Modern financial system risk for macro trading

Financial system risk refers to the probability of breakdowns in financial intermediation. It is the main constraint and disruptor of macro trading strategies. There are four key areas of modern systemic risk.

[1] In the regulated banking sector vulnerability arises from high leverage and dependence on funding conditions. The regulatory reform of the 2010s has boosted capital ratios and liquidity safeguards. However, it has also induced new hazards, such as accumulation of sovereign risk, incentives for regulatory arbitrage, and risk concentration on central clearing counterparties.
[2] Shadow banking summarizes financial intermediation outside the reach of standard regulation. It channels cash pools to the funding of asset holdings. Vulnerability arises from dependence on the market value of collateral and the absence of bank backstops.
[3] Institutional asset management has grown rapidly in past decades and is now comparable in size to regulated banking. Asset managers play a vital role in global funding conditions. A key systemic risk is their potential as a catalyst of self-reinforcing market momentum.
[4] Finally, emerging market financial systems have grown in size and complexity. China constitutes a global systemic risk factor due to the aggressive use of financial repression to sustain high levels of leverage and investment.

Banks and the side effects of regulatory tightening

Expansion and regulatory reform

From the early 1890s to the 1970s the average bank credit-to-GDP ratio in the developed world was stationary, hovering around 50%. However, bank lending soared in the subsequent decades, alongside deregulation and a decline in interest rates, and reached 114% by 2010 (view post here). The expansion of regulated banking also nurtured the rise of macro trading through the provision of funding and market liquidity, the monitoring of creditworthiness of a large part of the economy, as well as payment and settlement services.

Regulated banks are highly leveraged institutions: their average ratio of debt to equity has been roughly 19:1, compared with roughly 1:1 for large non-financial companies. At the same time, their functioning is critical for modern economies. Individual banking crises in the past have on average entailed losses of almost 100% of annual GDP overtime (view post here).

Hence public supervision and capital regulation have long been essential. However, the great financial crisis of 2008/09 revealed shortcomings of (a) capital adequacy, (b) liquidity management, and (c) moral hazard in the risk management of large systemic banks. This motivated an unprecedented expansion of regulatory restrictions in the 2010s, which has affected both macroeconomic trends and structural features of markets. Moreover, greater complexity and policymaker discretion in regulatory policies mean that investment managers must pay more attention to them, not unlike the way they follow monetary policies (view post here).

Tighter capital regulation and new liquidity regulation

The capital regulation reform of the 2010s has laid the ground for more effective micro- and macroprudential policies:

  • Individual institutions’ required capital ratios have been lifted drastically and defined more restrictively. Under the so-called Basel III rules, the minimum Tier 1 capital ratio (equity capital and disclosed reserves) has been set to 10.5% of a bank’s risk-weighted capital. Separately, Basel III sets a 3% minimum leverage ratio, defined as the ratio of core tier 1 capital to consolidated but un-weighted assets. Capital adequacy and leverage ratios have different purposes. Capital adequacy ratios limit the risk that banks’ equity can be consumed by a decline in the value of risky assets. Leverage ratios limit the debt financing of assets, irrespective of risk characteristics.
  • To some extent capital ratios can now be adjusted to macroeconomic conditions, in particular through a counter-cyclical capital buffer. Regulators also levy a capital surcharge on banking groups that have attained great systemic importance.

Another key area of regulatory reform are rules for the transformation of liquidity and maturity risk (view post here). Liquidity regulation is motivated by past funding crises and a fundamental moral hazard: financial institutions might hold insufficient liquidity buffers because they disregard the social cost of systemic crises and count on emergency support.

  • The liquidity coverage ratio requires institutions to hold enough “high-quality liquid assets” to withstand a 30-day period of funding stress (view post here). The idea is that the disposal of such assets will not easily escalate into fire-sale dynamics.
  • The net stable funding ratio focuses on a one-year time horizon and establishes a minimum amount of stable funding each bank must obtain based on the liquidity characteristics of its assets.
  • The large exposure framework of the Basel Committee on Banking Supervision imposes limits on banks’ exposure to single counterparties. As exposures to central banks and governments are exempt it probably encourages more central bank financial intermediation.
  • Banks are also a major liquidity provider in the huge OTC (“over-the-counter”) derivatives market. Due to its vulnerability, standardized derivative contracts been migrating onto central counterparty (CCP) clearing platforms, and remaining non-standard derivatives require higher capital requirements. In principle, this should facilitate risk management and the mutualization of default losses.

Side effects of regulatory tightening

The tightening of capital regulation has side effects, including a bias of banks for holding sovereign risk, strong reliance on collateralized transactions, and greater efforts of regulatory arbitrage:

  • Government bonds receive preferential treatment in respect to both capital and liquidity regulation. In particular, in government bonds are treated as liquidity risk-free (view post here). Hence, regulatory reform has increased banks’ proclivity to holding government debt and contributed to an unprecedented decline in real interest rates on government securities (view post here). The neglect of sovereign risk in constitutes significant systemic risk as developed market debt-to-GDP ratios are at record highs.  There is a distinct risk of sovereign-bank feedback loops (view post here), due to the mutual dependency of sovereign creditworthiness and banks’ holdings of government securities.
  • If markets are dominated by need for liquidity and dealer balance sheets are constrained by regulation, investors have an incentive to liquidate safe assets pre-emptively to avoid outsized mark-to-market drawdowns. Put simply, concerns over liquidity and dealer balance sheets are self-fulfilling. Without government intervention, they can escalate into runs and render a safe asset market dysfunctional (fortchoming post).
  • The broader bank capital, derivatives, and resolution reforms favored collateralized over unsecured lending. In a highly collateralized and risk-averse financial system credit may be granted mainly on the basis of collateral value and aim at wealth extraction rather than wealth creation. On the macroeconomic level, this creates unproductive debt, i.e. debt that is not backed by productive investment (view post here).
    Moreover, increasing collateralization could increase bank asset encumbrance (pledging of assets for specific transactions) and, as a consequence, unsecured institutional creditors’  risk of statutory bail-in (view post here).
  • The tighter and more complex capital rules are, the greater the incentive to gear balance sheets towards using all remaining degrees of freedom, a process that is called “capital arbitrage” (view post here). This has two problematic consequences. First, risk weights used to calculate capital adequacy ratios may understate true portfolio risk, undermining the credibility of regulation. Second, banks may dedicate considerable human resources and misallocate financial resources to that end.
  • Regulatory net stable funding ratios interfere with the essential role of banks in maturity transformation, affect the functioning of conventional monetary policy, and encourage migration of financial transactions into the shadow banking system (view post here).
  • The drawback of the shift in derivatives trading from banks to central counterparty clearing platforms has caused an unprecedented concentration of risk in a few global central counterparties and their members (view post here). For this reason, CCPs are required maintain sufficient liquid resources, including the collection of initial and variation margins and default arrangements. However, CCP margin calls or calls on unfunded liquidity arrangements could themselves propagate crises by aggravating scarcity of liquid assets and collateral (view post here).

Shadow banking and the collateral issue

The function of shadow banking

The main systemic function of shadow banking is to channel the cash pools of institutions, such as non-financial corporates and asset managers, to the funding and leveraging of loans, bonds, and equities holdings (view post here). For example, cash managers “park” funds through short-term secured lending, while asset managers borrow against their securities to gain leverage. Key intermediaries of this process are dealer banks and money market funds. Dealer banks issue repos and money market funds issue shares with constant net asset values. Both are forms of “shadow money”. They are similar to regular monetary aggregates, such as M2, insofar as they always trade at par on demand and can easily be converted for settlement purposes.

Collateralization, i.e. the pledging of assets as security for repayment, is at the heart of the shadow banking system. The principal benefit of collateralization is that it facilitates short-term lending with low research and information cost (view post here). Thus, the lenders or depositor in a secured transaction only needs to know that the security’s value exceeds a critical threshold. He or she does not need the full information set for assessing the security’s exact value and the creditworthiness of the borrower.

Interestingly, the securities used as collateral are often sourced from asset managers and it has become common practice to re-use pledged collateral. This means that the shadow banking system has become a catalyst for the build-up of so-called ‘collateral chains’, sequences of transactions that use the same asset for multiple securitizations. As a consequence, the role of asset managers and off-balance vehicles of banks in intermediation has increased, as has the importance of asset managers as a source for ‘collateral mining’.

Institutions typically prefer shadow money over bank deposits for larger amounts, because the former are collateralized and diversified, while the latter are largely unsecured and imply concentrated risk exposure to one or more banks. Hence, the shadow banking system establishes secured transaction-based wholesale funding (view post here) in parallel to the classical unsecured deposit-based funding through banks.

The systemic risks of shadow banking

Unlike regulated banks, shadow banks typically have no direct access to public sources of liquidity or credit backstops. They are not usually counterparties of central bank operations. This means that shadow banking has only limited capacity to withstand liquidity pressure and may itself become a catalyst of market turmoil, particularly when it has grown in size and when its difficulties affect regulated banks (view post here).

Moreover, unlike traditional money, shadow money is constrained by the value of assets that serve as collateral. Secured financing is vulnerable to market shocks. The classical vicious cycle of lower asset prices and lower collateral value would probably be accentuated by two aggravating forces:

  • First, collateral values are likely to fall more than asset prices when uncertainty is rising(view post here). Indeed, the whole point of collateralized transactions is for the lender to save transaction costs and not having to worry about the exact value of the underlying security. If these worries arise nonetheless, they inevitably catch lenders “uninformed” triggering outsized risk premia.
  • Second, a decline in collateral values usually translates in additional collateral calls possibly compounded by higher haircuts and margins requirements. This is a tightening of credit conditions and may enforce a reduction in secured lending and leverage. The nexus between asset prices and secured lending also can easily spread to unsecured lending, including money markets, which means that all systemically important markets could seize up at the same time (view post here).

The risk of fire sales is a particular concern in private repurchase operations (view post here), the main market for funding of securities holdings. Moreover, distress in collateralized transactions is likely to spill over to regulated banking activity for two reasons.

  • First, a large part of shadow banking system is either owned or funded by regulated banks. Ownership is common for special purpose vehicles or European asset managers. The funding link is strong to corporates or leveraged funds.
  • Second, regulated banks are directly involved in shadow banking through their broker-dealer activities. Even if they act only as intermediaries on a matched-book basis, they still incur risk. For example, in order to achieve collateral efficiency dealer banks engage in re-hypothecation (re-pledging of collateral). And to minimize balance sheet usages, they use their scope for netting positions. This means that in case of market distress and collateral value losses, dealer banks face rollover risks, which are not dissimilar to a classical deposit run (view post here).

Shadow banking becomes a systemic risk particularly if it grows rapidly relative to other markets and is motivated predominantly by regulatory arbitrage (view post here). These risks may end up being “put” to the public safety net, as many shadow-banking-related entities—banks, dealer banks, and (under some conditions) money market funds—benefit from implicit or explicit guarantees. These “puts” make the system effectively subsidized (view post here).

Institutional asset management and the momentum problem

Size and trend of asset management

Professional asset management has been growing in the past decades with total assets now close to USD90 trillion, roughly equal in size to global GDP. The largest holders of marketable securities are mutual funds, pension funds, insurances, and sovereign wealth funds. Asset managers are a major contributor to money creation in the shadow banking system and provider of liquidity in many securities and derivatives markets. The expansion of institutional investment is being propelled population ageing, which is bringing the median age of the world population closer to the point of maximum saving (view post here). As a result, the importance of asset management for global liquidity (defined as the ease of financing) has been increasing relative to the regulated banking system, in particular through a greater presence in bond markets (view post here).

Many investment funds have thrived as a consequence of the secular downward trend in interest rates and fixed income term premia. This includes fixed income, credit, risk parity and trend-following funds. A stable or rising yield environment could disrupt or even reverse this expansion. The threat is obvious for fixed income and risk parity strategies, but similarly serious for trend following. Trend followers have historically not just benefited from rising bond prices, but also from the sizable carry of long duration positions and the diversification value of long duration positions in the deflationary crises of the past 20 years. The latter two tailwinds could turn into headwinds in a rising interest rate environment (view post here).

Systemic concerns

As asset managers have put on weight, inefficiency and market runs have become a greater systemic concern. Market conventions, accounting practices, and regulatory changes in the industry all contribute to such risk (view post here). For example, insurance regulation, such as the EU’s Solvency II framework, has created a bias against assets with high market risk and daily price volatility, such as equity (view post here). Simultaneously, this regulation favours holdings with lower mark-to-market volatility but serious medium-term shortfall risks, such as government bonds or high-grade credit.

Asset managers have become a key ultimate source of funding for bank loans, particularly corporate loans. This creates a link between fund in- and outflows and credit conditions in the economy. It also establishes new financial impact channels. For example, the USD exchange rate has become a key factor of U.S. and global credit conditions (view post here). That is because USD appreciation leads to a deterioration in balance sheets of non-U.S. corporates, which typically triggers outflows from credit funds. These outflows reduce demand for loans in secondary markets.

In contrast to banks, asset managers use very little leverage. Outside hedge funds and private equity funds, leverage is typically less than 2% of assets under management. However, asset managers can use some debt financing to enhance returns, either through outright borrowing or through derivatives (synthetic leverage). They tend to do so in a pro-cyclical fashion. Considering the huge volume of assets, changes in buy-side leverage can still have a significant impact on financial conditions, particularly in areas where funds carry more leverage, such as in emerging markets (view post here).

The big issue of “pro-cyclicality”

Institutional features of asset management make it prone to accentuating market booms and busts:

  • Regulations and conventions typically encourage herding (view post here), particularly when portfolio managers are measured against benchmarks and peers, and are risk-averse in respect to relative performance (view post here). Indeed, the common practice of benchmarking forces many investment managers to chase overvalued and volatile assets to contain the risk of underperforming benchmarks with an unacceptable margin. This can lead to market inefficiency, perverse relations between risk and returns and predictable flows in the market than can be exploited by momentum traders (view post here). Real money funds can become a catalyst of market sell-offs because they are averse to significant under-performance versus peers or benchmarks (view post here).
  • Asset managers are an large provider of liquidity in securities and derivatives markets and – indirectly – a provider of funding for outright or synthetic leverage (view post here). Hence, negative shocks to asset prices can trigger self-reinforcing dynamics, with multiple rounds of liquidity pressure.
  • Asset managers have a tendency to hoard cash in market downturns, in order to prepare for redemptions and protects against disproportionate fires sale costs in markets with precarious liquidity (view post here). Moreover, end-investors of U.S. mutual funds have an incentive to rush for redemption in serious market downturns, since liquidation costs will have to be borne disproportionately by those that stay invested (view post here).
  • Institutional investors often bias portfolios to the highest-risk securities within the confines of prescribed risk metrics in order to improve formal track records (view post here). Theoretical models suggest that investment managers that maximize assets-under management have an incentive to enhance their risk-adjusted returns in normal times (when there are inflows) at the expense of larger drawdowns in crisis times (view post here). There is empirical evidence of funds re-allocating according to market conditions, chasing assets with high returns in boom times and reverting to low-risk securities in times of uncertainty (view post here).
  • Risk management systems struggle with the estimation of tail risk and statistical models are usually thrown into disarray during financial turmoil (view post here). Also, investment managers that focus on short-term performance targets and can be compromised by human stress response (view post here).

EM, China and the political economy

Dependence and limited policy scope

Financial conditions in most EM countries are closely tied to U.S. financial trends (view post here). They cannot normally influence these conditions or even just isolate themselves from them. Indeed, the expansion of EM local-currency bond markets with large foreign participation and the rise in foreign-currency EM corporate bond issuance have increased dependence on foreign funding (view post here). In particular, US dollar funding has a pervasive influence on emerging financial systems (view post here). For example, there is empirical evidence that non-conventional monetary policy in developed markets has a significant impact on EM capital flows and financial conditions (view post here). Accentuating this dependence, trading flows in and out emerging markets have become highly correlated due to the widespread use of common benchmarks and the pro-cyclical behaviour of end investors (view post here).

Policymakers options for mitigating these risks are limited:

  • The shift of most EM foreign exchange regimes from pegs in the 1990s to managed floats in the 2000s has given central banks more flexibility to deal with capital inflows and outflows. However, it did not insulate emerging economies from external developments. In particular, capital inflows often drive currency appreciation, reducing local interest rates and narrowing credit spreads at the same timeThis broad-based financial easing turns into broad-based tightening when capital flows revert. Hence, EM currency depreciation often compounds financial dislocations and gives rise to self-reinforcing dynamics (view post here) before its medium-term benefits for competitiveness make a more significant difference.
  • Evidence suggests that FX interventions cannot shield emerging countries from excessive appreciation and overheating at the same time. This holds true even if such interventions are sterilized, i.e. if the money creation is reversed through the issuance of local securities. Indeed, sterilized interventions seem to have an expansionary impact on local financial conditions, because securities issued in the process of sterilization function as substitutes for bank reserves. Hence, sterilization can expand the collateral available for lending and encourage an expansion of loan-to-securities ratios (view post here).

The China issue

China constitutes a global systemic risk factor in its own right due to its sheer size and rapid expansion. Macroeconomic management in China has predominantly relied on “financial policy”, a combination of credit, monetary and regulatory policies with powerful direct effects on growth and stability. This “financial policy” has critically shaped the structural development of the economy, fostering particularly state-owned enterprises, heavy industry, and real estate (view post here). As a result, China’s economic rise has long been associated with a massive expansion in domestic credit. Easy lending conditions have been related to two major financial distortions (view post here).

  • First, low controlled bank deposit rates in conjunction with capital controls have subsidized banks and borrowers.
  • Second, implicit loan guarantees by the state have spurred excessive lending and neglect of profitability.

China’s credit boom is widely seen as a consequence of ambitious growth targets. This ambition manifested in a highly accommodative monetary policy framework (view post here), implicit subsidies for banks and implicit loan guarantees for a range of corporate borrowers. Easy credit conditions have fostered neglect of profitability and default risk. The economy may be on an unsustainable path where generous credit supply is necessary to sustain growth and debt-servicing capacity. There is evidence of this risk, such as high leverage of the corporate sector (view post here), a large and dynamic shadow banking sector (view post here and here), a vast booming property sector and an abnormally high investment-to-GDP ratio.