This should concern investors, although not because a financial crisis is likely to explode right now — at least not in the headline-grabbing style of 2008. At least two factors mitigate that risk.
First, the US Federal Reserve and other central banks have made it clear that they will do "whatever it takes", to cite Mario Draghi's 2012 promise, to keep markets functioning through the pandemic. Events in March were a case in point: when the US treasury bond market froze, the Fed dived in with extraordinary liquidity support.
Second, banks are not the source of this year's economic shock. They are also much better capitalised in the US and most of Europe than in 2008. "Large US banks entered this crisis in strong condition, and the Federal Reserve has taken a number of important steps to help bolster banks' resilience," Randal Quarles, a senior Fed official, has said. Or, as Morningstar, a financial data group, puts it: "The risk of insolvency and a capital crisis for the US financial system appears to be much lower this time."
However, there is a rub: a financial crisis does not always materialise in the same way it did with the Lehman Brothers' collapse. Sometimes financial stress emerges in a more insidious manner. Purists may quibble about whether such a scenario merits description as a "crisis". But the key point is that chronic stress can be very economically debilitating, as the respondents to the Oxford survey surely knew.
One problem haunting finance, as Carmen Reinhart, chief economist of the World Bank, notes, is that leverage at many institutions was sky-high even before Covid-19. "If you look at financial sector vulnerabilities, in the longer term it is difficult to not be pretty bleak," she told me during a webinar.
Added to this is that it remains impossible to calculate the scale of eventual credit losses from Covid-19 while the pandemic continues to rage, especially as the widespread policy of credit forbearance conceals much of the damage. "Although banks were not the origin of the crisis, they cannot expect to remain unscathed," Hyun Song Shin, chief economist of the Bank for International Settlements, has noted. "The immediate liquidity phase of the crisis is [now] giving way to the solvency phase, and banks will undoubtedly bear the brunt."
Big US banks have increased their reserves to cope with this. But Reinhart fears that those in countries such as India and Italy are less prepared. Furthermore, ultra-low interest rates erode bank profitability.
Another issue is that it is hard to model future risks due to the lack of historical precedent. "Crises usually happen because of a boom-to-bust cycle and investors know what that looks like. This is different," Reinhart adds. As far more financial activity flows through the non-bank sector, via capital markets, nasty surprises can easily erupt.
The trigger for the March freeze in Treasuries, for example, lay among hedge funds, a sector that regulators know less well than banks. If or when interest rates rise, more such shocks could emerge. As Deutsche Bank told clients this week: "We see an increasing risk of financial disruption down the road [from] the growing overvaluation of assets and mounting debt levels."
Of course, such a disruption might not merit blazing headlines, given all the other more immediately worrying pieces of news right now. But investors should remember this: if lenders react to a stealthy rise in defaults — and, most important, a fear of future stress — this could tighten credit conditions despite central banks' policies.
"Surveys [already] show a significant tightening of lending standards," observed Shin. Or as Reinhart notes: "A credit crunch seems really very likely." No wonder Oxford found that fears about finance were poisoning confidence; or that the chance of a V-shaped economic recovery seems increasingly low.
Written by: Gillian Tett
© Financial Times
