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I’ve been asked several times why the price of a given financial asset could violently fall while the fundamentals of that same asset were sound. I have often answered that crises and periods of stress on the markets were generally accompanied by forced selling that was independent from the fundamentals of these assets.
We provide an illustration with the stock exchange indices of the United States (in the US, in the Eurozone): we know that the evolution of the latter is clearly linked to the risk aversion phenomenon in all its forms (bank risk, sovereign risk…). This phenomenon has broken the links between stock indices and traditional equity market fundamentals. : Growth perspectives, company results, interest rates (some simple econometric tests demonstrate it by the way). But there is more than just risk aversion. In fact, the history of market crises and their amplification during the past 15 years cannot be understood by focusing solely on pure fundamentals. We need to integrate the contagion phenomenon between financial assets and forced selling because of commercial, prudential, regulatory and accounting reasons.
1. Contagion among assets linked to cash requirements
We are not referring here to the liquidity that we highlight to measure the possibility of selling a financial asset more or less easily on a secondary market.
– We can also mention the situation of speculative funds with very strong leverage during periods of great stress such as the default of Lehman Brothers in the fall of 2008. They were confronted to an underperformance of their strategies and had to reimburse the funds provided by prime brokers as well as answering margin calls. This amounted to selling their assets and arbitrages at any given price. We also have to include the default of some funds which led some banking institutions to sell billions of USD worth of assets they had received as collateral from these funds.
This forced selling phenomenon must not be underestimated during periods of stress on some financial assets whose outstanding amounts by speculative funds are quite high (we naturally think about the debt of countries such as Spain or Italy).
2. Contagion among assets for prudential and regulatory reasons
This will lead an institution to sell for example shares which have been downgraded and / or whose capital consumption becomes too important for it not to degrade its solvency ratios.
3. Finally, as an extension of the previous contagion, there is contagion among assets for accounting reasons
Within the guiding framework of their half year but most annual accounts, we often see investors or banks selling sound assets on which they can still realize profits and which will compensate for the losses (unrealized or otherwise of other assets. In this case we once again see the value of some assets getting disconnected from its fundamentals.
We therefore understand better why a crisis in a given sector or a given country or regarding a financial institution becomes a global financial crisis. We have pretended to discover that since 2007 banking activity was systemic in the sense that it could have dramatic consequences on the financial stability of a country or a group of countries. These systemic risks are further increased by contagion and herd behavior phenomena which transform a local crisis into a global crisis.
– Financial instruments are more sophisticated and complex with ever more financial innovation that regulators do not fully master
– Globalization and interactions among actors with more risks of seeing a potential systemic risk.
– Procyclical accounting and prudential norms meaning that they can accentuate periods of depression or in opposite fashion the enlargement of bubbles. This creates permanent risks of a solvability crisis for all the financial actors (corporates, households, states…) when bubbles burst and the prices of overpriced financial assets go down violently
The lesson that we can take out of all these developments and most notably for banks is the following: By selling loss making assets, you generate liquidity but you degrade you solvency (the losses negatively impact your capital level) ; if you don’t sell, you need to refinance at conditions that progressively worsen and you prepare yourself to go through a liquidity crisis.
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