This is how the next financial crisis will spread around the world economy

Losses will be directed to insurance companies, pension funds and private investors – bailing them out may prove to be politically necessary

London's financial district, Canary Wharf (Getty)

A new economic crisis, which I believe we are on the brink of experiencing, will have similarities, and differences, to 2008. The problem of crowded trades – where market participants all have the same basic positions and strategies, and identical risk models – will be familiar.

The effect of new regulations, ironically designed to minimise the risk of a new crash, and a reduction in trading liquidity will create new problems. Extra capital, while welcome, does not alter the level of risk, but merely who bears it.

To recapitalise banks, regulators have approved risky hybrid securities, such as contingent capital and bail-in bonds. In the event of a systemic crisis, losses will be transmitted to insurance companies, pension funds and private investors; bailing them out may be politically necessary or expedient.

With simpler solutions proving politically difficult, attempts to reduce the risk in the chains of derivative contracts have focused on Central Counter Parties (CCPs), a theoretically bankruptcy-proof guarantor of transactions and collateral. CCPs have added complexity, creating new instability; CCP risk management is unproven under conditions of stress.

The reliance on collateral is likely to prove troublesome under conditions of real stress. The emphasis shifts from the borrower or counterparty’s creditworthiness to the collateral creating different risks.

Government securities now are not risk free. It assumes liquid markets for the collateral, which must be realised in case of default.

Unexpected changes in the amount of collateral needed create liquidity risks. Collateral use also entails significant modelling, operational and legal risk.

Trading liquidity in markets has also diminished markedly since 2008. Traditionally, market makers act as shock absorbers in periods of stress allowing investors to readjust portfolios at a price. But consolidation – through bankruptcies, mergers or acquisition or withdrawal – has reduced the number of dealers.

Higher capital charges and specific prohibitions on trading, such as the Volcker rule or narrow banking, have increased the cost of trading. The amounts that can be transacted without moving prices materially have fallen, meaning shocks will be rapidly transmitted.

The decline in liquidity is exacerbated by the changing structure of many markets. There is increased participation by high frequency traders (“HFT”), retail and private investors either directly or through funds. Paralleling the decline in the number of dealers, the number of major asset managers through whom these funds are deployed is small.

The combination of size, the nature of the underlying assets and the redemption feature may prove especially toxic. It is simply not possible to transform highly illiquid instruments, using financial engineering into liquid equivalents. This lack of liquidity is not reflected in pricing, with the premium for liquidity risk in most segments having fallen to 2007 levels of below.

As the following scenario outlines, these changes in market structure are likely help to create instability in any new crisis.

The key drivers will be higher liquidity reserves for banks, more stringent calculations of risk in derivative transactions and use of government securities to lower capital requirements as collateral. Given pre-existing exposures to government bonds via repurchase transactions, investments or trading inventories, the regulations increase bank exposure to sovereign bonds. This coincides with the deterioration in the quality of government securities and unprecedented low rates driven by policy, creating a dangerous source of instability, which will feed market volatility and transmit losses across different markets.

Where rating downgrades or deteriorating credit quality result in falls in the value of sovereign securities, banks suffer losses on their holdings. Where the securities are used as surety for funding or derivatives, banks need to lodge additional collateral, draining liquidity from markets. The deterioration in a sovereign’s credit quality will affect risk calculations, requiring additional capital as well as collateral.

Banks may hedge this risk, usually by purchasing default protection on the sovereign or shorting government bonds. This will exacerbate losses as the sovereign bonds’ value falls further. Market constraints may necessitate use of proxies for the sovereign, including shorting or buying insurance on equity indices or major stocks. Banks may short sell the currency as a de facto hedge. Proxy hedges transmit the volatility into other asset markets. They create additional risk where volatility is high and correlation between major asset classes becomes unstable, such as in a risk-on risk-off trading environment.

Second round effects focus on the financial position of banks adversely affected by losses on government bond investments and reduced ability of the nation to support its financial institution. The increased default risk of affected banks sets of a chain reaction of additional capital charges increase and loss exposures across international active banks who deal with them , requiring further hedging, compounding the negative spiral.

The reduced demand for the affected sovereign’s bonds result in higher funding costs and reduced market access, which is transmitted to banks and other firms in the country. Higher counterparty risk or downgrades may trigger more collateral calls.

Financial market shocks flow through into the real economy, affecting the supply of credit, growth, investment and employment. In turn, this feeds back into further sovereign and financial sector weakness.

The exact sequence of events is unpredictable because of the complexity of transmission pathways. But once these feedback loops start, they are very difficult to control.

Satyajit Das is a former banker and the author of ‘A Banquet of Consequences: The Reality of our Unusually Uncertain Economic Future’​