As the world’s central banks, beginning with the Federal Reserve, ease off their easy money policies, there could be various shocks to financial markets. One mechanism could be increases in interest rates on bonds and corresponding declines in their values; another could be a potential fall in housing prices as mortgage rates increase. On balance, however, I suspect that participants in the financial markets are adequately prepared for these changes because they have been so widely anticipated for so long. Some of the sharpest swings in yields occurred last spring–summer, and as we saw the world didn’t end.
As far as the risk of a financial crisis goes, I think there are two main concerns. One is that changes in the macroeconomic climate could hit large banks especially hard because, unlike (say) hedge funds and other asset management companies, their actions are not guided by economic rationality. In some cases they are motivated by spurious accounting games; for example, one US bank recently said it would have to write down its holdings of Collateralised Debt Obligations, CDOs because of the Volcker Rule, which is basically an admission that they were hanging onto CDOs, marking them above their real value, and hoping they would increase in value to justify their marks. This could be an even bigger problem for European banks with their holdings of government bonds.
The second, and bigger, concern is that we missed the opportunity to force through the structural changes required to make the financial system safer. Most important, the financial system is still hostage to a relatively small number of megabanks. So even if the chances that rising interest rates will cause one of them to suffer large losses are relatively small, the consequences of one of them blowing up are still very large. We also know they are too big to manage (consider JPMorgan, which is now example number one in the US), so we really don’t know what kind of risks they face in a new macroeconomic climate. That’s the really worrying thing.
James Kwak is an Associate Professor of Law at the University of Connecticut School of Law, and co-author with Simon Johnson, of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown