The early warning signs of a new financial crisis have been flashing red over the last few months, with the influential Bank of International Settlements’ latest review of the globe’s finances reporting on an $80 trillion “blind spot” at the centre of the system that threatens the ability of governments across the world to rein in a crisis.
The spectacular collapse of crypto trader FTX is an indicator of stresses
Rising interest rates across the globe are exposing some of the shakier arrangements that the traders in our financial institutions made during the last decade of ultra-low interest rates and cheap money. With prices for essentials still soaring – added to by a cold snap in Europe and tensions with Russia threatening real energy shortages – and recessions next year all but guaranteed, the risk of a major financial blow-out is climbing.
BIS’s blind spot is the huge dollar liabilities that financial institutions, including pension funds, have built up off their balance sheets – owing billions in unregulated and unmonitored additional borrowing as part of the so-called shadow banking system. That shadow banking system is the looming threat to global financial stability in general because whilst the regular banks – like the big, familiar institutions we see on our high streets – have been much more tightly regulated since the 2008 crash, building up buffers of capital to insulate themselves from a crisis, the off-balance sheet, unregulated shadow system has flourished.
We’ve had a taster of the kind of problems this can cause in the wake of Liz Truss and Kwasi Kwarteng’s disastrous mini-Budget in September. Back then, the shock announcements of a very major increase in government borrowing caused those trading the pound against other currencies, and those trading UK government debt, to panic – rushing to sell both, making the pound drop in value and the cost of government borrowing soar. But this sudden spike in borrowing costs had a consequence few had foreseen. UK pension funds, faced with a decade of low interest rates but still expected to pay out to their pensioners, had become entangled in complex financial schemes intended to help manage the difference between the low interest rates being paid on their investments, and the large sums they needed to pay to pensioners. They had used their holdings of government debt as collateral to borrow money, which they then used, under advice from asset managers like BlackRock, to set up complicated bundles of financial instruments that were designed to smooth out the pension payments they needed to make.
Unlike the debacle of 2008, when, as anyone who has seen The Big Short will know, major banks took on massive, hidden risks using complex, poorly-understood financial instruments, this wasn’t inherently stupid. Pension funds needed to find a way to meet their obligations to their fundholders. But it was a fragile system and the shock rise in borrowing rates pushed it into crisis. By the Monday after the Friday mini-Budget, it was clear British pensions funds could become insolvent – being unable to meet those obligations. The Bank of England stepped in with a £65 billion offer of assistance and, shortly after, both Kwarteng and then Truss were removed from office.
Elsewhere, the spectacular collapse of cryptocurrency trader FTX, with the one-time poster child for the industry now exposed as owing billions of dollars in potentially fraudulent transactions, is another indicator of the stresses and strains now making themselves known. Cryptocurrencies have grown through a series of bubbles and manias since Bitcoin was first developed in 2009, but the bursting this time looks more fundamental. The basic “business model” for crypto, chasing those with dollars and other conventional currencies to spare to pump into the bubble and keep it inflated, looks broken once borrowing costs rise sharply.
The rise in borrowing costs is key to understanding the general problem here. With interest rates as low as they have been since 2008, an enormous volume of borrowing has been encouraged. The IMF estimates that global debt reached a record-breaking $221 trillion at the start of 2021, close to two and a half times the global economy – with the Covid pandemic seeing another surge, the biggest since World War Two. That surge has come from all sources – government debt rose during 2020, as the pandemic bit, but firms and households also saw rapid increases in their debt burden. China has been the biggest single source of new debt, with rising property prices before Covid fuelling borrowing.
Much of this borrowing will be on financial institutions’ balance sheets, and subject to (in theory) more regulation and control. A 2008-style blowout, when the global banks, the core institutions of the world’s system, failed is now unlikely. But a huge amount of borrowing is taking place off those balance sheets, in the shadow banking system, and even if the dangers are less acute, there is a prospect of a serious financial crunch adding to the woes of rising prices and global recession.