Solvency of financial institutions could be bigger threat than liquidity in next crisis, economist says.

In a sign of the darkening outlook for the global economy and financial markets, the continuing debate over whether the next major crisis is on the way is shifting into a conversation about just what type of crisis it will be.

For Neil Shearing, group chief economist at London-based Capital Economics, the bigger threat is not a liquidity crisis arising from rapidly rising interest rates and falling asset prices worldwide. Rather, it is the threat to the solvency of financial institutions, which usually requires government action, that’s more important.

The distinction matters because central banks can generally deal with liquidity crises, by providing greater access to credit and unlimited amounts of money if needed. A solvency crises, on the other hand, poses a graver threat to the economy because institutions theoretically wouldn’t be able to stay alive no matter how much help they got. While some say the 2007-2009 financial crisis and recession was primarily driven by a lack of liquidity, it also arose from a loss of investor confidence in financial firms where solvency was at risk.

Talk of whether the next financial crisis is on the way picked up steam last week, when cracks in everything from credit markets to mutual-fund flows and the implied volatility of bonds, stocks and currencies pointed to the potential for something to break. Shearing’s comments on Tuesday came on the same day that the International Monetary Fund warned the global economy is at its most vulnerable moment since the onset of the 2020 COVID crisis, and that a general lack of liquidity in markets, especially for government debt, could act as a “shock amplifier.”

Recent turmoil in the UK bond market, which has led to repeated interventions by the Bank of England, is “primarily a liquidity crisis,” Shearing said. “Instead, the real danger lurks in solvency crises (or the risk that liquidity crises are allowed to morph into solvency crises).”

In a nutshell, solvency trouble occurs when the value of an institution’s assets falls below that of its liabilities. On a large scale, that can ” impair the entire system of financial intermediation and credit creation, which in turn can cause a sharp contraction in the real economy,” the economist said. Ultimately, governments would be required to absorb the losses and recapitalize parts of the financial system.

To be sure, the 2007-2009 financial crisis and economic downturn has led to stricter regulation and oversight that should make commercial banks less vulnerable to solvency crises, he said. Even so, “sources of financial risk have a habit of materializing in a way that is difficult to fully anticipate in advance.”

In addition, another source of risk is the shadow banking sector, with the greatest threats being in places where assets “are illiquid and difficult to value,” Shearing wrote.

In a roller-coaster session on Tuesday, stocks ended mostly lower, with the Dow Jones Industrial Average DJIA,
holding on to a small gain while the S&P 500 SPX,
declined for a fifth straight session. Meanwhile, Treasury yields held relatively steady as investors await Thursday’s US consumer-price index report for September.


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