The central argument of the 2015 documentary ‘Boom, bust, boom’, which features several high-profile experts including Nobel laureates Paul Krugman, Robert Shiller and Daniel Kahneman, is that financial crises are natural events caused by human nature.
However, the current economic policy toolkit does not take into account the human element, making crises potentially more frequent and destructive.
The effects of the 2008 financial crisis were still being felt as Theo Kocken, the founder of UK/Dutch consultancy and fiduciary manager Cardano, started working on the production of the documentary, which was presented by the late Terry Jones, member of the well-known British comedy group Monty Python. Kocken, who is also professor of risk management at VU Amsterdam and chairman of the Cardano Development Foundation, wanted to raise awareness among the public, particularly economics students, about the lack of a historical and behavioural perspective in the study of financial crises.
Today, thanks to swift central bank and monetary action, the world seems to have averted the financial crisis that could have followed the 2020 market crash induced by COVID-19. The economy seems headed towards a robust recovery from last year’s recession thanks to massive stimulus. Both central banks and governments have revised some of the long-held beliefs around inflation and austerity.
But Kocken’s views about financial crises seem more relevant than ever. Debt as a share of global output is peaking and stock markets are widely disconnected from economic reality. Institutions such as the International Monetary Fund (IMF) have warned about the potential consequences of a steep and fast rise in global indebtedness. But there is arguably little attention paid to systemic risk.
“There is a total disconnect between the real economy and the financial economy. It is not the first time in history that this happens, of course. But it is getting worse and worse, and it is mainly due to monetary policy that fuels the euphoria,” says Kocken.
“The economy is trapped in a vicious circle, whereby central banks have to act fast and strongly to avoid negative consequences from shocks like COVID-19. But their actions end up making the long-term problem potentially worse.”
The concept of loss aversion, whereby people tend to want to avoid losses more than they want to make gains, is a powerful key to read the current situation, according to Kocken. “Negative rates force those who have large wealth to invest in financial assets instead of deposits at banks. They are so rich they won’t spend more in the real economy,” he says.
Those with low wealth, instead, have to borrow to buy houses at high prices. This debt leads to less spending and debt deflation. It is no surprise that asset inflation is high and real-economy inflation is low.
These are the unavoidable effects of negative rates and what Kocken calls “quantitative flooding” by central banks. Institutional investors are not immune to the loss-aversion bias that Kocken describes. That is why, until the end of the first quarter of this year, the tech sector was the main driver of stock market returns.
Kocken is by no means alone in his analysis of the long-term effects of negative rates but, in his view, the fragility of the system is caused by other factors as well.
“The rules implemented after 2008 have made banks safer individually, but one-size-fits-all regulation could have unintended consequences beyond the banking sector,” he says.
“The fact that banks have cut their trading activities means liquidity in the financial system has been reduced significantly. At present, there has not been a real test of liquidity.”
The significant growth of exchange-traded funds (ETFs) investing in less liquid credit assets is a potentially weak spot in the system, according to Kocken. That is an area where the promise of liquidity does not necessarily match the actual liquidity of the underlying assets.
Another market that investors, particularly pension funds, should watch carefully is derivatives. The recent changes in regulation around central clearing mean that the clearing of derivatives is done exclusively through central clearing counterparties (CCPs). There are 13 CCPs authorised in Europe and Kocken points out that such a limited number of market participants, given that there are no more than three to four real big players, could give rise to unintended systemic risk.
“I am not saying all these developments are necessarily dangerous. For instance, banks are well capitalised on an individual level. I am saying these new developments are untested and it appears as if connectivity has increased in the financial world. We have quite a different system compared to the 2007 crisis, but the same level of overvaluation of assets. This is why investors need to focus on scenario analysis,” says Kocken.
His approach might seem pessimistic, but it is rooted in his risk management-based view. In fact, Kocken says that through group processes at institutional level, one can become aware of behavioural biases and, to some extent, correct them and de-bias the investment process.
“Furthermore, our advice has always been to build convexity in portfolios. To protect portfolios from downside risk, often investors need to give up part of the upside. In equity portfolios, that might mean buying options,” says Kocken.
“When taking risks in portfolios, we advocate a Nassim Taleb approach, which means taking into account tail risks.”
Kocken refers to the ‘black swan’ concept popularised by statistician Nassim Nicholas Taleb, which identifies unexpected events that can have a huge impact on portfolios. COVID-19 may well be seen as an example of a black swan event to some, although Taleb himself does not consider it as such, according to Kocken, whose bigger concern is about a sudden, unexpected and total collapse of the financial system.
The other key risk to take into account is liquidity. Kocken says: “We encourage clients to think about where they might get access to liquidity if needed. In today’s world, there is a trade-off between liquidity risk and credit risk, whereby investing in supposedly risk-free assets from a credit-risk standpoint, such as sovereign bonds, potentially brings unknown liquidity risks.
“Investors might want to build diversified portfolios not just in terms of credit risk but also liquidity. The point is to build a defence against the risks that can hurt the most, however small. Rather than hoping for the best, it is important to also prepare for the worst.”