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Prior to the financial crisis of 2007-09, the Bank for International Settlements made itself unpopular with monetary authorities around the world by pointing to the risks being created by accommodative monetary policies, excessive leverage, high asset prices and a lack of transparency. These warnings were ignored. The result was a calamitous financial crisis, which not only caused a huge recession, but has also bequeathed a legacy of high public debt and populist politics.
Once again, the BIS is sounding the alarm. It has expressed concern over fiscal and financial risks for some time. But only last week, its general manager, Pablo Hernández de Cos, former governor of the Bank of Spain, delivered a sobering account of “fiscal threats in a changing global financial system”.
He starts from the fact that ratios of sovereign debt to GDP in many advanced economies are at post-second world war highs. In the absence of an artificial intelligence-fuelled acceleration in economic growth, there is good reason to believe these will continue to rise. The reasons include the possibility of further economic shocks (including yet another financial crisis), higher yields on government bonds, ageing populations, hostility to immigration, an evident unwillingness to bear the political pain of curbing fiscal deficits and many other pressures, notably towards more spending on defence.
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Rising public debt is one concern. Another is how it is being financed. This is part of a bigger change, which is the relative decline of banks and rise of non-bank financial intermediaries within global holdings of financial assets. Thus, the ratio of NBFI holdings of financial assets to global GDP rose 74 percentage points between 2008 and 2023, while that of banks rose by only 17 percentage points. But, warns Hernández de Cos, the combination of rising government bond issuance with the post-financial crisis retrenchment of banks created a steadily growing gap between the supply of government bonds and the assets of bank dealers needed to support the capacity of these crucial markets to intermediate.
NBFIs are a heterogeneous group. A vital distinction is between “real money” investors, such as pension funds and insurers, and leveraged speculators, notably hedge funds. The former group of long-term private investors has greatly increased its holdings of government bonds, from an amount worth 82 per cent of global GDP in 2008 to one of 135 per cent in 2023. Meanwhile, money market funds and hedge funds have also increased the value of their holdings from 13 to 18 per cent of global GDP over these years. Many of these NBFIs also need to hedge foreign currency risks, given the rise in their cross-border holdings. This has caused a huge jump in their reliance on foreign currency swaps.
So, what do these shifts imply for the stability of markets in government bonds, which are the benchmark financial assets? There has been one obvious benefit, namely that, as intended, banks are less exposed. Moreover, in theory, government bonds should still be the safest financial assets. But as the debt mountains rise, they must become less safe. Moreover, changes in risk awareness are sure to be discontinuous: complacency one day, and panic the next.
In addition, there is concern about the risk-bearing capacity of — and balance-sheet constraints on — NBFIs. Thus, duration matching by pension funds and insurance companies caused destabilising feedback loops in the UK gilt market shock of 2022. Another risk is the possibility of fire sales of government bonds by money market funds and other such intermediaries, in the event of a rush of redemptions, because these are the most liquid assets. Finally, foreign currency losses can trigger capital flight and collapsing bond prices.
These risks are now well known. But the speech emphasises newer ones, too. One concerns the leveraged trading strategies of hedge funds. The latter have been able to borrow amounts equal to, or even greater than, the market value of their collateral, with no haircuts. About 70 per cent of bilateral repos taken out by hedge funds in US dollars are, for example, offered with zero haircuts. This could exacerbate market shocks, as funding disappears. Again, less leveraged investors, such as pension funds, are, according to Hernández de Cos, exposed to “dollar funding rollover risks related to their use of FX derivatives”. In essence, “by using FX swaps they are . . . transforming currency risk into maturity risk”.
The point is that the instability caused by leverage and maturity mismatches has not disappeared just because banks are less important than they were. One solution is what Hernández de Cos calls “congruent regulation”: when vulnerabilities are similar, so should regulation be. But, inevitably, the sheer heterogeneity of the players is going to make this very difficult. More concretely, he suggests, there should be greater use of central clearing and imposition of minimum haircuts. Today’s zero haircuts, he warns, allow some market participants “to operate with as much leverage as they want”. That cannot end well. Two further lessons emerge. One is that the greater the fragility of NBFIs, the more control there must be over the stability of banks that finance them. The other is the need for greater transparency.
Another round of financial crises would be a nightmare. But it would be worse still if states had ceased to be creditworthy and their money to be sound. Some suggest, wrongly, that the answer is to let banks replace NBFIs yet again. A far better solution is to make government finances safer.
martin.wolf@ft.com
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