MIT Sloan professor warns the next shock could be lurking in the ‘shadows’

via Marketwatch:

‘Where will the next shock come from? Could changes in the global financial system — including those aimed at building bank resilience — be sowing the seeds of the next crisis?’

That’s the question posed by MIT Sloan professor Kristin Forbes in a paper set to be published in an upcoming issue of the American Economic Review.

In other words, she’s concerned that the measures taken to bolster the global financial system after the meltdown a decade ago could actually create the next one.

Forbes, who previously worked at the World Bank and Morgan StanleyMS, -0.24%  , acknowledges that we’ve come a long way, but also warns that “there is more to do in terms of monitoring the new vulnerabilities that develop as individuals, banks and other firms adapt and shift risky exposures outside the regulatory perimeter.”

She explained that regulations in the subsequent years have made meaningful progress, “especially in requiring that the banks at the heart of the last crisis are better capitalized and less leveraged.”

But while banks are, indeed, more secure, risks may have shifted, she said. Specifically, vulnerabilities lie in the “shadow” financial systems — hedge funds, pension funds, insurance companies, securitization vehicles, mortgage funds, etc.

“Most macroprudential regulations focus on banks, leaving these ‘shadow’ institutions outside the regulatory perimeter or subject to oversight by other bodies, which are usually less powerful, adopt less stringent regulations, and are less focused on macroprudential risks,” Forbes wrote.

As just one example, she pointed out that if tighter regulations on banks’ mortgage exposures cause consumers to shift to other sources of financing, like pension funds, then another key sector could become exposed to troubles in the housing market.

Forbes said that despite significant improvements, regulations have “some way to go… to ensure that there is not another crisis and economists are not asked again by a future monarch: ‘Why did no one see it coming?’”

She was referring to when the queen of England asked that very question during a discussion in the aftermath of the 2008 crisis.

 

 

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