Financial System | Macrosynergy Research

Inefficiencies of financial institutions, laws, and regulation are at the heart of systemic risk. The most critical areas of financial intermediation are the regulated banking system (due to its massive leverage), the so-called shadow banking system (due to its lack of transparency and dependence on collateral values), institutional asset management (due to its massive size and rapid secular growth) and emerging markets, particularly China (due to evident inefficiencies and political context).

The amounts at stake in global financial intermediation are huge. The total debt of households, corporates, and governments reached almost 290% of global GDP in 2014 and has remained on a path of expansion even after the great financial crisis (view post here). The total amount of credit, outstanding bonds, and stock market capitalization is much higher. The global total of outstanding over-the-counter (OTC) and exchange-traded derivatives has soared to USD700 trillion or almost 1000% of world GDP.

Key areas of financial system risk for markets

The regulated banking system

The regulated banking system has a powerful impact on macro trading strategies, through various channels. The great financial crisis revealed vulnerabilities of its capital structure, liquidity reserves and resolution regimes. This has given rise to an unprecedented expansion and tightening of regulatory rules that include a massive increase in minimum capital ratios, mandatory minimum leverage ratios, new compulsory liquidity ratios and new resolution regimes. The new rules may have unintended consequences, however, including tighter bank lending conditions and more regulatory arbitrage.

The shadow banking system

Shadow banking refers to financial intermediation outside the reach of standard regulation. Shadow banks engage in term, credit, and liquidity transformation similar to regulated banks and function principally to channel institutional cash pools to the funding of asset holdings. This makes them a key force in financial markets. Often this intermediation takes place in a complex multi-institutional setting. The special vulnerability of the shadow banking system arises from its dependence on collateral (asset) value and the absence of a safety net in form of central bank backstops.

Institutional asset management

Institutional asset management seems to be in structural ascent, due mainly to demographic developments. The importance of asset managers for global financial conditions is now comparable in importance to the regulated banking system. Asset managers bear much less leverage than banks, but the sheer size of their asset holdings and their vital role for market liquidity and leverage in the shadow banking system has created substantial vulnerabilities. There is evidence that institutional asset managers and their clients can be the source of self-reinforcing market momentum.

Emerging markets and China’s financial system

The importance of emerging markets for the global financial system and their own local economies has grown substantially since the 1990s. As a consequence EM economies and even political systems are now more dependent on global financial conditions, while the their feedback potential onto developed markets has become stronger. A particular concern in China, due to the massive size of its economy and the aggressive use of financial repression to sustain high levels of leverage and investment. The widely expected trend decline in economic growth will put the sustainability of private debt, corporate earnings and property prices to a test.

Key areas of financial system risk for markets

The regulated banking system

The shadow banking system

Institutional asset management

Emerging markets and China’s financial system

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