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HOME NRI JOURNAL Takahide Kiuchi's View - Insight into World Economic Trends: What is the Appropriate Way to Handle the United States’ Monetary Risks?


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Takahide Kiuchi's View - Insight into World Economic Trends: What is the Appropriate Way to Handle the United States’ Monetary Risks?

Takahide Kiuchi, Executive Economist, Financial Technology Solution Division

#Market Analysis

#Takahide Kiuchi

May 14, 2021

The US financial market has begun to show sporadic signs of overheating. At the beginning of the year, all eyes were on the Gamestop issue where individual investors colluded over SNS to drive up that company’s stock price. Then followed the soaring share prices of SPACs (special purpose acquisition companies), the dramatic rise in the price of the virtual cryptocurrency Bitcoin, and the boom in digital assets known as NFTs (non-fungible tokens), all led by individual investors. And in March, there were the major losses involving family offices (organizations established for the purpose of managing the assets of wealthy families).

Risks concentrated in nonbank (shadow banking) and high-risk assets

In its Financial Stability Report (FSR) published on May 6, the US Federal Reserve Board (FRB) sounded the alarm bells over the risks of comparatively high asset prices and market overheating. For example, it noted how the interest rate spread between high-yield bonds or BBB-rated corporate bonds and Treasury bills is at an historic low, on par with pre-financial crisis levels. The P/E ratio (price-to-earnings ratio) of the S&P 500 has recently been around 23, the highest it has been since 2000.
Meanwhile, the FRB also pointed out that in terms of prime brokerage activities (wherein investment banks provide their hedge fund clients with stock loans, credit, and other such services), leverage at hedge funds involving equity investments was quite high. I believe this suggests that the recent massive losses suffered by Archegos Capital Management, a family office similar to a hedge fund, is not just an individual problem, but rather may have exposed risks facing the entire industry.
In response to the financial risks facing these hedge funds, family offices, and other so-called nonbank institutions (shadow banking), the FRB and financial authorities around the world have gone on high alert.
On the other hand, when it comes to financial products, people are also noticing the risks associated with the excessively high prices of high-yield bonds, BBB-rated corporate bonds, CLOs (collateralized loan obligations), and ABCP (asset-backed commercial paper), the prices of which continue to soar. The holders of most of these high-risk assets are nonbank institutions, including hedge funds, investment trusts, ETFs (exchange-traded funds), prime MMFs (money market funds), and life insurance companies.
Given these circumstances, a price drop in these high-risk assets would deal serious damage to nonbank institutions, and would also trigger a sell-off of these assets. That would synergistically produce further declines in the prices of these risky assets and greater nonbank losses. I believe it is this potential risk leading to a vicious cycle that currently lies at the core of the financial risk for the US and even the world.

Tightening financial regulations has the aspect of a rat race

In the interest of reducing such risks, there is a growing movement across the world to tighten regulations on the nonbank sector going forward. Leading this agenda is the Financial Stability Board (FSB), an organization consisting of representatives from central banks, other financial authorities, and international agencies from 25 major countries and regions.
Incidentally, it is worth observing that financial regulations enacted for the purpose of maintaining the stability of the financial system are generally more likely to have the aspect of a rat race. When the financial authorities tighten regulations on financial institutions in a certain field with the aim of reducing monetary risks, investors with a penchant for making highly risky investments—and “risk capital”—end up transitioning to financial institutions in other fields, to escape the new restrictions.
The 2008 global financial crisis severely shook the world of bank management in the West. Afterwards, in order to prevent future bank crises, regulatory authorities moved to strengthen capital adequacy and liquidity regulations and such, the aim being to lower the risks to bank solvency and liquidity. In response to this enhancement of international banking regulations, the big banks reduced their holdings of highly risky financial assets, and also scaled down their market making activities in order to keep their balance sheets in check.
In place of these big banks, it was the nonbank institutions I discussed earlier that began expanding their holdings of high-yield bonds, securitized instruments, and other high-risk assets. The effect of these regulations was to shift monetary risks from banks to the shadow banking system.
The Covid-19 crisis rattled the financial markets last spring, temporarily sending the prices of high-yield bonds, securitized instruments, and other high-risk assets plummeting. When that happened, the view began to spread that the cause of these major market adjustments had been nonbank institutions selling off their assets, and there has been a growing momentum for the nonbank sector to be more heavily regulated.

Regulatory flight causing people to leave hedge funds for family offices

Although strong regulations on the nonbank sector have yet to be rolled out in earnest, they have been implemented in part. For instance, in the West, regulations on hedge funds were enhanced after the financial crisis in order to protect investors. In the US, hedge funds are required under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) to register with the SEC (Securities and Exchange Commission). Hedge funds that have registered with the SEC are obligated to retain records of their operations, and must periodically file reports as well. Meanwhile, they are also accountable to their clients, meaning that they can no longer take unlimited risks.
That said, a trend is now underway among hedge funds to change their organizational form in order to evade these regulations and various other restrictions. George Soros and other wealthy heavyweight investors have been shutting down their hedge funds and founding family offices in droves instead.
Having got their start as way for royal families in medieval Europe to manage their property, family offices were once safe options that tended to engage in long-term investments. Now, they have transformed into organizations that engage in extremely high-risk investments, at least in part.
In response to the major losses mentioned earlier, US financial authorities have begun to consider new regulations, such as enhancing the obligation of family offices to make information disclosures. However, if they were to proceed with tightening regulations on family offices, investors with a taste for high-risk investment activities (and risk capital) would likely flee these regulations and transition to some other organizational form, creating what is known as regulatory arbitrage. For this reason, it is possible that tightening regulations may not constitute a complete solution here.

Eliminating excessive monetary easing is necessary to reduce financial risks

To maintain the stability of the financial system, it is important not to rely solely on tightening restrictions, but to also have appropriate macro-level monetary policy management, one that produces the sort of monetary environment that does not give rise to investment activities involving excessive risks.
The FRB implemented unprecedented monetary easing policies in response to the Covid-19 crisis. This certainly helped to restore stability to the financial market. However, in a sense, these measures can surely be said to have taken away the opportunity for sound corrections to be made to a market that had already been overheating prior to the pandemic. Various indicators now show that the current overvaluation of asset prices and overheating have intensified even beyond what they were before Covid-19. This could very well suggest that monetary easing policies—designed as a Covid-19 countermeasure—may have ultimately gone too far.
Having sounded the alarms about the financial risks in its Financial Stability Report, the FRB has intimated that it will address these risks not by making monetary policy corrections, but rather by using tighter regulations or macro prudential policy measures. Yet in actuality, reducing these already ballooning monetary risks may require more than micro prudential policies (such as stress tests on individual financial institutions), macro prudential policies, or regulatory enhancements that are more likely to have the aspect of a rat race.
In order to reduce monetary risks and avoid major financial crises in the future, I believe the FRB should now begin to seriously consider the gradually normalization of its monetary easing policies, which seem to have gone too far in responding to the Covid-19 crisis.

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