The aftermath of the global financial crisis of 2008, followed in Europe by the sovereign debt crisis, mainly consisted in the adoption of new, more stringent economic and market discipline instruments for the Eurozone Member States.
On top of that, crisis-response mechanisms have been put in place, such as the EDIS, the Single Resolution Fund, the European Stability Mechanism, to name a few, which can be described as safety nets for public, private or individual actors in the capital markets.
But, is this enough to avoid a new financial calamity?
A couple of articles in last week’s brief seem to suggest otherwise. Financial researchers, journalists and analysts have flagged risky trends in the investment world that could be signalling an impending crisis.
When investors get stuck in the past
Buttonwood’s notebook (The Economist) reveals that investors are relying on past performances reported in capital markets (in long-term investments, 25yrs or 30yrs) in order to make predictions for future financial transactions. It is described as ‘the tendency to assume that the future will resemble the past’, although evidence indicates otherwise.
The article presents the moot case of a pension fund in order to illustrate that figures reported back in 2001 tell a very different story from results now, considering the same proportion and level of the fund’s assets under management. He explains the tendency to speculate on future high returns, in spite of high market valuations, as ‘cognitive dissonance’. In reality, and contrary to what investors predict (based on their targets and financial transactions), future yields for bonds and the value of equities and other stocks are likely to be low.
Insurers’ risk-taking might cause the next crisis
Tim Wallace and Anna Isaac report on an IMF warning concerning the risky financial placements by insurers and banking institutions. In the quest to increase revenues, either to have a higher coverage in case of a default (for insurers) or either to prove ‘resilience’ in times of financial hardship (for banks), they are mostly invested in high-risk assets.
According to the authors, these risky strategies are favoured because capital markets currently report historically low interest rates, meaning that the quest for higher returns necessarily entails higher risks. But, whereas this strategy could prove well-inspired for some, it leaves the majority ‘massively exposed if markets take a turn for the worse’.
Take, for instance, the low credit rating (BBB, which is the lower medium grade creditworthiness, according to S&P) of ‘at least a third of the bonds owned by American and Equity insurers’.
One in five FTSE 100 pension funds at risk of failure in a recession
Another story, by Iain Withers, covers the capacity of British occupational pension schemes of surviving an economic recession. He remarks that, after applying the Pension Protection Fund’s stress test to the top 100 companies (based on market capitalisation) listed at the London Stock Exchange, 20% proved to ‘be at risk of failure if Britain entered another economic downturn’.
The finance industry ten years after the crisis
The article ends with a striking remark: ‘[a]t the heart of the next economic crisis will be the finance business’. It focuses on New Financial’s report on the effects the crisis of 2008 has had on the finance industry.
The report points out that yields have dropped to a historical low (with prices growing) because of the QE programmes undergone by Central Banks in their quest to buy off non-performing assets that were weighing heavily on the industry’s shoulders. The statistical data shown in the report speak for themselves:
Return on capital for banks, in 2016, was less than half that of 2006;
- Profits for investment-banking have fallen by 46%;
- The combined level of debt (sovereign, household and non-financial) in the Eurozone was 428% in 2016, although asset prices continue to grow;
- The investment market is more concentrated, with 20 firms managing 42% of total assets under management;
- ‘[T]rading volumes in equities, foreign exchange and derivatives have increased in real terms’; and so on…
As pointed out at the beginning of this article, more stringent rules and limitations imposed on the finance industry do not fully address the problem. Nevertheless, it does make it ‘less likely to suffer an exact repeat of the last crisis’.