Strategically speaking: Cardano | Interviews
However, the current economic policy toolkit fails to take into account the human element, making crises potentially more frequent and destructive.
The effects of the 2008 financial crisis were still being felt as Theo Kocken, the founder of the British and Dutch consultancy Cardano, began work on the production of the documentary, which was presented by the late Terry Jones, a member of the well . famous British comedy group Monty Python. Kocken, who is also a professor of risk management at VU Amsterdam and president of the Cardano Development Foundation, wanted to educate the public, especially economics students, about the lack of historical and behavioral perspective in the study of financial crises.
Today, thanks to a swift central bank and monetary action, the world appears to have avoided the financial crisis that could have followed the 2020 stock market crash induced by COVID-19. The economy appears to be heading for a robust recovery from last year’s recession thanks to a massive stimulus. Central banks and governments have revised some of the long-held beliefs about inflation and austerity.
But Kocken’s views on financial crises seem more relevant than ever. Debt as a share of global output is peaking and stock markets are largely out of touch with economic reality. Institutions such as the International Monetary Fund (IMF) have warned of the potential consequences of a sharp and rapid rise in global debt. But arguably, little attention is paid to systemic risk.
“There is a total disconnection between the real economy and the financial economy. This is not the first time in history that this has happened, of course. But it’s getting worse and worse, and it’s mainly due to monetary policy fueling the euphoria, ”Kocken says.
“The economy is trapped in a vicious cycle, in which central banks must act quickly and decisively to avoid the negative consequences of shocks like COVID-19. But their actions end up making the problem worse in the long run. “
The concept of loss aversion, that people tend to want to avoid losses more than they want to make gains, is a powerful key to reading the current situation, according to Kocken. “Negative rates force those with great wealth to invest in financial assets rather than deposits in banks. They are so rich that they will not spend more in the real economy, ”he said.
Those with low wealth, on the contrary, have to borrow to buy houses at high prices. This debt results in less spending and deflation of the debt. It is not surprising that asset inflation is high and real economy inflation is low.
These are the inevitable effects of negative rates and what Kocken calls “quantitative flooding” of central banks. Institutional investors are not immune to the loss aversion bias described by Kocken. That’s why, until the end of the first quarter of this year, the tech sector was the main driver of stock returns.
Kocken is by no means alone in his analysis of the long-term effects of negative rates but, in his view, the fragility of the system is caused by other factors as well.
“Rules implemented after 2008 made individual banks safer, but universal regulation could have unintended consequences beyond the banking sector,” he says.
“The fact that banks have reduced their trading activity means that the liquidity of the financial system has been drastically reduced. At present, there has been no real liquidity test. “
The significant growth of exchange-traded funds (ETFs) investing in less liquid credit assets is a potential weak spot in the system, according to Kocken. This is an area where the promise of liquidity does not necessarily match the actual liquidity of the underlying assets.
Another market that investors, especially pension funds, should watch carefully is the derivatives market. Recent regulatory changes regarding central clearing mean that the clearing of derivatives is done exclusively through central clearing counterparties (CCPs). There are 13 approved CCPs in Europe and Kocken points out that such a limited number of market players, given that there are no more than three to four real large players, could give rise to unintentional systemic risk. .
“I’m not saying that all of these developments are necessarily dangerous. For example, banks are well capitalized at the individual level. I’m saying these new developments haven’t been tested and it looks like connectivity has increased in the financial world. We have a system quite different from that of the 2007 crisis, but the same level of asset overvaluation. That’s why investors should focus on scenario analysis, ”says Kocken.
His approach may seem pessimistic, but it is anchored in his vision based on risk management. In fact, Kocken says that through group processes at the institutional level, one can become aware of behavioral biases and to some extent correct them and dismantle the investment process.
“In addition, our advice has always been to create convexity in portfolios. To protect portfolios from downside risk, investors often have to forgo part of the upside. In equity portfolios, that could mean buying options, ”says Kocken.
“When taking risks in portfolios, we advocate a Nassim Taleb approach, that is to say, taking into account extreme risks.”
Kocken refers to the concept of “black swan” popularized by statistician Nassim Nicholas Taleb, which identifies unexpected events that can have a huge impact on portfolios. COVID-19 may well be considered an example of a black swan event for some, although Taleb himself does not view it as such, according to Kocken, whose greatest concern is a sudden, unexpected and total collapse of the financial system.
The other major risk to consider is liquidity. Kocken says, “We encourage clients to think about where they might access cash if needed. In today’s world, there is a trade-off between liquidity risk and credit risk, in which investing in assets that are assumed to be risk-free from a credit risk perspective, such as sovereign bonds, potentially carries risks. unknown liquidity risks.
“Investors might want to build portfolios that are diversified not only in terms of credit risk, but also in terms of liquidity. The goal is to build a defense against the risks that can harm the most, no matter how small. Rather than hoping for the best, it’s important to prepare for the worst as well. “