‘Cockroach’ warning by America’s top banker sparks fears about the financial system

But Dimon’s comments resonated because they touch on long-standing concerns about how the global financial system has evolved since the 2008-09 financial crisis.

Before this crisis, the financial system was fairly evenly divided between banks and nonbanks. Since then, banks’ share of the system has increased from 164 percent to 177 percent of global GDP, while the share of nonbanks has increased from 167 percent to 224 percent, according to the Bank for International Settlements.

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With banks squeezed by increasing capital and liquidity requirements, the system is now dominated by asset managers, private equity firms, hedge funds, insurers, private lenders and other nonbank financiers who are much less regulated and whose activities are not as transparent.

While banks can originate and arrange credit, they are now increasingly spreading debt to non-bank institutions and managed funds rather than holding capital-intensive assets on their balance sheets.

The post-GFC architecture of the system should reduce systemic risk by spreading risk across many aspects and diversifying risk exposures. The fear is that risk concentrations will move elsewhere and spillovers into a particular non-bank sector may still pose a threat to overall financial stability.

There is also a concern that responsibility and accountability for assessing credit risks has diminished due to changes in the way loans are made, evident in recent corporate failures and allegations of fraudulent activity.

Banks are less concerned about credit quality when they transfer risks to a range of third parties.

Nonbanks do not necessarily have the risk assessment experience or systems to screen for credit risks, and in any case, they have less incentive to focus on the risk of individual loan tranches that someone else arranges and sells, while holding only one tranche of a loan within a diversified portfolio of split and split loans financed with other people’s money.

In the post-GFC, post-pandemic environment of loose monetary policies and easy access to cheap money, credit standards and the pricing of risk have become less memorable. Spreads in the junk bond market have been compressed to the point where there is little distinction between creditworthy borrowers and the riskiest ones.

Financing has also become more complex. First Brands leveraged multiple financing markets, including banks, private loans, leveraged loans, secured debt markets and receivables financing.

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In an environment where too much money from too many sources chases a limited number of opportunities, while portfolio approaches to risk management with nonbank funds make individual credit risks irrelevant, it should not be surprising that underwriting standards are being questioned in a system where there is no compelling incentive to devote resources to examining credit quality.

Easy money and competition create an uneasy and potentially flammable mix, especially when risks are concentrated within an industry rather than concentrated in individual banks or nonbanks. Hence the growth rate of the private credit industry, the US$2 trillion market for collateralized loan obligations, and the increasing debate over other forms of leveraged lending.

Although the Trump administration has sought to roll back some of these regulations in the US, bank “runs” may have become less likely due to the tougher regulatory regime put in place after the financial crisis, although it is conceivable that a contagion-induced run on non-bank funds could occur if enough “cockroaches” emerge from the shadow banking sector; this contagion can have spillover effects on the banking system.

As the US Federal Reserve begins lowering interest rates, it is also unwinding the cheap credit splurge it injected into the system after the financial crisis and again in response to the pandemic. The system is now experiencing quantitative tightening instead of quantitative expansion.

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It is instructive that banks accessed the Fed’s short-term lending facility last week, given that they would normally be able to borrow more cheaply in the market; This is an indicator of liquidity pressures. The era of excessive credit may finally be nearing its end.

The recent spate of corporate collapses and lack of due diligence by lenders may be a sign that the non-bank debt market is overheated and companies are being given loans they never should have taken on terms that do not reflect the risk.

There is always a concern about financial bubbles. A bubble may occur in private debt markets. There is probably one in AI-related stocks and investments, and this is causing a bubble to form in the overall stock market.

It is impossible to say how threatening these developments may be. There is little transparency in the shadow banking sector and little understanding of the potential returns from massive investments in AI and data centers to support the technology coming to any conclusions.

But history shows that when too much money is lent to companies with poor creditworthiness, or when too much money is invested too quickly in certain industries, it rarely ends well.

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