and public debt is high and is an obstacle to expansionary fiscal policy? Here are some safeguards:

  • Stay liquid, avoid investing in long-term illiquid assets if a significant part of your liabilities are liquid and prone to ‘runs’ (cf. Neil Woodford’s funds, where redemptions had to be blocked) and avoid investing in vehicles that offer significant liquidity or maturity transformation, even if they offer high returns.
  • Cut debt exposure – especially debt that can be called in (e.g. if the value of the collateral you have posted might deteriorate).
  • Eliminate or reduce hedge-currency exposures – sharp exchange rate changes can be disastrous to households and firms (consider, for example, Hungarian and Polish households that took out mortgages in Swiss francs – the interest rates were low, but when the Swiss franc suddenly appreciated by a lot, they couldn’t service their debts).
  • Look carefully at your own balance sheets and those of your counterparties, so that sharp repricings (if interest rates finally do rise) won’t get you into trouble.
  • Make sure your bank deposits don’t exceed the deposit guarantee for any individual account.

These measures may lower your income or short-run capital gains – but remember, there is normally an inverse relation between return and risk.

And above all, don’t panic.

Richard Portes is Professor of Economics and Academic Director of the AQR Asset Management Institute at London Business School.



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