Time for alarm over fiscal and fin­an­cial risk

Grow­ing pub­lic debt is one con­cern — another is how it is being fin­anced

Mar­tin Wolf Eco­nom­ics mar­tin.wolf@ft.com

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Prior to the fin­an­cial crisis of 2007-09, the Bank for Inter­na­tional Set­tle­ments made itself unpop­u­lar with mon­et­ary author­it­ies around the world by point­ing to the risks being cre­ated by accom­mod­at­ive mon­et­ary policies, excess­ive lever­age, high asset prices and a lack of trans­par­ency. These warn­ings were ignored. The res­ult was a calam­it­ous fin­an­cial crisis, which not only caused a huge reces­sion, but has also bequeathed a leg­acy of high pub­lic debt and pop­u­list polit­ics.

Once again, the BIS is sound­ing the alarm. It has expressed con­cern over fiscal and fin­an­cial risks for some time. But only last week, its gen­eral man­ager, Pablo Hernández de Cos, former gov­ernor of the Bank of Spain, delivered a sober­ing account of “fiscal threats in a chan­ging global fin­an­cial sys­tem”.

He starts from the fact that ratios of sov­er­eign debt to GDP in many advanced eco­nom­ies are at post-second world war highs. In the absence of an arti­fi­cial intel­li­gence-fuelled accel­er­a­tion in eco­nomic growth, there is good reason to believe these will con­tinue to rise. The reas­ons include the pos­sib­il­ity of fur­ther eco­nomic shocks (includ­ing yet another fin­an­cial crisis), higher yields on gov­ern­ment bonds, age­ing pop­u­la­tions, hos­til­ity to immig­ra­tion, an evid­ent unwill­ing­ness to bear the polit­ical pain of curb­ing fiscal defi­cits and many other pres­sures, not­ably towards more spend­ing on defence. (See charts.)

Rising pub­lic debt is one con­cern. Another is how it is being fin­anced. This is part of a big­ger change, which is the rel­at­ive decline of banks and rise of non­bank fin­an­cial inter­me­di­ar­ies within global hold­ings of fin­an­cial assets. Thus, the ratio of NBFI hold­ings of fin­an­cial assets to global GDP rose 74 per­cent­age points between 2008 and 2023, while that of banks rose by only 17 per­cent­age points. But, warns Hernández de Cos, the com­bin­a­tion of rising gov­ern­ment bond issu­ance with the post-fin­an­cial crisis retrench­ment of banks cre­ated a stead­ily grow­ing gap between the sup­ply of gov­ern­ment bonds and the assets of bank deal­ers needed to sup­port the capa­city of these cru­cial mar­kets to inter­me­di­ate.

NBFIs are a het­ero­gen­eous group. A vital dis­tinc­tion is between “real money” investors, such as pen­sion funds and insurers, and lever­aged spec­u­lat­ors, not­ably hedge funds. The former group of long-term private investors has greatly increased its hold­ings of gov­ern­ment bonds, from an amount worth 82 per cent of global GDP in 2008 to one of 135 per cent in 2023. Mean­while, money mar­ket funds and hedge funds have also increased the value of their hold­ings from 13 to 18 per cent of global GDP over these years. Many of these NBFIs also need to hedge for­eign cur­rency risks, given the rise in their cross-bor­der hold­ings. This has caused a huge jump in their reli­ance on for­eign cur­rency swaps.

So, what do these shifts imply for the sta­bil­ity of mar­kets in gov­ern­ment bonds, which are the bench­mark fin­an­cial assets? There has been one obvi­ous bene­fit, namely that, as inten­ded, banks are less exposed. Moreover, in the­ory, gov­ern­ment bonds should still be the safest fin­an­cial assets. But as the debt moun­tains rise, they must become less safe. Moreover, changes in risk aware­ness are sure to be dis­con­tinu­ous: com­pla­cency one day, and panic the next.

In addi­tion, there is con­cern about the risk-bear­ing capa­city of — and bal­ancesheet con­straints on — NBFIs. Thus, dur­a­tion match­ing by pen­sion funds and insur­ance com­pan­ies caused destabil­ising feed­back loops in the UK gilt mar­ket shock of 2022. Another risk is the pos­sib­il­ity of fire sales of gov­ern­ment bonds by money mar­ket funds and other such inter­me­di­ar­ies, in the event of a rush of redemp­tions, because these are the most liquid assets. Finally, for­eign cur­rency losses can trig­ger cap­ital flight and col­lapsing bond prices.

These risks are now well known. But the speech emphas­ises newer ones, too. One con­cerns the lever­aged trad­ing strategies of hedge funds. The lat­ter have been able to bor­row amounts equal to, or even greater than, the mar­ket value of their col­lat­eral, with no hair­cuts. About 70 per cent of bilat­eral repos taken out by hedge funds in US dol­lars are, for example, offered with zero hair­cuts. This could exacer­bate mar­ket shocks, as fund­ing dis­ap­pears. Again, less lever­aged investors, such as pen­sion funds, are, accord­ing to Hernández de Cos, exposed to “dol­lar fund­ing rollover risks related to their use of FX deriv­at­ives”. In essence, “by using FX swaps they are . . . trans­form­ing cur­rency risk into matur­ity risk”.

The point is that the instabil­ity caused by lever­age and matur­ity mis­matches has not dis­ap­peared just because banks are less import­ant than they were. One solu­tion is what Hernández de Cos calls “con­gru­ent reg­u­la­tion”: when vul­ner­ab­il­it­ies are sim­ilar, so should reg­u­la­tion be. But, inev­it­ably, the sheer het­ero­gen­eity of the play­ers is going to make this very dif­fi­cult. More con­cretely, he sug­gests, there should be greater use of cent­ral clear­ing and impos­i­tion of min­imum hair­cuts. Today’s zero hair­cuts, he warns, allow some mar­ket par­ti­cipants “to oper­ate with as much lever­age as they want”. That can­not end well. Two fur­ther les­sons emerge. One is that the greater the fra­gil­ity of NBFIs, the more con­trol there must be over the sta­bil­ity of banks that fin­ance them. The other is the need for greater trans­par­ency.

Another round of fin­an­cial crises would be a night­mare. But it would be worse still if states had ceased to be cred­it­worthy and their money to be sound. Some sug­gest, wrongly, that the answer is to let banks replace NBFIs yet again. A far bet­ter solu­tion is to make gov­ern­ment fin­ances safer.