An­other rea­son to worry about banks

The Pak Banker - - OPINION - Mark White­house

FOR in­vestors seek­ing rea­sons to worry about banks, here's an­other: They've lent a lot of money in cur­ren­cies that bor­row­ers will have a hard time pay­ing back. The phe­nom­e­non il­lus­trates how cap­i­tal flows work in a fi­nan­cially in­te­grated world -- and how they can con­trib­ute to booms and busts. As the U.S. Fed­eral Re­serve and the Euro­pean Cen­tral Bank held in­ter­est rates ex­tremely low to sup­port their own economies, they pushed banks to seek higher re­turns else­where, and also made bor­row­ing in their cur­ren­cies very at­trac­tive all around the world. The re­sult was that the to­tal amount of dol­lar and euro lend­ing to non-bank bor­row­ers out­side the U.S. and the euro area grew 57 per­cent dur­ing the past six years -- to $12.7 tril­lion, ac­cord­ing to the Bank for In­ter­na­tional Set­tle­ments. Here's how that looks:

Such rapid credit growth is a clas­sic pre­cur­sor of fi­nan­cial crises, and the for­eign-ex­change el­e­ment adds a nasty twist. The Fed's plans to in­crease in­ter­est rates, to­gether with grow­ing con­cerns about emerg­ing mar­kets, have caused the value of the dol­lar to rise sharply against a range of cur­ren­cies. The euro has gained against some cur­ren­cies, too. So for bor­row­ers in coun­tries such as Brazil and Turkey, whose cur­ren­cies have weak­ened, the cost of pay­ing back all that debt has shot up. Here's a break­down by coun­try, es­ti­mat­ing how much the lo­cal-cur­rency value of dol­lar and euro debt to banks (in­clud­ing that of fi­nan­cial in­sti­tu­tions, com­pa­nies and gov­ern­ments) has grown as a share of gross do­mes­tic prod­uct dur­ing the past two years, due to ex­change-rate changes alone: The re­sult tends to be what we've seen hap­pen­ing in global mar­kets. Con­cerns about de­faults cause in­vestors to flee -- a re­sponse that, by push­ing ex­change rates down fur­ther and halt­ing the flow of credit, makes those de­faults ever more likely. The ques­tion then be­comes whether lenders -- those same banks whose share prices have gy­rated in re­cent days -- have enough equity cap­i­tal to ab­sorb the losses. If not, the fi­nan­cial dis­tress can spread quickly, as the world learned in 2008. Can any­thing be done? Ac­tu­ally, yes. As the econ­o­mist He­lene Rey has noted, tougher lim­its on lev­er­age -- that is, on the amount that banks and oth­ers can bor­row for each dol­lar in equity -- could go a long way to­ward mit­i­gat­ing the global boom-bust cy­cle at lit­tle or no cost to the econ­omy. Bor­row­ers would have less op­por­tu­nity to get overex­tended in the first place, and the fi­nan­cial sys­tem would be bet­ter pre­pared to ab­sorb the losses if they did. Reg­u­la­tors have moved in that di­rec­tion since 2008, but not far enough.

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