Don’t Underestimate The Risks Of Contagion

Don’t Underestimate The Risks Of Contagion
Stéphane Renevier, CFA

11 months ago2 mins

I’ve been warning for months about the rising risks of a financial accident, both in the US and in Europe. And while some parts of the thesis have played out, there’s unfortunately still a dangerously elevated risk of further accidents.

That said, it’s important to acknowledge that banks are better capitalized now, there’s less risky leverage in the financial system, and there are fewer signs of excesses now than there were in the runup to the global financial crisis. But it’s equally important to remember that the problem is rarely with the things we can see, and more often with the things we can’t see.

For instance, private markets (including private equity) occupy an area where risks may have built up beneath the surface. As we explained here, tighter banking regulation and ultra-low interest rates pushed non-bank financial institutions (like private equity firms or speciality lenders) to replace banks in giving capital to companies. And those new actors aren’t just less heavily regulated, they’re also more opaque, less liquid, and could have a higher tolerance for risk.

That dangerous cocktail means that we can’t be sure about the quality of their underlying investments, or how they’re structured, and to what extent there could be “hidden risks”. For instance, as the chart shows, there could be multiple layers of leverage involved (for instance, from a bank to a speciality lender, from a speciality lender to a private equity firm, and from a private equity firm to a company) and banks may be involved in different places within this whole ecosystem. Should lending dry up, big banks default, or companies start to struggle to pay the interest on their debt, that could become problematic.

Now, none of this guarantees that we’ll experience another financial crisis, but it does suggest that you shouldn’t underestimate the risks of contagion if further accidents happen. They’re likely right there under the surface…

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