Toxic cocktail: The global financial system is on shaky ground

There are, however, some less than transparent links between banks and non-banks that might surface more visibly during any bout of significant stress. The recent leveraged buyout of Twitter by Elon Musk has left a group of major banks holding $US13 billion ($20.2 billion) of debt that they can’t syndicate in the current environment.

They are sitting on at least $US500 million, and probably more, of unrealised losses. The Twitter deal isn’t an isolated instance, with a number of other very large buyouts trapping banks in very similar situations. A leveraged buyout of US software company, Citrix, has left banks nursing similar open-ended losses to the Twitter consortium.

Those are the highly visible deals that have come unstuck by the rapidity of the surge in interest rates this year. It is conceivable that there are many more that are less visible. The major US banks reported about $US1 billion of losses on leveraged loans in the September quarter alone.

Those are losses within the regulated banking system, with the banks lending large sums to private equity firms for their buyouts.

What isn’t as transparent is what exposures banks might have to other non-banks – the “shadow” banking system, although the Fed said there had been a rapid increase in lending to non-banks in recent years, with a record $US2 trillion exposure in the second quarter of this year.

The abrupt tightening of conditions and the increased risk aversion in financial systems will make it more difficult for shadow banks to raise funds from other sources, which the Fed said could be a source of increased vulnerability for the financial sector.

In a global financial system short of liquidity and long on uncertainty and fear, even relatively modest events, viewed isolated, have the potential to trigger the kind of market malfunctioning and  threat to systemic stability experienced in the UK.

That increase in risk aversion and shrinking of liquidity is most visible in bond and equity markets, where losses have mounted as rates have risen, and where increased volatility and reduced trading volumes have become of increasing concern to market participants.

In the bond market, the withdrawal of the major buyer, the Fed, as it switched abruptly from buying bonds and mortgages to quantitative tightening – allowing $US95 billion a month of bonds and mortgages to mature without reinvesting the proceeds – and the selling of US dollar assets, mainly bonds, by other central banks to try to slow the depreciation of their currencies against the dollar, has contributed to the increased volatility and thinning of liquidity.

The Fed said low liquidity amplified the volatility of asset prices and might ultimately “impair” market functioning, while increasing the funding risks for financial intermediaries that rely on marketable securities as collateral and that these “potential amplification channels” could interact with leverage within the financial system. That is essentially what occurred in the UK.

It cited uncertainty for the economic and monetary policy outlooks and the war in Ukraine for the lack of depth in the market for shorter-maturity Treasury securities and said similar influences could be seen in other financial markets like equities, crude oil and wheat futures.

Volatility attributable to foreign risks, like the war in Ukraine or China-related risks, could, it said, pose risks for institutions hedging dollar positions as well as for emerging market economies that had borrowed in dollars.

“Continued or more extreme market volatility could contribute to liquidity strains that play out in unexpected ways,” it said. Structural vulnerabilities in short-term funding markets could further amplify the problem.

The seizing up of short-term funding markets in the US in 2019, or the paralysis of those markets at the onset of the pandemic, provided a glimpse of what can happen within the plumbing of a financial system during moments of intense stress and uncertainty.

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There are myriad uncertainties within the global economy and system at present. While monetary policies are probably the most powerful, the impact of the war in Ukraine on energy and agricultural commodity prices and supply and China’s property crisis and the impact of its zero-COVID policies on its economy are other destabilising factors.

While the Fed doesn’t appear to see any immediate threat to financial stability it has identified numerous sources of potential threats.

In a global financial system short of liquidity and long on uncertainty and fear, even relatively modest events, viewed isolated, have the potential to trigger the kind of market malfunctioning and threat to systemic stability experienced in the UK.