In a deeply connected global financial system, contagion may be inevitable
Is it possible to talk about financial contagion without perpetuating it?
Regulators and public officials are anxious to be reassuring, but for Canadians trying to understand how a series of ostensibly unconnected global bank failures could affect them, being like the meme dog in the burning kitchen that turned 10 this year may not be the best plan either.
After market turbulence last week, worries continued over the weekend. New reports on Sunday said money market funds had swollen by $286 billion US in two weeks as people withdrew deposits from banks. Also on Sunday, International Monetary Fund managing director Kristalina Georgieva warned a Beijing audience of the growing risk of global financial instability.
As shares in Frankfurt-based global investment banking giant Deutsche Bank fell 14 per cent in early trading on Friday and U.S. Treasury Secretary Janet Yellen held an unscheduled in-camera emergency meeting of the Financial Stability Oversight Council, it was pretty clear that what seemed like an isolated failure of one overextended California bank is still sending out ripples around the world.
Last week, Yellen told depositors that U.S. banks were safe and sound. While calming words are nice, emergency meetings are not entirely reassuring.
The phenomenon of financial contagion is not new and has been widely studied.
"Financial contagion describes the cascading effects that an initially idiosyncratic shock to a small part of a financial system can have on the entire system" sounds like a discussion of the collapse of Silicon Valley Bank (SVB) about two weeks ago and the events that followed, but the quote actually comes from the 2013 Handbook of Safeguarding Global Financial Stability.
And while experts know that such a cascading series of events can sometimes be hard to stop, financial experts who are themselves deeply embedded in the same financial system are, quite reasonably, anxious to explain that the problem is limited to unique causes that can be fixed.
Likelihood of crisis 'quite limited'
"So far, the problems have been concentrated in U.S. regional banks and one specific weaker entity in Europe," said a report issued early Friday from the Netherlands-based ING, whose shares also fell sharply on the day. "The European issue has been more or less addressed by prompt interventions by the Swiss government and central bank.
"This makes a likelihood of a wide systemic crisis quite limited," said the report, titled Market Turmoil: Making Sure You Don't Make a Drama Out of a Crisis … Yet.
The question that is so difficult to answer in the heat of the moment is what is causing the contagion and the correct analogy to choose. Is it just a "weaker entity" or two that will soon stabilize. Or is it like an accumulation of snow at the top of a financial mountain built up over a period of low interest rates and loose lending?
According to Jacqueline Best — a University of Ottawa political studies professor who has examined previous periods of inflation and market instability, and who is currently doing research as the Visiting Hallsworth professor at the University of Manchester in England — the fact that the correct analogy is unknown as a crisis begins perpetuates contagion.
As someone who studies financial crises, she says her feelings are torn.
"These are fascinating times, intellectually, for me, but deeply worrying personally," said Best, speaking on the phone from England as European markets were closing on Friday.
In a theoretical sense, she said, contagious market rises and falls are a combination of psychological and real factors, tied to the concept of "animal spirits" proposed by John Maynard Keynes during the Great Depression after the market crash of 1929, as periods of enthusiasm are replaced by fear.
Searching for buried bodies?
In the current case, the flaws found at SVB and Credit Suisse mean everyone is looking for similar flaws elsewhere.
It is a well-known concept that rising markets can cover up a lot of unrecognized creative accounting, risk-taking and outright fraud that are only revealed once falling markets require that someone be paid.
That's the concept that the falling tide shows who has been swimming naked. But Best has a more macabre analogy.
"If we don't know enough about where the bodies are buried, that's where you can get crises jumping from sector to sector, institution to institution, from country to country," she said.
"The self-fulfilling dynamic of markets can be quite rational," Best said. "Once you see that others are selling or withdrawing their deposits in large number, it is rational to do the same thing as quickly as you can."
The other real kind of contagion is the unforeseen impact when solving one problem leads to another. Last week, U.S. Federal Reserve chair Jerome Powell warned of the effect of "tighter credit conditions," which at its extreme is called a credit crunch where no one is willing to lend.
Another unexpected impact has been caused by a financial tool intended to prevent bank failures.
Few Canadians even knew that AT1s existed before last week. Now the special bonds intended to help banks in distress are leading to a cascade effect of their own after the shutdown of Credit Suisse turned $17 billion US of AT1s into worthless paper.
It is hard to imagine in advance the chain of events that will lead the next domino to fall. It may be even harder for Canadians to think about how a global crisis could affect them.
Canadians like to complain about their banks, but Best points out that Canada's small number of large and well-regulated banks have been a bulwark against previous crises, including in 2008.
"We did better than many, many other major economies," she said. "But that said, it was also pretty miserable."
We are part of a global system, and if global finance gets bad enough, we may discover there are bodies buried in Canadian institutions if the economy faces a deeper recession, which can affect politics, businesses, budgets, jobs and real estate.
"That's where I get particularly concerned because of the Canadian vulnerabilities right now with huge indebtedness and so on. It's pretty clear that certainly in a more significant recession, we could potentially have a worse time of it this time around," Best said.
It is not just ING telling us in its report that a wide systemic crisis is unlikely. But rather than saying, "This is fine," being just a little bit frightened and a little bit careful may be a good strategy for the country and for individual Canadians.
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