One of the key elements of the modern economy, indeed one of the key factors that allowed the modern economy to evolve, is the liquidity mismatch banks encounter when they accept your deposit and give you access to your money instantaneously, while that same bank lends it out to a business or home buyer over many years, or decades.
In banking we call this borrowing short term and lending long term as “maturity transformation” and it has allowed banks to lend money for productive assets and consumption, and allowed the economy to grow. But, clearly it also comes with a very large liquidity mismatch the banks have to manage.
Essentially, in order to achieve what can sometimes be a fine balance, bankers take a bet on how many customers will want their money back on any given day, hold that in cash, and lend out the rest. Sometimes, like Northern Rock in the UK and Lehman Brothers in the US more borrowers than expected want their money back.
But global regulators have largely dealt with this lack of liquidity in banking, according to RBA Deputy Governor Phil Lowe.
Lowe delivered a brilliant speech this morning on “the transformation of maturity transformation.”
But while he was sanguine on the outlook for the Australian and global banking systems he gave a warning of the potential danger in the amount of money tied up in what he called “collective investment vehicles” – things like managed funds.
Low said that in the search for global yield, “money has flowed into collective investment vehicles that invest in a range of higher-yielding assets, including those in emerging markets.”
The problem Lowe says is that “many of these vehicles allow investors to redeem their funds at short notice, even though the underlying assets are not particularly liquid, and are likely to be even less liquid at a time when there are large-scale redemptions.”
He added that this has happened at a time when “liquidity has declined in some markets.” This “raises the question of what might happen in stressed conditions,” Lowe said.
Here is what is worrying Lowe:
The underlying concern is not that these vehicles will be unable to meet their obligations to their investors, but rather that they could serve to spread distress across the broader financial system. Two features of these vehicles, in particular, have drawn attention. The first is the ease of redemptions even when the underlying assets are illiquid. And the second is the possible misalignment of incentives between the portfolio manager and the end investor, which could amplify shocks.
Markets are going along swimmingly at the moment buoyed by low global rates and quantitative easing. But as the first Fed tightening approaches – and the signs are that it will come this year – and as the UK economy steadily moves the Bank of England toward following the Fed higher, so the preconditions for a “stress event” grow.
Lowe’s warning and last night’s little sell-off in stocks suggest it may not be banking where the next crisis concentrates.