Brace yourself for nasty surprises from the financial system

IMF International Monetary Fund Credit Suisse Europe Economy
IMF International Monetary Fund Credit Suisse Europe Economy
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Don’t get me wrong, Credit Suisse has got problems. But if we are looking for what might go pop as the financial system convulses in the face of rising interest rates and market volatility, we should probably look elsewhere.

The recent tremors in the UK pension system provide a clue: expect the unexpected.

In recent weeks one of the biggest lenders in Europe has effectively become a memestock. It doesn’t help that Credit Suisse’s chairman is called Axel Lehmann nor that the bank has got into so many pratfalls that it is beginning to look like a deliberate strategy.

But the basic fact of the matter is that the Swiss lender looks to have plenty of capital and sufficient liquidity. That’s a consequence of the far more stringent bank regulations that we put in place globally following the collapse of Lehman Brothers.

Credit Suisse - Arnd Wiegmann/Reuters
Credit Suisse - Arnd Wiegmann/Reuters

Which is not to say all is well. In fact, it might be part of the problem. If history is any guide, the regulations that were put in place to deal with the last crisis may well be exactly what sow the seeds of the next one.

This is precisely what the IMF, for one, has been warning for nearly a decade.

As far back as 2013 the fund was warning that tighter bank regulation and low interest rates were combining to increase risk in the so-called shadow banking system, where less well-regulated financial institutions ply their trade.

On Wednesday, Gordon Brown, the former prime minister who knows a thing or two about financial crises, reiterated that warning and urged the Bank of England to tighten up its scrutiny of this corner of high finance.

“I do fear that as inflation hits, and interest rates rise, there will be a number of companies and organisations that will be in grave difficulty,” said Brown on Radio 4’s Today Programme. “I do think there’s got to be eternal vigilance about what has happened to the shadow banking sector. And I do fear there could be further crises to come.”

The trouble is, we can’t really know what the Bank should be on the lookout for. If regulators knew what the next problem was, they’d deal with it. A genuine crisis tends to come out of the clear blue sky, its obviousness only obvious in hindsight.

We can, however, take a pretty good guess at the rough mechanics of the next crisis after Kwasi Kwarteng’s mini-Budget sparked a fire sale by UK pension schemes. The irony here is that the problem was caused by a strategy called “liability-driven investing (LDI)”, which is supposed to provide protection against interest rate moves.

However, the crash in gilt prices (and hence rise in yields) as a result of worries about the Chancellor’s fiscal plans happened so fast that schemes were faced with huge margin calls.

As a result they had to dump what should have been the most liquid assets – gilts – to raise cash. As everyone was selling, no one was prepared to buy. This caused the price of gilts to plummet yet further and yields soared even higher in a self-perpetuating spiral.

The tremors were so severe that they were felt in the ultra-liquid US Treasury market. Calm was only restored when the Bank said it would step in as a buyer of last resort. It was a timely reminder that risk can never really be eradicated, only parcelled up and shipped off to another part of the system.

The question is where? Part of the answer is: not banks. Since the financial crisis, lenders have quite rightly faced a deluge of new rules around capital, liquidity and the types of risk they can take. They have also been “stress tested”  by central banks to see if they can withstand various painful scenarios.

Watchdogs also monitor how banks trade with each other by demanding that most derivative contracts pass through clearing houses. These institutions are designed to cope with the fallout should one or two of the biggest counterparties in the market go bust.

All of this is well and good and makes banks much safer. The possibility of a government having to step in and bail a bank out at an enormous cost to the taxpayer is vastly diminished.

But it is not cost-free. If banks have to hold more capital to do certain types of business they will, of course, charge their clients a bigger fee. That is why there is a constant tension between safety and, the key concern of the moment, promoting growth.

What’s more, it creates opportunities for non-bank financial institutions to undercut lenders and steal their business and clients. Welcome to the world of shadow banking.

By definition, since this activity is not being undertaken by systemically-important banks, it is not so tightly regulated or closely monitored. The worry, as expressed by Gordon Brown, is that pockets of potentially risky activity may have built up that nobody really knows about or don’t properly understand.

LDI strategies, for example, protected pension schemes from interest rate moves right up to the point when they didn’t.

We know this activity is out there. Just after the financial crisis, non-bank financial institutions held a similar value of assets as banks. Now their collective balance sheets are about 25pc bigger. A lot of corporate and consumer credit, for example, has been packaged up and held by the likes of private equity firms and hedge funds.

Do these alternative investors have the appropriate risk management skills and controls in place to cope with the losses if companies and consumers start defaulting en masse amid rising borrowing costs and a strengthening dollar? Here’s hoping.

And, if not, can we be sure no individual firm is so big or interlinked with others that it sets off a chain reaction? Fingers crossed.