Renewed volatility is forcing market participants to recognise just how much the structure of financial markets has changed since 2008. Crucial efforts to make the financial system safer have centred on increasing banks’ capital ratios and penalising activities deemed higher risk with greater capital charges. This has substantially reduced banks’ willingness to intermediate when markets are falling, and indeed has led to a sharp decline in the inventory of debt securities that banks maintain. The reduction in market liquidity creates an illusion of underlying strength to market rallies when, in fact, some of the strength is simply a function of worsening market depth. To the extent that investors and policy makers alike judge the strength of fundamentals by the behaviour of asset markets, this has created a false sense of security — about the robustness of the US recovery and the resilience of the eurozone to new shocks. The roots of the recent return of financial market volatility are not in fundamental factors, but rather reflect the Tower of Pisa-like financial architecture that has grown up in the wake of the global financial crisis.
Posted on: Thu, 22 Jan 2015 02:08:53 +0000