This is not your usual sovereign contagion post.
We’ve argued once before that Ireland’s failed bondholder bailout has unleashed contagion that does not just threaten the eurozone. Sudden illiquidity could also strike banking systems across the core, returning markets to volatility last seen during the late-2008 crisis.
That moment in the market witnessed an intense dollar shortage for European banks, requiring the establishment of central bank swap lines. Trouble reappeared over Greece in May 2010 and dollar swaps were again pressed into service. Interesting to observe the current pressure on euro basis swaps, even if it’s nothing like at levels of the recent past:
But back to this core illiquidity risk.
Ireland looms surprisingly large as a node in this globalisation process. For example — here’s a chart Monk points out that underlines Ireland’s share of the $25,500bn global funds industry:
Not bad for a very small economy. Not good for financial contagion.
That’s because the IMF paper really uses ‘global funds industry’ as a euphemistic portmanteau for the shadow banks. You should know ‘em well enough by now, but if not, the paper has a nice summary of what shadow banks (or if you prefer, nonbank financial intermediaries) did:
In the run up to the crisis, LCFIs [large, complex financial institutions] generally increased their reliance on market-sensitive funds, as the global search for yield prompted a move away from more expensive deposit funding. Facilitated by regulatory arbitrage, this liability re-composition also reflected, and was supported by, changes on the asset side, through securitization, ratings creep, and leverage. This process resulted in balance sheet growth and aided greater interconnections of banks with nonbank funding sources and across borders. It also resulted in the buildup of systemic risk concentrations and formed the critical fault lines along which liquidity shocks were subsequently transmitted globally.
Transforming maturities, enhancing liquidity, arbing the regs.
For example, consider a structured investment vehicle connected to a bank that borrowed short-term liquidity from the money and repo markets for investing in longer-term asset-backed securities. It was a relationship hedged with credit derivatives, and unfortunately primed to blow up in 2007 and 2008.
That’s a horrific simplification, but there you are. Fast forward to 2010.
What the paper points out is not only that European banks remain far more connected to the funds industry than their US peers; but also that funds’ overall cross-border exposures are still not fully understood, amid a complex ecology of countries that are common lenders and/or common borrowers, and sometimes key offshore finance centres to boot.
Which is where we start to move from shadow banks to shadow sovereigns. It’s a good bet Greece is a bit less interconnected with banking and shadow banking systems in the core than Ireland. But there’s an interesting chart in the IMF paper (click to enlarge):
This is assuredly not the path of Greek contagion markets have been looking for in 2010. And as the authors explain (emphasis ours):
Figure 10 presents four clusters (i.e., countries that together form more of a closed system), centered around a set of core connections that are closely linked to Greece: (i) a red cluster of countries with access to funds domiciled in Luxembourg; (ii) a black cluster with access to funds domiciled in the offshore centers of British Virgin Islands, Jersey, Cayman, Guernsey, and the Isle of Man; (iii) a blue cluster with Ireland at the core; and (iv) a green cluster of the U.S. with several key European and other countries. Greece is interconnected with each of the central nodes of these clusters. This close interconnection across other core countries suggests why asset re-allocations and flows might have been large systemically, with potentially significant impact on countries such as Ireland.
Which should perhaps focus minds on the consequences of not carrying through an orderly sovereign restructuring in Ireland or Greece — or any other distressed sovereign hiding out there, actually. (A chart with the Kingdom of Spain in the centre would be most interesting.) There’s an emerging consensus that this must be prepared for. See the latest German whizz on when restructuring provisions should be inserted into that two-tiered eurozone government bond market, for example.
(And the above applies just as much to any European bank bondholder burden-sharing as part of a sovereign restructuring, of course.)
It’s practically a truism these days that a modern European sovereign default would be vastly larger in terms of size of debt, and much more legally complex than the Russian or Argentine restructuring that once held the records. Even without considering any tricky shadow bank connections.
Doesn’t stop it being a lethal truism if tested, though.