The main causes of the bad debt market crisis in recent years

The dramatic increase in defaults at the world’s largest banks is worrying. The Covid-19 outbreak has affected everyone, from ordinary people to giant corporations to social safety net systems, and paved the way for another financial crisis.

A majority of well-known financial institutions in the United States, such as JPMorgan Chase, Bank of America and Wells Fargo, are warned by the world’s major banking institutions that they may not meet their loan obligations, resulting in a disastrous loan market. seizures.

According to Federal Reserve Bank of New YorkU.S. households are expected to hold $14 trillion in debt, including more than $1.3 trillion in auto loans and more than $900 billion in credit card debt, by the end of the year. last year.

While low global interest rates may have contributed to booming housing markets and speculative excesses, microeconomic distortions and misunderstood innovations in the financial system played a more fundamental role in creating this havoc.

Although banks are in much better shape than the financial crises of 2008-09, the impact of late payments and defaults can be severe and could even damage even the most balanced balance sheets. It remains unclear how and when the US market will regain its economic momentum, as conditions worsen following the detection of the Omicron variant among US citizens.

In recent years, US policymakers and economists have been very active in offering policy advice to other countries on how to avoid and manage financial crises. But it is a huge surprise that the country itself is on the brink of a bad debt crisis after the outbreak of the Covid pandemic.

An overview of the main causes of the bad debt market crisis

The precise causes of the bad debt market crisis remain surprisingly controversial. Much recent analysis has blamed the pandemic and the role of developments in US housing and financial markets on this economic downturn.

Understanding the root causes of this dire situation is key to overcoming ongoing defaults.

  • Pandemic and subsequent lockdowns

The root cause of this crisis is none other than the pandemic and the resulting containment measures. It’s no secret that Covid-19 has hit the global economy hard, and the US market is no exception. While the shutdowns and other security issues limit the spread of the virus, they automatically put US institutions at alarming risk of default. March 19, Swiss credit warned in a report that “the impact of the pandemic on our financial results is difficult to assess, but we are trying to carefully determine our credit risks”.

The CEO of German BankChristian Sewing, also spoke with German news publication FAS in a interview the possibility of widespread defaults on business loans, warning that such a scenario depends mainly on the extent and, above all, how long the coronavirus weighs on the economy.

Undeniably, the Covid-19 pandemic and its different variants have crippled businesses and other financial institutions, leading to such a crisis.

  • Dependence on unstable short-term funding

Banks’ reliance on unstable short-term funding has seen a gradual increase in recent years, which has led to the situation. The shadow banking system and the world’s largest banks rely on various forms of short-term wholesale funding, including commercial paper, repurchase agreements, contingent funding commitments, certain types of interbank loans, and more.

Shadow banks’ reliance on unsecured short-term funding has made them subject to a run, as have commercial banks and thrift institutions. However, he insists that financial companies set aside liquidity by shifting their assets into highly liquid securities.

The supply of highly liquid securities is relatively inelastic in the short term. Moreover, the efforts never increase the liquidity of the financial system as a whole, but only serve to increase the price of liquid assets while decreasing the market value of less liquid assets such as loans. These liquidity pressures will make companies less willing to extend credit to financial and non-financial companies, leading to a crisis in the bad debt market.

Central banks have also warned that the risk of temporary liquidity shortages persists as the economic shutdown continues.

  • Gaps in risk management paradigms

Although the vulnerabilities associated with a pandemic or short-term funding can be considered a structural weakness of the global banking system, we cannot overlook that they are a consequence of the poor risk management system.

From the significant collapse of mortgage underwriting standards, to the weakening of commercial real estate loan underwriting standards, to the overreliance on credit ratings and the insufficient ability of many large companies to track enterprise-wide risk exposures, everything shows the deficiency of risk management and control system.

Excessive leverage is often a significant cause that contributes to the bad debt market crisis. Undoubtedly, several households, businesses and financial companies took on more debt with banks than they could handle or repay on time, leading to credit downgrades and defaults.

However, what is worse is that the assessment of trends in the indebtedness of financial companies is not easy because the available statistics are insufficient. Additionally, leverage can be very difficult to measure in a world of complex financial instruments.

Moreover, this cause tends to be procyclical, increasing in good times, when confidence between lenders and borrowers is high, and decreasing in bad times, when confidence turns to caution. This, in turn, increases financial and economic stress during the recession and leads to defaults.

Payment defaults also lead to an increase in high risk loans. With lower credit scores, households are opting for many payday loans and other unsecured loans to overcome the financial crisis.

Central banks around the world are taking appropriate measures to protect international financial institutions to maintain the flow of credit as economies are deeply affected by the pandemic. They do this by keeping interest rates low and extending lifelines to hard-hit businesses and lenders. A team of analysts from BlackRock Investment Institute wrote a research note arguing that such monetary policy measures will reduce downside risks to the economy and the growing threat of an outsized spike in debt and credit defaults.

Priscilla C. Carnegie