Why banks should be preparing for stormy weather

Now is the time for banks to be modelling how their assets perform under stressed scenarios. The next period of disruption could be just around the corner, writes Brian Caplen.

Bankers may have improved their risk assessment skills since the financial crisis but markets – aided and abetted by quantitative easing (QE) – have not followed suit. Currently risk is as mispriced as it was in the run up to 2008 and yet there are huge risks out there such as populist politics in Italy, a currency crisis in Argentina, growing indebtedness in China and wayward fiscal policy in the US.

At the same time, the major central banks are attempting to ‘normalise’ monetary policy by raising rates in the US and with the European Central Bank preparing to wind down its QE programme (money creation through the purchase by central banks of assets such as sovereign and corporate bonds).

 

Central banks currently hold about $11trn in assets on their balance sheet, equivalent to about 15% of global GDP. It is the largest monetary experiment in history and unwinding QE will cause bouts of volatility at best, at worse some kind of financial dislocation is possible.

Holding more capital and with less leverage than during the last financial crisis, banks are better prepared to face this. But they need to understand that a generation of investors and borrowers have been sailing along on the low-interest-rate, low-volatility environment created by QE and will be rudely shocked when it ends.

Who are they? At an economists’ roundtable organised by the Centre for the Study of Financial Innovation in London in May, a number of candidates emerged. Concern was expressed about asset managers as, desperate to find yield, they have been tempted to take exposure to higher risk assets.

 

More than 40% of the increase in global debt since 2007 has taken place in China. Both households and corporates are exposed and while the government has the largesse to deal with any problems that arise, a bumpy ride in China cannot be ruled out.

In the UK, house prices are well above their long run average in relation to salaries with purchasers taking out large mortgages that are only serviceable at low interest rates. Some economists believe this factor alone will constrain the Bank of England from raising rates too quickly.

But central banks may find themselves caught between not wanting to hurt borrowers but, at the same time, needing to fulfil their mandate of keeping inflation within a targeted range which would require rate rises. One economist worries about the “astonishing complacency” being shown by central banks in regard to inflation, something they haven’t had to worry about in most advanced countries for decades.

Bankers should not fall into the same trap of assuming the inflationary threat has disappeared and they should be cognisant of how the combination of mis-priced risk and rate rises could be highly disruptive in the markets.

 

Via: The Banker

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