Financial risks

From credit to fragility

A financial system that only financed safe, short-term, self-liquidating projects would be dull and probably poor. Growth requires long-term investment, and long-term investment requires someone to bear maturity and credit risk.

Banks and other intermediaries bear that risk by transforming maturity and liquidity. They issue short-term claims that households and firms treat as money, and they hold longer-term claims that are harder to sell in a hurry. That is the source of the system's economic value and its vulnerability.

Leverage

Leverage is the ratio of assets to equity. A bank with $100 of assets and $10 of equity is leveraged 10 to 1. A 10% fall in asset values wipes out the equity. A 5% fall halves it.

Leverage is not inherently bad. It allows a bank to earn a return on equity that compensates for the risk it takes. But high leverage makes the system sensitive to small shocks, and it creates incentives to take risks that are not fully borne by the bank's owners.^[1]

The same logic applies to households and firms. A highly indebted borrower is more vulnerable to a fall in income or asset prices. When many borrowers are exposed at once, the result can be a wave of defaults and a credit contraction.

Liquidity and runs

Liquidity risk is the risk of being unable to meet obligations as they fall due. A bank can be solvent — assets greater than liabilities — and still fail because it cannot convert assets into cash quickly enough.

Deposit insurance reduces the incentive for retail depositors to run, but wholesale funding can still be flighty. Money market funds, repo markets, and commercial paper can withdraw funding quickly, especially when collateral values are uncertain.^[2]

Minsky's taxonomy

Hyman Minsky argued that financial systems move through phases in which the mix of financing shifts from conservative to fragile:^[3]

The categories are analytical, not moral. A start-up may be Ponzi-like for a period and still become viable. The problem is when the aggregate share of speculative and Ponzi finance rises, and when the system assumes that asset prices will keep rising.

Procyclicality

Financial systems amplify the business cycle. In expansions, credit grows, collateral values rise, and risk looks lower than it is. In contractions, losses rise, collateral values fall, and lending contracts. The financial cycle can be longer and larger than the business cycle.^[4]

Research on long-run credit data finds that credit booms are a robust predictor of financial crises and that the composition of credit matters. Mortgage credit booms, in particular, have been associated with deeper recessions.^[5] The BIS credit-to-GDP gap is one attempt to measure the build-up of excess credit.^[6]

Too big to fail and moral hazard

A large, interconnected institution can impose costs on the rest of the system if it fails. If creditors expect to be rescued, they may lend to it more cheaply than its risk warrants. That is moral hazard.

Post-2008 reforms tried to address this with higher capital requirements, liquidity rules, resolution planning, and stress testing. The debate over whether these measures are sufficient is ongoing. The Federal Reserve's Financial Stability Report is a useful public account of the current assessment.^[7]

Measuring risk

No single indicator captures financial stability. Useful inputs include:

• Credit growth relative to GDP.
• Leverage and capital ratios.
• Liquidity and funding profiles.
• Asset valuations and risk premia.
• Borrowers' debt-service burdens.
• Concentration and interconnectedness.
• The share of short-term wholesale funding.

The point is not to forecast the next crisis precisely. It is to identify where the system is accumulating exposure and to build buffers before the shock arrives.

Where to go next

• The banking system — maturity transformation and runs.
• Macroeconomics — credit, demand, and balance-sheet recessions.
• Deflation risk — how debt turns a downturn into a deflationary spiral.
• Monetary policy — the limits of rate cuts in a financial crisis.