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Market complacency around global financial system risks [ClearOnMoney]
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Market complacency around global financial system risks

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Commentary

Market complacency around global financial system risks

11 Oct 2012 by Jim Fickett.

The IMF's twice-yearly Global Financial Stability Report was extremely useful in the runup to the last crisis, and so it is worth keeping an eye on now, as well. Below are some summary extracts from the most recent report, which came out this week, on the US, Europe, Japan and global financial reform. To me the overwhelming impression is of market complacency in the face of significant risks.

Regarding the US, the GFSR says, in a very polite way, that no one in their right mind would own long Treasuries.

unsustainable debt dynamics remain the key medium-term concern. If compressed credit spreads rise in a disorderly or rapid manner, longer-term fiscal risks could pose increasing stability challenges for the United States and the global financial system. Markets are not pricing in such an outcome, suggesting a degree of complacency, as reflected in extended long positions in Treasury bills across broad investor classes, in which interest rate risk, given near-zero policy levels, is essentially all one way.

Europe is still the current focus of financial system risk. Despite the relative quiet from Europe since Draghi said the ECB would do “whatever it takes” to save the euro, the GFSR is very clear that

The euro area crisis remains the key threat to global financial stability.

Here is one graph that puts the recent improvement in credit spreads in perspective:

This is for banks, but the banks and the governments are so tightly linked that the spreads move in tandem. Clearly the recent improvement is relatively small when seen on a larger time scale.

The continuing migration of deposits from the periphery to the core means it will take more than cheap money from the central bank to fix the crisis:

Regarding Japan: the GFSR says that there is really no rational reason for markets to treat Japan more favorably than the European periphery:

Japan has been a beneficiary of safe-haven inflows from Europe and elsewhere, with yields on Japanese government bonds (JGBs) reaching record lows. However, the problems of high sovereign debt and a concentration of government bond risk in the banking system are as characteristic of Japan as they are of euro area sovereigns currently under market pressure.

And here is a very scary chart showing just how vulnerable Japan's banking system is to a market rise in rates:

Globally, there has been much talk of tighter regulation and reform of the banking system to prevent another crisis like the last one. The GFSR is honest in saying that so far the results are unimpressive:

despite improvements along some dimensions and in some economies, the structure of [financial] intermediation remains largely unchanged. The data suggest that financial systems are still overly complex, banking assets are concentrated, with strong domestic interbank linkages, and the too-important-to-fail issues are unresolved. Innovative products are already being developed to circumvent some new regulations. These same traits have been linked to the crisis, suggesting financial systems remain vulnerable.