Two of the most senior figures in international finance have separately issued gloomy forecasts on the state of the world banking system and whether it is equipped to ride out another global financial crisis.

By Daniel Herborn

Posted on December 12, 2018

In a speech on 10 December local time, Janet Yellen, the former Federal Reserve Chair, warned that the banking system was ill-prepared for another global financial crisis which may be on the horizon.

“I think things have improved, but then I think there are gigantic holes in the system,” Yellen told The New York Times economist and columnist Paul Krugman during a talk at City University, New York.

“There remain holes, and then there’s regulatory pushback. So I do worry that we could have another financial crisis.”

Corporate indebtedness has skyrocketed in the US

Yellen highlighted leveraged lending as a particular source of concern. This type of loan is where a lending institution grants a loan to a party who is seen as high risk, often because they have a negative credit history or significant existing debts, or both. As such, leveraged loans carry a higher risk of default.

“Corporate indebtedness is now quite high and I think it’s a danger that if there’s something else that causes a downturn, that high levels of corporate leverage could prolong the downturn and lead to lots of bankruptcies in the non-financial corporate sector,” Yellen said.

“I think a lot of the underwriting of that debt is weak. I think investors hold it in packages like the subprime packages … the same thing has happened. It’s called CLOs, or collateralized loan obligations”.

Corporate indebtedness has trended sharply upwards in recent years; US companies are now carrying a US$9 trillion debt load, up from US$4.9 trillion in 2007.

While Yellen was pessimistic about the ability of the finance sector to address another global financial crisis, she stopped short of forecasting a shock that would trigger such a dramatic downturn. She noted that the current holders of corporate debt generally do not appear to be overleveraged and as such would be unlikely to sell off other assets in the event of defaults, leading to “fire sale contagion”.

Further, Yellen noted that interest rates have been historically low in recent years and were likely to stay low.

IMF’s David Lipton sounds the alarm on international preparedness for a financial crisis

Speaking at the Bloomberg Regulatory Forum in London the morning after Yellen’s comments, International Monetary Fund (IMF) Deputy Director David Lipton told the audience that world governments and the banking system may not be equipped to deal with another crisis.

He was generally less optimistic than Yellen that the world would avoid another GFC but echoed her concerns over the adequacy of the current regulatory framework.

“History suggests that an economic downturn lurks somewhere over the horizon. Many are already speculating as to exactly when, where, and why it might arise,” he said

“Over the past two years, the IMF has called on governments to put in place policies aimed at just that goal—as we have put it, ‘fix the roof while the sun shines’. But like many of you, I see storm clouds building, and fear the work on crisis prevention is incomplete.”

IMF Deputy Director calls for a ‘new multilateralism’

Lipton went on to warn that many central banks will be severely restricted in which monetary policy levers they can pull as their governments have racked up significant debts.

He urged IMF member nations to turn away from isolationism and cooperate to mitigate global economic risks.

Lipton’s speech also covered the potential impact of the US-China trade war and his fear that the world will suffer a “self-inflicted wound”.

The IMF has previously estimated that the tariffs both sides are promising could shave up to 0.75% from global GDP by 2020.

Referring to the temporary pause in tariffs, Lipton said: “It is vital that this ceasefire…leads to a durable agreement that avoids an intensification or spread of tensions.”

Header image credit: Bookings Institution