Banking dynamics, credit supply and systemic risk

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Credit drives economic growth. And when credit dries up after a financial crisis, consumers, lenders and even governments can face a self-reinforcing spiral of distress. Since 2007 many individuals and countries have experienced this crippling and potentially catastrophic spiral. In the US alone, more than 4 million homeowners have lost their properties[1] while Eurozone unemployment numbers have increased by 6.9 million[2]. What has been less apparent is the need for a sustained and diversified credit supply as this distress spiral takes hold.

 

While several factors determine the supply of credit, two of these have reversed since this financial crisis started

•  a bank leveraging trend has become a de-leveraging dynamic (driven, in part, by incremental risk capital and liquidity requirements); and

•  markets for credit risk transfers between financial institutions have collapsed.

 

Reviving a sustainable credit supply will depend, amongst other things, upon a revival of the collateralised credit risk transfer market[3]. And for the credit risk transfer market to revive properly, adjustments to the information and transaction dynamics between ultimate borrowers, ultimate lenders and their intermediaries are needed [4]. That is, current market norms in both the regulated and non-regulated (i.e. “shadow”) banking sectors need to shift in response to the lessons learned from the most recent crisis.

 

How well we do this will determine the speed and robustness with which the lending and risk transfer markets recover. It will also define their future contribution to broader systemic risk in the financial network. Stated more simply, how we adjust these markets will determine their susceptibility to repeating the latest crisis as well as how well regulated and non-regulated banking are positioned to support our economic growth ambitions. 

 

[1] see page 2, “A leaf being turned”, a speech by Andrew Haldane, Bank of England, 29 October 2012

[2]  This is more than the combined populations of Europe’s second and third largest cities, Berlin and Madrid. Youth unemployment in Italy, Ireland, Spain, Greece and Portugal exceeds 33% as of September 2012 (and in some of these countries it exceeds 50%). Mervyn King, the governor of the Bank of England, has stated "this is the most serious financial crisis at least since the 1930s, if not ever" - sources: Eurostat [une_nb_m] and [une_rt_m] Euro area (17 countries) statistics; for Mervyn King's comment see http://www.guardian.co.uk/business/2011/oct/06/britain-financial-crisis-quantitative-easing

[3] notably the market for repurchase agreements (“repos”) and securitisations between financial institutions, whether the participants are regulated or not

[4] n.b. a credit risk trade is likely to revive, one way or another. The question is in what form?