Michalis Persianis
When inflation began to run out of control in the 1970s, a provision of the Glass-Steagall framework, then approaching its 40th anniversary, began to make its presence felt in the markets. Regulation Q allowed the Federal Reserve to cap deposit interest rates, which it did with enthusiasm. But those caps kept deposit rates below inflation, leaving savers with negative real returns—much as they have in Cyprus today.
Savers realized that keeping their money in bank accounts no longer paid and began looking elsewhere. They turned to U.S. Treasury securities, investments, and, eventually, a growing new trend: money market mutual funds. A new golden age was dawning for Wall Street’s increasingly complicated products, roughly a decade before Oliver Stone’s film of the same name gave us that unforgettable moment when Gordon Gekko, played by Michael Douglas, summed up the spirit of the age: “Greed is good.”
The financial world that develops around the edges of regulated markets is often called “shadow” finance precisely because it sits just beyond the reach of regulators and supervisors. It is a space where funds, private credit, and derivatives thrive, generating immense profits that grease the wheels of the global economy.
Over the past 18 to 24 months, concern has been growing about the quality of these private loans outside the banking system and falling valuations of the collateral underpinning funds’ investments. Meanwhile, waves of mass withdrawals suggest that loan defaults could increase. Analysts and official bodies have begun issuing warnings, no longer able to conceal their unease about three developments: the rapid expansion of shadow finance, which accounts for more than half of global financial assets, or $258 trillion; its growing connections with traditional banks, with lending by conventional U.S. banks to the sector rising 35%; and the continuing lack of transparency in its books. Rapid growth, connections with mainstream finance, and opacity are always an explosive mix. Concentrating large sums among a small number of counterparties also increases the likelihood that, should an “event” occur, it will quickly escalate and spread through the wider financial system.
From Tricolor’s failure last year to withdrawal restrictions at Blue Owl, which ultimately closed, and at BlackRock, the familiar names of Apollo and KKR, and other funds in the spring, followed by HSBC’s awkward announcement in early summer, the tremors in the shadows continue.
If a correction is beginning, there is nothing unprecedented about it. We have seen this process before. Examples abound, from the “paper tigers” of 1997 to Alexander Fordyce in 1772 and the U.S. crisis of 1907. That was when the collapse of the Knickerbocker Trust Company sent shock waves through the system, eventually bringing a certain Mr. J.P. Morgan to the fore. He took matters into his own hands and became the last-minute savior.
Each time, a gap in supervision encouraged excessive risk-taking in a pocket of the financial system more exotic than the mainstream of its day. Often, that risk was tied to financing a rapidly developing technology that would “change everything.” And when asset values corrected, the resulting collapse hit the rest of the system like a sledgehammer, spreading from there through the global economy.
Shadow banking exists because other parts of the system are supervised and regulated in ways that constrain the imagination of finance’s golden boys. Under favorable conditions—easy money, attractive interest rates and returns, particularly when accompanied by a new technology or the opening of new economic “territory”—these activities expand rapidly. Hedge funds, structured investment vehicles, and elaborate financial structures hungrily absorb market funding and create new, usually ingenious, innovative products.
By definition, they operate beyond the reach of supervision. Their natural habitat is the system’s “shadows,” since their products are designed to manage risk on the assumption that spreading it around makes it disappear.
Yet this fund-based shadow banking system rests on an inherently unstable mismatch: short-term liabilities and long-term assets. It owes money now and collects later, over and over again. It survives by employing people with cutting-edge training, high intelligence and unrestrained imaginations, free to maneuver in the system’s unregulated shadows. But that is not enough to prevent an eventual fatal wrong turn. It is only a matter of time. Heavy borrowing against collateral—hardly a Cypriot invention—the illusion of liquidity and these maturity mismatches make such structures inherently unstable and unbalanced.
And because they are connected both to markets and to the traditional banking system, their strains spread through the economy. The dominance of the dollar, and now cryptocurrencies, in transactions and investments also means that the health of shadow banking has a direct and immediate impact on currencies.
The creaking heard in the beams of the shadow system in recent weeks does not originate in Iran, which is intensifying uncertainty and instability and worsening the already growing pressures on economic growth. Nor does it originate in the streets of France, where fiscal pressures have exhausted both the public and the public purse. Even without cryptocurrencies and artificial intelligence, even without constant geopolitical upheaval, including Iran, even without Germany’s AfD and the looting in France, those pressures were already there. All these developments have simply tightened the vise.
If such a scenario unfolds, Cyprus will come under pressure and face difficulties. And, if it avoids mistakes, it will withstand them.
It has been through worse, with a state and political system ill-equipped to manage such problems. Today, existing institutions are better placed to respond more quickly and effectively to everyday demands under prolonged pressure. It would now take a succession of mistakes, or one major mistake, to seriously test our resilience.
The country’s very healthy public finances provide another layer of protection. If foreign direct investment outflows can be avoided, those investments will offer another important line of defense. Naturally, that requires a strategy, which does not currently exist. The country will certainly need social support measures, but those do not amount to “economic policy.” Initiatives to support small and medium-sized businesses, including high-tech firms, need not depend on public spending. And the most obvious mistake—propping up the prices of assets undergoing a correction—is easy to avoid.
Above all, a correction in global finance would offer a golden opportunity for reform. And since that word has been so overused, the most important reform would be the least glamorous and the least appealing to politicians: changing the state’s own procedures, simplifying applications and bureaucracy, and undertaking a genuine overhaul of internal processes.
Digitizing government beyond the services voters can see, deep within the workings of the civil service, must finally become a priority, even if it offers little material for election campaign self-congratulation.
The same applies, of course, to our entirely passive approach to foreign direct investment. We watch it arrive with delight but take no steps to anchor its presence here for the long term or embed it in the domestic economy. In information and communications technology, just 4.2% of output is “consumed” within Cyprus.
We do nothing to make a potential departure from Cyprus more costly by building those domestic links. Nor do we steer these investments toward areas of the economy where we, too, stand to benefit over the long term.
