Karen Shaw Petrou’s memorandum to Federal Financial Analytics clients on the equity market inter-connectedness and the next crisis.
[dalio]
TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: January 8, 2016
Is an acid bath refreshing? If so, welcome to 2016. By some reckoning, the last few days in the U.S. equity markets have been the worst ever, although I’ve seen at least one analysis that happily says 1932 was worse. In the 2008 crisis, financial panics caused equity market woes. This time, could it be the other way around? I don’t think so, but what really does worry me is the correlation between the factors driving equity-market volatility and their ability to cause financial-market instability. Get a rollicking negative-feedback loop going and financial markets could get all too interesting all over again.
Space doesn’t permit an in-depth analysis of how the factors affecting equity prices correlate with those that could send the financial system into a swoon. So, to just a short outline of what I think is at work in equities and how it could reverberate in finance:
- Liquidity Risk: Much to the Fed’s consternation, Treasury-bond and bill prices only erratically reflect its rate rise. As happened all too often in the last few years, emerging-market and equity turmoil are driving a flight to safety hurtling into Treasuries regardless of real return. This is happening now as investors sock away their proceeds from equity sales, running for cover along with other assets taken from the financial system and put into USGs out of fear. The more hoarded Treasuries, the fewer available to ensure market liquidity, especially given the sharp spike in fails observed in a Federal Reserve Bank of New York blog earlier this week. Although the Treasury market may remain liquid despite reduced supply under stable conditions, considerable evidence suggests they won’t under stress. Illiquid Treasuries mean cascading fails and a deluge of cliff effects that could quickly translate across the payment, settlement, and clearing system. The repo market could also be put at acute risk, threatening overall market liquidity. In 2008, the liquidity freeze derived from risky market-funding practices – the undue reliance on short-term wholesale funds of which the FRB is fond as an example of very bad behavior. This time around, banks may well be liquid, but they won’t have much to offer the rest of a still-illiquid financial system. One way out of this liquidity bind is still more USG sales by China in a desperate effort to support its currency, but that this would help shows how dangerous these times surely are.
- Clearing Risk: Another thing that worries me a lot is the increasing concentration of clearing in CCPs. I’ve little confidence that any of them could currently withstand acute stress. None of them has yet been tested for resilience nor do most have substantial resources or capital beyond those of their members with which to weather a storm. Equity prices are of course reflecting an array of factors that drive the FICC markets – commodity prices are awesomely volatile, and the financial condition of some end-users in critical areas is uncertain. Combine this with financial-market strain in the futures market and it’s at the least very worrisome. Same goes for forex, where even a relatively mild action like last year’s Swiss devaluation can cause near-death experiences.
- Operational Risk: Critical equity market players like ETFs have significant operational weaknesses, as we saw on August 24, and high-frequency and algo traders are no more comforting edifices of operational resilience. Combine the fragility of leveraged fund structures and high-speed trading with huge reliance on complex instruments (e.g., options on ETF) that have to clear and one gets a very worrisome picture of market complexity combined with inter-connectedness atop the head of a few really big computers that had better work. Equity market volatility, especially in “flash” scenarios could strain financial-market operational capability to the breaking point.
- Structural Risk: Leaving aside the big questions of Treasury liquidity, infrastructure resilience, and equity market stability, there’s another fundamental, structural tie between equity and financial markets – a lot of share prices do not fully take into account financial risks like yield chasing, leverage, and inter-connectedness. When the equity issuer is a giant financial institution, loss of market confidence has a very nasty habit of reverberating between stock price and cost of funding in ways that can shatter any company without robust capital and liquidity resources.
Which brings me to big banks. Very much unlike 2008, this time around these banks – especially in the U.S. – do have large capital and liquidity resources. What they don’t have is a recovery-and-resolution system that ensures that their counterparties outside the banking system, those across a trade from them in a CCP, or those in other nations without robust regulatory and resolution systems can stand tall under acute stress.
Since 2008, we’ve built a thoroughly asymmetric financial system in which there are companies able to portray their balance sheets as “fortresses” without prompting guffaws that are exposed to counterparties and relying on market infrastructure that are still built on sand. Big banks were not unreasonably blamed for the past crisis, but reforms to them only emboldened competitors and gave them still greater scope to take on increasingly systemic roles. Macroprudential regulation was supposed to solve for macro-systemic risk, but of course it remains a reality only for big banks subject both to stress tests and, soon, the FRB’s counter-cyclical capital buffer. Other than one or another non-bank financial institution that FSOC nailed to the SIFI cross, the financial market and its infrastructure outside banking remain little changed but a whole lot bigger.
Although August 24, 2015 was no fun at all, the last really close call with a systemic debacle came on October 15, 2014 – a day dubbed either the “flash crash” or “flash rally” depending I suppose on how happy you are. Since these hot flashes, Treasury and the regulatory agencies mounted an all-hands-on drill to figure out what happened and how to prevent another calamity. As noted in FedFin’s analysis of these reports and speeches, all agree that a confluence of factors caused a crisis, but none knows which was the most important or how a repeat could be prevented. The Treasury-market crisis of 2014 isn’t the same as the equity market one on the brink of which we now teeter. However, that we know so little about how the financial system functions so long after 2008 shows how really risky all critical financial markets still remain. Without sound policy, we live or die by the market and the market has a nasty habit of wreaking havoc.
