What probability do you give that there could be another financial crisis? This month, experts from Oxford Economics, a research group, posed this question to 162 global companies. Their average response was 20% over the next two years.
That’s twice the perceived risk of a second global wave of the Covid-19 pandemic and also, unfortunately, the likelihood that an effective vaccine will arrive early.
These fears are already having tangible consequences: They lowered business morale in this month’s Oxford survey more than reliable data warranted. “Our analysis suggests that financial crisis fears account for much of the gloom,” said Jamie Thompson, senior economist for the poll.
This should worry investors, but not because a financial crisis is likely to explode right now – at least not in the style that made the headlines of 2008. At least two factors are mitigating that risk.
First, the US Federal Reserve and other central banks have made it clear that they will do “whatever it takes,” to quote Mario Draghi’s pledge in 2012, to keep markets functioning during the pandemic. The events of March are a case in point: when the US Treasuries market froze, the Fed plunged with extraordinary liquidity support.
Second, the banks are not the source of this year’s economic shock. They are also much better capitalized in the United States and most of Europe than in 2008. “The big American banks entered this crisis under solid conditions, and the Federal Reserve has taken a number of measures. important in helping to build the resilience of banks, ”Randal Quarles, said a senior Fed official. Or, as Morningstar, a financial data group puts it, “The risk of insolvency and capital crunch for the US financial system appears to be much lower this time around.”
However, there’s a catch: A financial crisis doesn’t always materialize the same way it did with the collapse of the Lehman Brothers. Sometimes financial stress emerges in a more insidious way. Purists may wonder if such a scenario deserves to be called a “crisis”. But the key point is that chronic stress can be very economically debilitating, as respondents to the Oxford survey surely knew.
One problem that haunts finance, as Carmen Reinhart, the World Bank’s chief economist, notes is that the leverage of many institutions was exorbitant even before Covid-19. “If you look at vulnerabilities in the financial sector, longer term it’s hard not to be dark enough,” she told me in a webinar.
To this must be added that it remains impossible to calculate the extent of the possible credit losses of Covid-19 while the pandemic continues to rage, especially since the general policy of credit abstention hides a large part damage. “Although the banks are not at the origin of the crisis, they cannot hope to remain unscathed,” noted Hyun Song Shin, chief economist of the Bank for International Settlements. “The immediate liquidity phase of the crisis is [now] giving way to the solvency phase, and the banks will undoubtedly bear the brunt of it. “
The big US banks have increased their reserves to deal with this. But Ms Reinhart fears those in countries like India and Italy will be less prepared. In addition, extremely low interest rates erode bank profitability.
Another problem is that it is difficult to model future risks due to the lack of historical precedent. “Crises usually arise from a boom-bust cycle and investors know what that looks like. It’s different, ”adds Reinhart. As financial activity circulates much more in the non-banking sector, via the capital markets, unpleasant surprises can easily arise.
The trigger for the March Treasury freeze, for example, was among hedge funds, an industry that regulators are less familiar with than banks. If or when interest rates rise, other shocks of this type could occur. As Deutsche Bank told customers this week: “We see an increasing risk of financial disruption going forward. [from] growing asset overvaluation and rising debt levels. “
Of course, such a disruption might not deserve a big headline, given all the other most immediately worrying news right now. But investors need to remember this: if lenders are responding to a stealthy rise in defaults – and, most importantly, fear future tensions – this could tighten credit conditions despite central bank policies.
“Investigations [already] show a significant tightening of lending standards, ”Shin observed. Or as Ms Reinhart notes: “A credit crunch looks really very likely.” No wonder Oxford saw financial fears plague confidence; or that the chances of a V-shaped economic recovery seem increasingly slim.