What are the big risks to the stability of western financial markets today? This week I posed that question to powerful finance industry professionals at the Milken Institute global conference in Los Angeles.
Grexit was mentioned. So was a slowdown in China, Middle East instability and the looming US interest rate rise (although, when asked when the Federal Reserve would start raising rates, more than half of the audience thought it would not happen until 2016).
But there was another, more esoteric concern on almost everybody’s lips: liquidity mismatches deep in the bond markets. Seven long years after the 2008 crisis, reforms to the financial system have produced some success, in the sense that regulated banks have reduced their risks. But they have not just moved out of some of the crazier arenas, such as ultra-complex derivatives, in which they operated before 2008; they have left more mainstream areas, too. The inventories of US corporate bonds held by broker-dealer banks have plunged
from $300bn in 2008 to $50bn, according to research from CQS.
This is a classic unintended consequence. It has reduced the ability of banks to act as market makers, standing ready to buy or sell when investors want to trade, leaving it harder for others to do so. So while the stock of outstanding US high-grade corporate bond has risen since 2008, from $2,800bn to $5,000bn, the level of market turnover has tumbled to “at or close to the lowest levels on record”, Barclays says.
What makes this pattern particularly pernicious — and worrying to those Milken guests — is that while banks have cut their inventories of bonds, asset managers have recently been gobbling them up on a formidable scale in a search for yields. It is estimated that in the past year more than 70 per cent of corporate credit was purchased by investors such as mutual funds, a dramatically higher figure than before.
In theory, this could deliver benefits for the wider financial system; after all, if non-bank actors buy corporate credit, that diversifies risks. But the catch is that many asset managers rely on potentially flighty forms of funding. Mutual funds, for example, typically have to return investor funds on demand (in the jargon they operate with “daily liquidity”). And that creates liquidity mismatch: if US rates suddenly rise, retail investors might flood out of bond funds — since they fear the move will trigger sharp bond price falls — forcing those funds to sell. If that happens, those funds might discover the bonds are completely illiquid, or untradeable except at rock bottom prices, like those subprime assets back in 2008).
Is there any way to mitigate this risk? Regulators show little willingness to roll back regulatory reforms. Nor are they keen to use public money to keep markets moving (although some central bank governors privately admit that, if a really big crisis were to hit, central banks could eventually be forced to make markets themselves).
The key is to watch what the rest of the private sector might, or might not, do as banks retreat. There are plenty of actors still flush with liquidity: as Josh Harris, co-founder of Apollo Global Management, points out, private equity funds have big untapped resources and might buy bonds if the prices fell.
There are also signs that entrepreneurs are moving in to fill the void. “Creative destruction as banks are forced to evolve opens up enormous opportunity [for others],” argues Bill Blain of Mint Partners, a small London broker. Most notably, new trading platforms are springing up to provide alternatives to the banks, including one run by Mint.
Meanwhile, some banks are turning entrepreneurial. Last month State Street unveiled a service to enable its asset manager clients to assess their vulnerabilities and liquidity needs and help them withstand any future shock. The custodian bank knows asset managers face growing pressure from regulators to strengthen their buffers — and wants to jump into a new business niche.
Although these entrepreneurial responses are encouraging, it is unclear whether they will be enough to avoid future jolts, given the sheer scale of the structural mismatches.
Thankfully, nobody expects the test to come quite yet. And if a Fed rate rise is delayed until 2016 asset managers will have more time to prepare — and more entrepreneurs will jump in. Or so the hope goes. But, if nothing else, the pattern is a potent reminder that the problem of liquidity and maturity mismatches did not disappear with the 2008 crisis. Nor did the potential for some investors to keep ignoring them until it is too late