The march towards the next global economic crisis has begun and you must fear its coming

New Indian Express

20-05-2025

Lending by regulated entities to the shadow banking sector is greater than $2 trillion globally ($1.2 trillion by US banks alone). Lending to hedge funds, private equity, private credit, and buy-now-pay-later companies is one of the fastest-growing parts of the banking system. Hedge funds currently manage around $4.5 trillion, up from $2.8 trillion in 2008. They have recovered from the significant fall in assets under management after the 2008 crisis and have grown by almost 56 percent since 2015.
Global bank equity is around $6-7 trillion. Banks are leveraged around 8 to 10 times. Large losses would place some banks at risk of insolvency and threaten financial stability.
There are existing losses. Bank that purchased often long-dated bonds with excess liquidity, which outstripped loan demand, suffered markdowns from rising interest rates when inflation rose sharply in 2022. The failure of Silicon Valley Bank was related to these problems. US banks currently have around $500 billion in unrealised losses, representing 50 percent of their Common Equity Tier One Capital. Global losses are 3 to 4 times that. Liquidation of these holdings would crystallise these write-offs, reducing bank capital.
Following the 2008 financial crisis, regulators introduced stricter bank regulations. Known as Basel 3, they are still not fully implemented, with the industry seeking to weaken them. Their effectiveness also remains untested. If hybrid securities and bail-in securities do not work as intended then the capital available to absorb losses will be lower.
In any event, the crucial factor in banks surviving large credit losses is liquidity. Banks operate with a fundamental mismatch using short-term deposits to fund longer-duration assets. Rising credit losses may lead depositors, both retail and wholesale, to withdraw funds or limit exposures triggering a familiar bank run, especially where the levels of deposit insurance are low. Regulations to improve bank liquidity reserves have not been tested by a real crisis, and their efficacy remains unclear.
The shadow banking system (non-banks including institutional investors, public and private funds, securitisation vehicles, family offices and HNWIs) is now a significant supplier of capital. However, the real equity and liquidity reserves ultimately supporting these investments are not transparent. Fund losses will directly flow through to institutional and retail investors. Some, like insurers and pension funds, are contractually obliged to pay out on their obligations. Others, if leveraged, may have to sell assets for liquidity to cover losses. Problems in private credit markets will affect banks that have a significant exposure through their lending to non-bank financial institutions. The favoured strategy of 'originating', not 'holding' assets, means that a disruption in private credit will leave banks with warehoused loans intended for on-sale. This will affect prices, exacerbating markdowns.
The financial system now entails complex chains of risk with legal and financial rights or obligations, enforceability, and claim priorities uncertain. Transactions routinely involve multiple investors and lenders, sometimes managed by the same asset manager. One fund may hold equity interests while a related entity may be the primary creditor. Investors frequently collaborate in large transactions. Complex capital structures and competing claims will create conflicts of interest despite much-touted Chinese walls. Litigation and lower recovery rates may result in higher than expected losses.
Actual losses or markdowns, because of lower prices, will result in a contraction of credit. This will exacerbate any economic slowdown given the model of debt-funded consumption and investment. The diminished supply of capital will place pressure on cash-strapped firms. It will also affect the value of existing start-ups, many of which do not have sufficient liquidity to reach the operational stage and need follow-on funding.
The process is one of downward spiralling feedback loops. Losses lead to lower leverage and lower credit availability, which leads to economic retrenchment setting off a new round. As markets become increasingly illiquid, struggling to handle the selling and worsening conditions, the crisis will intensify.
Resilience and Resolve
A system weakened over time lacks the resilience and capacity to respond to a new crisis.
The ability to absorb shocks is limited by low growth, much of its driven by government deficits and debt, and high prices. Businesses have not fully recovered from the pandemic. With disposable income reduced by wages lagging inflation and excess savings from the Covid-19 period largely exhausted, individuals are struggling. 59 percent of US consumers would need to borrow or sell assets to cover an unexpected $1,000 emergency expense.
The wealthy have gained from rising asset prices.But these are phantom profits based on volatile market values. It is not cash in hand as the gains are unrealised. Investors are reluctant to sell because of fear of missing out on further appreciation. Many investors have taken out additional borrowings against these assets to fund spending. 50 percent of all US consumer spending now comes from the top 10 percent of income earners. The linkage between share and real-estate values and expenditure means that consumption expenditure may be less reliable than in previous downturns.
Any new crisis will be global as the principal drivers affect all economies. The impact of restrictions on trade and capital movements, one of the key factors in the expected downturn, is especially pervasive. The first-order effects of trade wars will be particularly damaging for Europe, China and Canada. Second-order effects from a decelerating global economy will be larger and more widespread.
Emerging markets, which have been under persistent stress, face problems. Those directly reliant on US trade, like Mexico, face major slowdowns. Asian, Latin American and African economies, integrated into Chinese supply chains, will be affected by the cage fight between the two great powers for supremacy. Lower commodity prices, as a result of slower demand, will affect raw materials producers. Remittances, the lifeblood of many emerging nations, will decline. Poorer countries, lower on the value chain and with limited ability to adjust, will be badly affected. Familiar vulnerabilities such as reliance on foreign investment, high debt, spendthrift policies, crony capitalism, corruption, dysfunctional rule and poor governance will be exposed.
Crises result in large loss of wealth. The US economy alone lost over $20 trillion in the 2008 financial crisis, although the number is disputed. There is the additional cost of support. In 2008, the US government committed around $ 2 trillion in interventions, bailouts and economic stimulus packages. The US Federal Reserve committed around $7.8 trillion in lending and asset purchases. Eurozone governments expended € 1.5 trillion in capital support and €3.7 trillion in liquidity support for the financial system. While some of the money was later recovered from sales of acquired assets and institutions, authorities still need to be in a position to make the required initial commitment.
Governments and central banks' ability to provide support is lower than in previous crisis. Chronic budget deficits, high public debt levels and the rising interest cost limit any new intervention.