Stress-testing the global financial system

Currencies, Economic growth, Financial Events, Leverage, Pension funds

Yesterday’s “swings in financial derivative prices were so extreme that they implied scenarios in which the core of the global liquidity system suffers a serious assault”, according to JP Morgan, the investment bank. Watch out, if current US sub-prime mortgage problems turn into a more general “flight from risk”.We are always being assured that the global financial system has never been in better shape. As a contrarian, I am therefore always interested in ‘What might go wrong’?

One answer to this question came today in a speech by Nigel Jenkinson, the Bank of England’s Executive Director for Financial Stability, to the European Central Bank’s High Level Conference on the subject of financial risk. He said http://www.bankofengland.co.uk/publications/speeches/2007/speech318.pdf :

“The global financial system is evolving at a tremendous pace…. Risks may have been dispersed more broadly…..The resulting reduction in credit risk concentration may have strengthened the robustness of the financial system to withstand small to medium shocks. But equally, greater market integration has strengthened the ties between firms within and across borders….If a shock is sufficiently large, the financial system may consequently act as a conduit for transmitting rather than absorbing risk. So the flip side of greater integration is that it may have lowered the frequency but increased the magnitude of potential financial crises.” (my emphasis)

So now I know what to worry about. If the current problems are systemic enough, any financial crisis could have a major effect.

The problems in the US subprime mortgage market need to be carefully monitored for signs that they are beginning to spread to the real economy. If they do, then JP Morgan’s comment implies that they might not be just another localised storm in financial markets. They may have the potential to become a global hurricane.

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