Central banks say hedge funds and insurance are the new epicenters of risk.

Regulations hobbled banks’ risk-taking abilities after the last global financial crisis. But risk never really went away, it just switched masks. And hedge funds are the new face of unbridled financial adventurism, according to the IMF and the European Central Bank (ECB).

Only now there’s a new factor ratcheting up hazards of another LTCM-like implosion: ultra-low, nay, negative interest rates. If the cost of money is low, free or even better, negative, it inspires risk-taking. Again, riskier assets that provide the promise of even marginally superior rates of return become a magnet for money looking to escape from the shackles of low yields. This money is seeking a speculative destination, not a production-, or employment generating deployment.

So is history repeating itself, and are the eddies of risk swirling out ever more further? LTCM in 1998, then the subprime crisis a decade later in 2008; is something bigger in scale lying in wait to spark the next recession?

Nobel laureates, leverage and a Russian default caused the LTCM implosion. Banks and profligate lending triggered the GFC. According to the ECB, hedge funds and insurers may be the next bad actors.

ECB: Hedge funds, risk, and recession

The ECB’s Financial Stability Review of November 2019, says: “Higher leverage, for example, in hedge funds, can add to procyclical investor behavior and accelerate outflows. So, a sudden and abrupt repricing of risk coupled with large outflows could force asset sales, amplifying the original shock to asset prices. In turn, this may have implications for the ease and cost of corporate financing, which could exacerbate any real economic downturn.”

Non-banking financial sector holding the bag

Post-crisis, central banks sought to jump-start sputtering global growth with a massive injection of liquidity amidst an unprecedented low-yield environment. Unfortunately, a lot of the liquidity seems to have ended up at the doors of the non-banking financial sector.

“That’s an unintended consequence of the flood of central bank liquidity,” says an op-ed by author W. E. Messamore in CCN. “Systemic financial regulations designed to recession-proof the economy are tailored for banks. The $3.2 trillion hedge fund sector could be the weak point where the dam finally bursts.”

Furthermore, here is a warning from the IMF:

“Vulnerabilities among nonbank financial institutions are now elevated in 80 percent of economies with systemically important financial sectors (by GDP). This share is similar to that at the height of the global financial crisis. Vulnerabilities also remain high in the insurance sector. Institutional investors’ search for yield could lead to exposures that may amplify shocks during market stress: similarities in investment funds’ portfolios could magnify a market sell-off, pension funds’ illiquid investments could constrain their ability to play a role in stabilizing markets as they have done in the past, and cross-border investments by life insurers could facilitate spillovers across markets.”

Perhaps early-warning red flags are already popping up. The Woodford fund collapse, and the suspension at M&G Investments are cases in point.

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