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Unearthing the Dark Secrets of Our Global Financial System: Are We on the Brink of a Collapse?

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The global monetary landscape is currently on shifting sands, with growth predictions encountering a slump, predominantly due to weaknesses arising from the Chinese and European economies. Compounded by military conflicts in areas like Gaza and Ukraine, and further amplified by the surge of oil prices, with Brent crude surging past $90 per barrel, the global economy is set for an exciting yet unpredictable ride.

But the question stands – Just how robust is our global financial structure?

Recent crisis with the Silicon Valley Bank (SVB) and Credit Suisse earlier this year gave a premonitory signal that not everything was rosy. However, timely intervention by the Fed and Swiss authorities helped retrieve the dwindling confidence. Today, despite the prediction of interest rates standing ‘higher for longer’, stock prices across the U.S and Europe are almost 10-12% elevated compared to the starting of the year. The overall financial ambiance is not as rigid as it used to be since the monetary policy has relaxed a tad bit.

The IMF’s Global Financial Stability Report (October 2023), alarmed us of potential vulnerabilities. It’s not surprising since global real estate value is thrice the GDP, implying a 10% decline would impact the asset wealth by a drastic 30% of GDP. History reveals banks’ susceptibility to falling real estate prices as these comprise a lion’s share of their collateral for bank credit. According to IMF, “Advanced economies have witnessed a drop of 8.4 percent in the real house prices in the first quarter of 2023, whereas the emerging markets saw a moderated decline of about 2.4 percent.”

Adding a long-term vision to their analysis, IMF threw light on the threat global warming poses on bank assets. The ability to furnish financing for current climate action-associated investment needs which are projected to raise from a hefty $2 trillion to an enormous $4 trillion annually, remains an uphill task for the financial system.

The Financial Stability Board (FSB), established after the 2008 crisis to champion the cause of global financial stability, released its Annual Report recently. The FSB believes its framework and prompt action helped alleviate the SVB and Credit Suisse induced crisis. But the global financial system still nurses vulnerabilities, some of which have magnified due to changes in the risk dynamics. The FSB is increasingly focusing on the emerging crypto-asset market, along with climate-related vulnerabilities and cyber risks.

The constant dread for FSB is the non-bank financial institutions (NBFIs) which were about 49.1% of total financial assets at the end of 2021. These lightly regulated bodies pose a threat of shifting system risks into the under-monitored NBFI area with potential hidden leverage. The runs on money market funds during periods of tight liquidity highlight areas where central banks fear problems spreading to the banking system.

Recently, The Center for Financial Stability, a non-profit think tank, released reports on “Supervision and Regulation after Silicon Valley Bank”, and “The Role of Monetary and Fiscal Policies in Recent Bank Failures”. Notably, the reports point out how a groupthink and blindspot allowed major banks like SVB, Signature Bank and First Republic to fail, casting a light on the role of oversight from financial regulators.

The overarching theme here is the expanding ‘safety net’ of central banks, who are increasingly buying a myriad of assets, ostensibly patching leaks in the financial system, but potentially building up a house of cards. For example, the Fed’s Bank Term Funding Program (BTFP), a lifeline created post-SVB failure in March 2023, has essentially offloaded bank’s mark-to-market losses onto its own books, propping up their balance sheets and potentially masking underlying issues.

The presumptive faith in central banks’ bailout powers has led investors to overlook financial risks. However, when fiscal discipline is disregarded, and central bankers don’t step in to balance the scales, we could be heading for a period of financial instability, inflation, or both. As always, the key is to properly assess and manage risk while keeping a long-term perspective.

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