The value of derivatives in the the financial system now totals an astonishing 802 per cent of the world’s GDP, providing 75 per cent of global liquidity. Securitised debt is worth 142 per cent of global GDP, providing 13 per cent of liquidity.
What threat does the rapid growth of these sectors, which now dwarf traditional measures of liquidity such as cash and bank reserves, or broad money including deposits and loans, pose to the financial system, asks Gillian Tett in Monday’s Comment & Analysis?
For Northern Rock, the issuer of mortgage-backed bonds which are in turn used to create CDO instruments, the group may be making itself less vulnerable to future economic shocks by moving some of the risk of default into the hands of new investors. That risk sharing also allows it to make more loans. But transferring risk can introduce an element of “moral hazard” into credit lending - where if lenders think they are insured against the risk of default they could be tempted to lend too much.
The transfer of risk also introduces opacity - making it fiendishly difficult to see who might be left holding losses if a credit shock did occur or to prevent concentrations of credit risk developing in the system.
Paul Tucker, head of markets at the Bank of England, conceded in a speech last month that the Bank found it hard to interpret M4 - one of the broadest measures of money - because structured finance and hedge fund activity seemed to be distorting the data. Worse, banks’ balance sheets are no longer an accurate guide to activity either because banks are shuffling risk around. So what would happen in a financial crisis remains - as he put it - “unknowable”.
Right now there is little sign of an end to the credit party, nor it would seem to the mounting uncertainty about what might happen when the debt dance ends.
