Since 2008, investors around the world have had one eye in the rearview mirror, wondering when the next crisis will hit. It’s a topic of numerous client conversations we have in the office, on the phone, and around the coffee table. Naturally, our first inclination is to expect the next panic to resemble the last (a credit crisis of some sort). Whether that is the specific catalyst for the next bear market only time will tell. However, what is certain is that a lot of effort has been made by our government to protect us against precisely that risk, including implementing the Volcker Rule and Dodd-Frank. While the intention of this post is not to focus on the merits of these legislations, we do want to communicate that we are aware of some new risks popping up as unintended consequences of these efforts.
In a recent opinion piece in the Wall Street Journal, Stephen A. Schwarzman (the CEO and co-founder of Blackstone) sees several potentially growing risks that worry us as well:
Lack of Liquidity — Although central banks around the world have saturated some markets (e.g. government bonds) through low interest rates and quantitative easing, this masks the shallowness of others.
“The Volcker Rule, for example, bans proprietary trading by banks. The prohibition, when combined with enhanced capital and liquidity requirements, has led banks to avoid some market-making functions in certain key equity and debt markets. This has reduced liquidity in the trading markets, especially for debt. A warning flashed last October in the U.S. Treasury market with huge intraday moves, unrelated to external events. Deutsche Bank has reported that dealer inventories of corporate bonds are down 90% since 2001, despite outstanding corporate bonds almost doubling. A liquidity drought can exacerbate, or even trigger, the next financial crisis. Sellers will offer securities, but there will be no buyers. Prices will drop sharply, causing large losses for investors, pension funds and financial institutions. Additional fire sales will aggravate the decline.”
Mr. Schwarzman is not the only one to notice this phenomenon. Bill Gross, the famed bond king, when asked about events in October 2014, stated that there is “very little liquidity” in the corporate bond markets, especially in high-yield debt. “Everyone is trying to squeeze through a very small door.”
Focus on Stress-tests, Not on Lending — Another unintended consequence of the new regulatory framework is that banks seem to have successfully passing government stress-tests as higher goals than providing loans to businesses and consumers. Small community banks in particular have been affected, and many have simply closed their doors:
“Small business owners will be particularly vulnerable because the number of community banks declined by 41% between 2007 and 2013. Recent studies by economists at the Richmond Federal Reserve and Harvard University both concluded that the 2010 Dodd-Frank financial law contributed to this decline. Dodd-Frank has disproportionately burdened community banks, despite their having no role in the financial crisis. We must revisit Dodd-Frank’s application to community banks because of their special relationship with borrowers in agriculture, small business and local real estate.”
Threat to the Banking System Safety Net — Finally, some politicians have even felt the need to go after our Federal Reserve’s ability be the financial back-stop to our banking system, due to the unpopularity of the 2008-09 bail-outs.
“In a financial crisis, only the Fed, as the lender of last resort, might stand between our economy and financial catastrophe. We must leave the Fed with the flexibility to provide liquidity in order to stop a financial panic. While moral hazard is a legitimate risk, limiting the Fed’s ability to enhance systemic safety is, as former Fed Chairman Ben Bernanke has said, like shutting down the fire department to encourage fire safety.”
Again, our goal is not to criticize the new legislative framework in which we find ourselves, although some of that is probably warranted. Our goal is to communicate that while the previous hole in the dam may have been patched, the patch itself has created new cracks to watch. And of course, there are many other weak spots as well, unrelated to regulation or even the banking system, such as investor expectation, general economic conditions, and geopolitical events. As your Personal CFO, our job is to stay vigilant and wary towards these cracks as they become visible or widen. We may not be able to completely avoid them, but we can watch for new opportunities that present themselves in their wake.
Read the full WSJ article here.