Modern financial system risk for macro trading

Financial system risk 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 but are prone to aggravating 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.

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The dollar as barometer for credit market risk

The external value of the USD has become a key factor of U.S. and global credit conditions. This reflects the surge in global USD-denominated debt in conjunction with the growing importance of mutual funds as the ultimate source of loan financing. There is empirical evidence that USD strength has been correlated with credit tightening by U.S. banks. There is also evidence that this tightening arises from deteriorating secondary market conditions for U.S. corporate loans, which, in turn, are related to outflows of credit funds after USD appreciation. The outflows are a rational response to the negative balance sheet effect of a strong dollar on EM corporates in particular. One upshot is that the dollar exchange rate has become an important early indicator for credit market conditions.

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The shadow of China’s banks

Unlike in the U.S., shadow banking in China is dominated by commercial banks, not securities markets. Regulated banks operate most shadow banking activity, take direct risks, provide implicit guarantees and use non-bank entities to shift assets off their balance sheets. That is why China’s shadow banking is called ‘the shadow of banks’ and why it is such a central factor of systemic risk in this highly leveraged economy. China’s shadow banking has important economic functions for individual savers and smaller enterprises. Outstanding ‘shadow savings’ are estimated at roughly 70% of GDP.

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The consequences of increased financial collateralization

There has been a strong upward trend in collateralization since the great financial crisis. Suitable collateral, such as government bonds, is essential for financial transactions, particularly repurchase agreements and derivative contracts. Increased collateralization poses new risks. Collateral prices and haircuts are pro-cyclical, which means that collateralized transactions flourish when assets values rise and slump when asset values decline. This creates links between leverage, asset prices, hedging costs and liquidity across many markets. Trends are mutually reinforcing and can escalate into fire sales and market paralysis. Central clearing cannot eliminate this escalation risk. The collateral policies of central banks have become more important.

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Why money markets remain vulnerable

New theoretical work shows that money markets remain fragile as long as there is a connection between asset prices, secured funding and unsecured funding. The degree of fragility depends on leverage in the financial system. Central banks can alleviate acute liquidity stress but cannot easily reduce financial system leverage. Hence fragility remains even with ultra-easy monetary conditions.

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Understanding “shadow money”

The shadow banking system creates money or money-like claims mainly through repurchase operations: cash managers “park” funds through short-term secured lending, while asset managers borrow against their securities to gain leverage. Large institutions have few alternatives to collateralized lending for cash management. Institutional cash pools and “shadow money” have been expanding rapidly over the past decade.

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The rise and risks of euro area shadow banking

The non-bank financial sector in the euro area has doubled in size over the last 10 years. It has become a concern for three reasons. First, its tight links with regulated banks imply contagion risk. Second, investment funds’ supply of liquidity has become critical for many markets, but is pro-cyclical. And third, rising synthetic leverage aggravates pro-cyclicality of both market prices and liquidity conditions.

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Size, risks and regulation of shadow banking

Recent FSB reports give an updated assessment of shadow banking. Non-bank financial intermediation in its broadest definition is estimated to be 120% of global GDP and growing. Its expansion is dependent on market prices for collateral. Dislocations can be contagious for banks. Regulatory policies may mitigate pro-cyclicality and contagion, but only modestly so.

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When does shadow banking become a problem?

A new ECB paper explains key risk factors of shadow banking. First, if unregulated finance outgrows market size, tightening liquidity can escalate into runs and fire sales. Second, if shadow banks are operated by regulated banks they become a source of contagion. Third, and most importantly, if shadow banking focuses on regulatory arbitrage it erodes classical financial system safety nets.

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The basic mechanics of shadow banking

Shadow banking creates liquidity outside the regulated banking system. Unlike traditional money, shadow money is constrained by the value of assets that serve as collateral. Therefore, shadow banking is vulnerable to market price declines. As shown in a new paper by Moreira and Savov, pro-cyclicality is compounded by collateral values falling more than asset prices when uncertainty is rising. This makes modern financial systems prone to collateral runs and liquidity crises.

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