Thursday, 28 April 2016

The trigger for the next financial crisis

We know that financial crisis are recurring. The last one was in 2008, almost 8 years ago, so it is not difficult to forecast that a new one is in the making.

The trouble for investors is that it is almost impossible to forecast when a new crisis will arrive. It may be next month, next year or in five years. Who knows?

Another annoying feature of financial crisis is that it is equally difficult to foresee which drop will spill the glass, that is, what will be blamed as its trigger.

Paul Krugman just listed two possible candidates – China and oil – in his NYT op-ed “The 8 A. M. Call”.

So, let me add another candidate – IRRBB Interest rate risk in the banking book – caused by the excessive reliance of banks on the derivatives market.

This choice may sound odd, given that the Basle Committee has been working hard on new standards for this risk which will be implemented in 2018, aimed at preventing IRRBB to materialize when interest rates normalise from historically low levels. Indeed, the notional value OTC derivatives which at end-2014 was 6.5 times larger than all outstanding debt securities has been reduced by 70 trillion USD in the first half of 2015.

It really does not matter if the crisis is triggered in these markets, or any other place like the M&A or the currency markets. The “fire” can be started anywhere, as long as the “wood” is close enough to spread it by contagion.

What matters is to know whether the “firemen” are capable of containing it.

In this regard the perspectives are frightening, given the resistance to apply the so-called Volcker rule to ring-fence commercial banking from investment banking, the exhaustion of ammunition by central banks to deal with a liquidity trap and the balance of public finances in some major economies.

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