Be warned. The global financial system in 2021 will face a gigantic stress test.
This follows from one of the more important lessons that emerged from the coronavirus-induced market turmoil in March last year — a lesson that is worth revisiting.
The so-called dash for cash was in part a reflection of how the big banks’ balance sheets had failed, since the 2008 financial crash, to keep pace with the growth in the stock of US Treasury securities that was spurred by the post-crisis surge in federal deficits.
Their ability to act as intermediaries in the Treasury market was thus impaired. And their readiness to provide liquidity to the market by absorbing investor flows on to their balance sheets, as opposed to simply matching buyers and sellers, was further reduced by the tougher capital and liquidity rules introduced after the financial crisis.
The stricter regulatory framework was, in one sense, good for financial stability. The banks emerged relatively safe from last year’s crisis. But their role as providers of liquidity has increasingly been filled by less-regulated non-banks, or shadow banks, such as hedge funds. These borrow heavily, often to maximise the return from trades that arbitrage tiny differences between the prices of closely related assets.
With the onset of heightened volatility and market stress last March, these non-banks faced margin calls and funding difficulties. They went from being market stabilisers to amplifiers of market stress.
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