Market participants have warned about liquidity shortages and market volatility as possible causes of the next so-called black swan event.
The term ‘black swan’ was popularised by writer Nassim Nicholas Taleb in his 2001 book. It is used to describe events that are highly improbable and have a catastrophic effect. In a panel discussion at the Asian Banker Summit yesterday in Hong Kong, speakers warned about areas vulnerable to these black-swan events.
Even though regulators globally have worked to improve the stability of the financial system by introducing new rules and capital adequacy requirements – most recently total loss-absorbing capacity (TLAC) – significant risk remains in the markets.
“By focusing too much on extreme events… sometimes we lose focus of what are the major risks out there which may be preventable,” said panellist Alicia Garcia-Herrero, chief economist for emerging markets at BBVA.
Instead she recommended focusing on outcomes, rather than the event itself. She added: “I think that word is liquidity, liquidity, liquidity,” she said.
Liquidity
The economists on the panel were focused on liquidity – and potential shortages of it.
A lesson central banks learned during the financial crisis is the difficulty in drawing the line between a liquidity problem and actual insolvency, said Satoru Yamadera, principal financial sector specialist in the Asian Development Bank’s regional and sustainable development department.
He highlighted the recent efforts between Asian central banks and finance ministers for making cross-border collateral arrangements for emergency cases. “Central banks are ready to be supportive if some unforeseeable events happen,” he said.
But Garcia-Herrero warned: “Let’s not forget that what is happening here is huge issuance in US dollars everywhere.”
She feared that swap lines with the Federal Reserve were not sufficient, and said that some others have expired. “I really don’t think we have enough liquidity mechanisms to avoid the next dollar shortage,” she said. “That to me is not a black swan – it’s a reality. It’s a huge potential risk.”
However US dollars aren’t the only risk. Other major currencies could have issues – for example, the supply of euros outside of the Eurozone.
Shifting risk
But a broader issue is the shifting of risk into the markets and into less-liquid entities – such as through shadow banking – due to increasing global regulation on banks.
An unintended consequence is increased market volatility.
Jeffrey Yap, chief executive officer at hedge fund Ark One, noted market events in the last 24 months such as the Swiss franc’s free float, the fall in oil prices and the surge in equity prices globally. He believed that many of these are due to banks being removed from the equation; global regulations mean that they can no longer warehouse risk.
“Things are going up and down because you’ve taken out the liquidity provider in the middle,” he said.
And that hasn’t resolved the issue of where risk will be warehoused in the markets. Yap believed that if banks were not constrained by rules such as Dodd-Frank and other global regulations, prices would not have reacted as they have in the last 24 months across asset classes, including commodities and equities among others.
“To me that’s very important because you’re moving the risk from the banking system into the markets,” he added.
He said: “We don’t know where the black swan is but having no last liquidity provider when the market needs it is fairly dangerous in my opinion.”
And any issues could be magnified by the growing shadow banking market; money has migrated from banks to less-regulated entities. While central banks have a transmission mechanism to provide liquidity to banks, they may be unable to deliver that liquidity to less liquid areas of the market.
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