By Mohamed A. El-Erian for Bloomberg
Intervening 10 years ago to contain the damage from the banking system’s excessive risk-taking in mortgage-backed securities, the European Central Bank initiated what has proven to be an exceptional and prolonged involvement in markets by central banks. Much has changed since then, yet too much remains the same. The risk of unsettling financial instability, while lower, has morphed and migrated but has not disappeared.
On Aug. 9, 2007, an announcement by BNP Paribas brought to life investors’ worst fear: that, regardless of price, they would not be able to redeem any of their holdings in three investment funds. Underlying this dramatic announcement was excessive exposure to inherently illiquid securities by investment funds that overpromised investors access to their funds.
Realizing the threat to systemic financial stability, the ECB under the leadership of Jean-Claude Trichet did what central banks do best in these situation to avoid cascading market failures — it provided ample liquidity. But neither officials in Frankfurt nor at other major central banks, let alone at ministries of finance, realized that there was a much larger problem — that of excessive risk-taking by a banking system.
Stretching afar for yields and comforted by implicit and explicit backstops provided by governments, banks had already exposed too much of their balance sheet to illiquid and hard-to-price securities. Problems were about to multiply over the next 13 months, putting in doubt the most critical element of the financial system — that is, confidence in settlement and payment — with the resulting danger of a “sudden stop” for financial and economic interactions, both domestic and international.
This all culminated in September 2008 in a financial crisis that would take the global economy to the precipice of a depression. Having no alternatives, central banks engaged in a way that was once thought unimaginable, opening many new emergency funding windows, buying all sorts of securities and slashing interest rates. This was accompanied by government injections of trillions of dollars of taxpayers’ money to save banks around the world.
The plan was to avoid a forced financial deleveraging, in the short term by replacing sources of private credit with public ones while significantly strengthening bank supervision and regulation, and in the longer term by promoting significant growth to allow for an orderly reduction in debt burden without sacrificing too much economic activity.
Significant progress on the short-term measures was not accompanied by enough on the long-term ones. With that, the risk of financial instability has evolved and shifted to non-banks, still with negative possible consequences for the real economy.
On the positive side, payments and settlement systems have been strengthened in a manner that significantly reduces the likelihood of paralyzing sudden stops.
But while the risks posed by the banking system have been reduced markedly, those assumed by financial players that aren’t banks have come roaring back, as traders and investors have been conditioned to rely on ample market funding.
The strong “quest for yield” remains visible in non-banks, including what most deem to be a stretched market for high-yield bonds. There has been a proliferation of products, including some exchange-traded funds, that over-promise liquidity access to investors, again particularly in the corporate space for both advanced and emerging market segments. Areas vacated by banks are being filled by other institutions that are subject to less regulatory scrutiny, and their reliability is yet to be tested in a full market cycle.
Admittedly, there’s lower systemic risk overall. There is little, if any, explicit call on guarantees backed by taxpayer funding for non-banks. The counter-party risk involved is lower. And, most importantly, it is quite far from the payments and settlement system.
As comforting as this sounds, the coast is far from clear. There is still too much debt in some of the more uncertain and slow-growing segments of the corporate and global economies. Should the ruling market paradigm shift suddenly, the “liquidity delusion” underwritten by the non-banking sector could result in asset class contagion that leads to sharply lower market prices. And should this persist in a disorderly fashion, in turn it could easily dampen both investment and consumption.
The ECB’s emergency response 10 years ago was part of an impressive central bank effort to contain systemic risk and safeguard the global economy. It has worked remarkably for banks, especially in the U.S., but at the cost of shifting risks elsewhere. If central banks’ efforts are not accompanied by more determined government action to enhance current and future growth dynamics, the lessons learned may not be enough.