Governments and central banks may be ill-prepared for the next financial crisis, warns a Wharton finance professor.
Predicting what will cause a financial crisis is extremely difficult. Because systemic risk is complex and can come from many sources, the next crisis will be different, predicts Wharton finance professor Franklin Allen.
"As we saw in the financial crisis, most governments, most central banks, just missed it," Allen tells Knowledge@Wharton
, the school's online publication. "One of the big worries that I think many people have is whether they’ll miss the next one, too, or whether now everything is under control."
Governments and central banks typically conduct fiscal and monetary policies separately. However, the crisis showed that system didn’t work properly.
Instead, policy makers should take of "a holistic view" and consider monetary and fiscal policies together, says Allen, who co-authored the paper "Financial Connections and System Risk."
"They’re all closely inter-related when it comes to financial stability, and the reason is that systemic risk is a very complex and involved phenomenon — it pops its head up in many ways."
An increase in interest rates now poses a major systemic risk, Allen warns.
Optimists say central banks can control rates, letting them rise gradually to limit possible damage. However, China, which now has high rates, is relaxing its capital controls. And that could impact global interest rates, potentially creating major problems worldwide.
If interest rates increase too quickly, prices of long-term bonds, including mortgage bonds, will drop precipitously, possibly causing a financial crisis much like falling house prices caused the last catastrophe. In addition, rising rates combined with large amounts of debt could lead to fiscal problems.
"We need to worry a lot more about financial stability, and worrying about financial stability is very different from worrying about inflation."
Panics, plummeting asset prices, rising interest rates, contagions, a breakdown in the financial system's plumbing, and problems in foreign exchange markets are top causes of economic crisis, he notes.
Shadow banking institutions, which operate outside regulated banking systems, could be another worry. Shadow banking assets worldwide jumped to a record $75 trillion last year, according to a new report from the Financial Stability Board
Shadow banking assets in China grew to $3 trillion last year, a 37.6 percent annual increase.
"Among emerging markets, the size and rapid growth of shadow banking in China warrants particular attention," the report states.
Nine emerging market jurisdictions saw growth rates over 10 percent. "While the non-bank financial system may contribute to financial deepening in these jurisdictions, careful monitoring is still required to detect any increases in systemic risk factors," the report states.
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