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Are we safe from the next financial crisis?

Conflicting headlines this week warn us that the next financial crisis could be both on the horizon and yet 'not likely in Janet Yellen's lifetime'. Should corporate treasurers take these warnings with a pinch of salt or start to double-down on mitigating the risks of another financial meltdown?

Trinity of financial risks

The Guardian reports that the Bank for International Settlements (BIS) has warned that a “steep rise in risky bank lending over the past year” could threaten the stability of the global financial system. The annual BIS report actually says the global economy has strengthened further in the past year, with growth, employment and inflation rates all signalling economic stability. But the report also examines four risks that could threaten the sustainability of the global economy's medium-term expansion: a rise in inflation; financial stress as financial cycles mature; weaker consumption and investment, mainly under the weight of debt; and a rise in protectionism. These risks, it says are all rooted in the 'risky trinity' of risks highlighted in last year's report: unusually low productivity growth, unusually high debt levels, and unusually limited room for policy manoeuvre.

The report also pinpoints the US dollar funding markets as being “a key pressure point during episodes of market stress”, while the financial sector is also undergoing the disruption of technological innovation and consolidation pressures.

On the whole, the BIS annual report is a lot less alarmist than the Guardian article makes out. But there are others in the press and financial industry that are voicing concerns about problems up ahead in the global financial system. Mark Carney, Bank of England governor, has called for more efforts to tackle risk in the financial system, such as shadow banking the derivatives markets. And the BIS's Claudio Borio said: “Leading indicators of financial distress point to financial booms that in a number of economies look qualitatively similar to those that preceded the great financial crash.” He says that the countries at risk might not be those at the centre of the last crisis, but could be those that have undergone significant property and lending booms in recent years.

We are generally led to believe that the regulations put in place following the 2008 global financial crisis have strengthened banks and eliminated some of the risks that led to that crash. And US Federal Reserve Chair Janet Yellen said this week that she doesn't believe we will see another significant financial crisis within our lifetime – because of the regulations such as Basel III and the Dodd-Frank Act, put in place to increase the stability of financial institutions and reduce systemic financial risks. She also warned against repealing those regulations.

Financial system at 'massive risk'?

But Richard Bove of Rafferty Capital disagrees with Janet Yellen and writes that the next financial downturn could be far more devastating that the previous one and says that “The financial system is now at massive risk” because financial regulations now prevent the government from bailing out a struggling bank, meaning that the bank may have no choice but to fail. Bove argues that the very regulations put in place after 2008 could in fact be the destabilising factor that leads to the next big downturn.

Whether you buy this argument or not, it seems clear that regulations such as Dodd-Frank and Basel III have strengthened the financial system, but eliminating risk completely is obviously not possible.

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