Stocks just a sideshow to the real drama of bond markets
Banking’s diminished role in lending has enormous, still under-appreciated implications
Robin Wigglesworth
Another way for Bane to create financial havoc in 'The Dark Knight Rises' would have been to focus on the bond market rather than Gotham's stock exchange
When Bane attempts to cause financial carnage and bankrupt Bruce Wayne in the final instalment of Christopher Nolan’s gritty Batman trilogy, he does it by attacking the Gotham Stock Exchange. But these days the real action is in the bond market.
Equities have always commanded far more public attention than fixed income. TV networks will run daily bulletins of what happened to the Dow, the “Footsie” or Nikkei, but rarely discuss what a country’s bonds have done — let alone mention popular debt indices such as the Aggregate, EMBI or CDX. But the bond markets are where the fortunes of the global economy are forged.
Financial innovations such as junk bonds and securitisation means banks have progressively done less of the bread-and-butter lending that has characterised the industry since its roots in Renaissance Italy, and famously exemplified by James Stewart’s community banker George Bailey in It’s a Wonderful Life. Instead, borrowers are increasingly turning to bond investors for their financing.
This is a longstanding trend, but has accelerated since 2008. The financial crisis showed the perils of relying on short-term, fickle funding markets, and banks have been burdened by stricter national and supranational regulation and tougher capital requirements designed to make them safer. In practice this has pushed more lending out from the banking system and into markets. That has enormous, still under-appreciated implications for how the global financial system functions.
A report by the Bank for International Settlement details how bank loans have flatlined since the crisis even as the bond market has ballooned. Bond financing made up about 57 per cent of all global borrowing in the first quarter of 2018, up from 48 per cent in 2008 and about 44 per cent at the turn of the century.
The bank-to-bond shift is particularly stark in the US. In the 1980s, banks made almost half of all loans in the US, but today only 18 per cent of all US corporate debt is owed to banks, notes Deutsche Bank’s Torsten Slok. Meanwhile, securitisation has transformed household lending by allowing banks to package up credit card debt, car loans and mortgages and sell them to investors, further reducing the role of banks in the US. The trends are similar, if less advanced, in Europe and Asia.
This is a hugely important development that will in all likelihood continue to deepen for the foreseeable future. And there are three big, interlinked implications.
Firstly, shifting lending out of banks and into markets makes banks safer. That is positive for the overall health of the financial system — given how destructive banking crises can be — but means regulators need to do a far better job of monitoring markets for broad issues, not just specific ones. The risks haven’t gone away, they have just migrated into a different corner of the financial ecosystem.
That means the traditionally retail-oriented approach of the US Securities and Exchange Commission or the Federal Reserve’s historically academic, narrow view of the economy are inadequate to deal with market regulation in today’s world. One only sees the trees, while the other only sees the wood.
Secondly, it raises some serious questions about modern central banking. The two primary roles of central banks are to control the heat of an economy by adjusting short-term interest rates, and to act as a lender of last resort in a banking crisis. But if bond markets do most of the lending, where does that leave central banks?
Bonds are naturally influenced by the short-term cost of money dictated by central banks, but investors set market interest rates, not the monetary officials appointed by governments. And if the 10-year Treasury yield matters more than the Fed Funds rate, it means previously unconventional measures such as quantitative easing will necessarily become mainstream. It might even argue for more central banks in future recessions adopting the Bank of Japan’s “yield curve control” policy, which stipulates that it will keep the 10-year Japanese government bond yield pinned near zero.
Thirdly, while the bank-to-bond shift makes banks safer, it increases the influence of markets over the global economy, and indirectly the Fed, as the central bank with the most sway over global fixed income markets. As the BIS said in its report: “Global financing conditions have become more sensitive to developments in the bond market, and even more tightly linked to US monetary policy.”
This matters, because while banks may be safer in the next downturn, bond markets are therefore likely to be even more volatile. And that will feed back into the economy. So everyone should care more about what the bond market does, and pay less heed to the undulations of the stock market.
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