Global credit flood approaches


By Andrew Sheng, special to The China Post

With world leaders meeting at the end of this week at the G-20 summit in Cannes, France, the next economic minefield that they will face is already coming into view. It is likely to take the form of an opaque global credit glut, turbocharged by the fragile mixture of too-big-to-fail global banking with a huge and largely unwatched and unregulated shadow banking sector. To be sure, that is not what many see. U.S. Federal Reserve Board Chairman Ben Bernanke and others have blamed the financial crisis of 2008 on a global savings glut, which fuelled flows of money from high-savings emerging-market economies — especially in Asia — that run chronic balance-of-payments surpluses. According to this school of thought, excessive savings pushed long-term interest rates down to rock-bottom levels, leading to asset bubbles in the United States and elsewhere. But Claudio Borio and Piti Disayat, economists at the Bank for International Settlements, have argued convincingly that the savings-glut theory fails to explain the unsustainable credit creation in the run-up to the 2008 crisis. They have shown that the major capital inflows were not from emerging markets, but from Europe, where there was no net balance-of-payments surplus.

The alternative theory — of a global credit glut — gained more ground with the release last week of the Financial Stability Board’s (FSB’s) report on shadow banking. The FSB report contains startling revelations about the scale of global shadow banking, which it defines as “credit intermediation involving entities and activities outside the regular banking system.” The report, which was requested by G-20 leaders at their summit in Seoul last November, found that between 2002 and 2007, the shadow banking system increased by US$33 trillion, more than doubling in asset size from US$27 trillion to US$60 trillion. This is 8.5-times higher than the total U.S. current-account deficit of US$3.9 trillion during the same period. The shadow banking system is estimated at roughly 25-30 percent of the global financial system (US$250 trillion, excluding derivatives) and at half of total global banking assets. This represents a huge regulatory “black hole” at the center of the global financial system, hitherto not closely monitored for monetary and financial stability purposes. Its importance was exposed only by analysis of the key roles played by structured investment vehicles (SIVs) and money-market funds (MMFs) in the 2008 meltdown. The shadow banking system is complex, because it comprises a mix of institutions and vehicles. Investment funds other than MMFs account for 29 percent of total, and SIVs make up 9 percent, but the shadow system also includes public financial institutions (such as the government-backed mortgage lender Fannie Mae in the U.S.). They are some of the largest counterparties with the regular banking system, and their combined credit creation and proprietary trading and hedging may account for much of the global liquidity flows that make monetary and financial stability so difficult to ensure.