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The hidden risks in the financial system are bubbling to the surface – The Telegraph - 07.12.22

The fallout from rising interest rates will no doubt be felt in the markets. But where? says Ben Wright.

At least the financial watchdogs know about some of things they don’t know about.

This week the Bank for International Settlements (BIS) warned that there is a $80 trillion (£65 trillion) “blind spot” at the heart of the financial system. The so-called “central bank of central banks” raised the alarm on the number of pension schemes and other non-bank financial firms that are holding exchange swaps - a form of debt derivative.

This large but esoteric corner of the markets suffered funding issues during the global financial crisis and in the early days of the pandemic. Could we be about to get a repeat?

As the years of cheap money come to an end and credit bubbles deflate, financial dislocations are all but assured. We’ve already felt the pre-tremors in the UK pension and cryptocurrency markets.

On the plus side, many such risks are unlikely to be on the books of big lenders and a systemic meltdown should therefore be avoided; on the downside, regulators are, as BIS’s wording suggests, essentially guessing at where potential problems do lie.

The markets have had a tough time already this year. This is causing some plucky investors to start looking for signs that valuations are bottoming out. But if, instead of looking at historical multiples and widening discounts, they cast a weather eye on the prevailing economic headwinds, it’s hard to avoid the conclusion of stormier weather ahead.

Globally, total public and private debt as a proportion of gross domestic product rose from 200pc in 1999 to 350pc in 2021, according to the Institute for International Finance. It’s closer to 420pc for rich nations. The US owes more than it did after the Second World War.

Like frogs in ever-hotter water, we became inured to the slow but steady rise in these ratios because interest rates remained so low, and in some cases were actually negative, for so long. But it’s hard to argue now that the era of cheap money didn’t result in many people overstretching themselves to buy houses they couldn’t afford and plenty of companies struggling on when by rights they should have gone to the wall.

They are now being rocked by a one-two punch combination of surging inflation and imminent recession. The result is rising interest rates, falling real incomes and sinking asset prices. The most overstretched households, companies and governments will snap. There is little doubt that the fall-out will be felt in the financial markets. But where?

Vincent Mortier, the chief investment officer of Amundi - with nearly €2 trillion (£1.7 trillion) in assets, the largest fund manager in Europe - recently warned that the ructions in the UK government bond markets should act as a wake up call to investors and regulators and offer some potential clues.

When Kwasi Kwarteng announced £45bn of unfunded tax cuts in September’s mini-Budget, investors took fright. This resulted in the value of UK government bonds falling and yields spiking.

That was far from ideal but potentially manageable had not a number of defined benefit pension schemes, which use complicated hedging strategies to match their assets and liabilities, started getting into trouble.

The sharp fall in gilt prices led to margin calls, forcing schemes to sell gilts to raise money, resulting in prices spiralling downwards. Eventually the Bank of England had to step in before things spiralled out of control.

It was a reminder that there are pockets of leverage dotted around the financial systems. And, while the squeeze in this case was extreme because of the speed with which gilt yields spiked, it provided a foretaste of the kind of issues that might result from rising interest rates.

Speaking to the Financial Times, Mortier said: “I don’t believe that anyone before the crisis had any idea of the magnitude of the shadow banking in the pension industry.” What other nasties are lurking in the dark corners of the financial system where regulators shine their torches all too infrequently?

In September, the European Systemic Risk Board issued its first “general warning” about “severe risks to financial stability” since it was created in 2010. It called on regulators in the 30 countries it oversees to get banks and financial institutions to start increasing their capital buffers. Effectively it was telling the European financial industry to return to their seats, fasten their belts and to ensure their trays are in the upright position.

The trepidation is vague and no one is being told to adopt the brace position - yet - but the ESRB identified three key sources of systemic risk: “The deterioration of the macroeconomic outlook, risks to financial stability stemming from a (possible) sharp asset price correction and the implications of such developments for asset quality.”

Among assets, the property market is one of its main areas of concern. House prices in the UK slumped by 2.3pc in November, according to data released on Wednesday by Halifax. That’s the biggest monthly drop since the midst of the financial crisis in 2008.

Russell Galley, a managing director at Halifax, said the three main determinants of what happens next will be “the trajectory of mortgage rates, the robustness of household finances … and how the economy … performs”. There is very little in the outlook for any of those areas that gives cause for optimism.

This is far from being solely a British phenomenon. House prices were falling in half of the 18 rich countries monitored by Oxford Economics in October. Prices in New Zealand have already fallen by 12pc from their peak last year.

Nowadays there are fewer of the risky, sub-price loans that were issued, especially by US banks, in the lead up to the financial crisis. Lenders in the countries that suffered most then are themselves better capitalised than they were 15 years ago. But that is not true everywhere. In some countries, exposure to property loans is likely to have seeped into the shadow banking system.

The head of the Swedish central bank recently likened the situation to “sitting on top of a volcano”. Everyone’s expecting eruptions. They just don’t know when they’ll happen or where they’ll occur.

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The hidden risks in the financial system are bubbling to the surface – by Ben Wright for T
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September's bonds crisis provided a foretaste of the kind of issues that might result from rising interest rates. Credit: Mike Kemp/In Pictures via Getty Images

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