The impact of the regulatory policy since the financial crisis has been to remove risk from a location where it can be closely monitored and to disperse it throughout the economy, leading overall to a reduced risk appetite.
The focus of attention on the banks has centred on their ability and willingness to lend to small companies whereas the restrictions upon their capacity to provide liquidity to financial markets has been overlooked. The combination of reduced market liquidity (through changes in capital requirements), the herding of investors towards a clear but fragile consensus over future prospects (in large part through policymakers actions) means that riskiness of markets is far greater than might be appreciated.
I would argue that with significantly reduced depth to markets and high congestion of investor positions, the next period of market disruption will be characterised by ‘gaps’ in trading as markets shift 5, 10 or even 20% in order to reflect new fundamental views. Overall we’re now creating a system with an ‘exit’ which is too narrow to allow investors to use when the next shock arrives.
In such a ‘gapping’ market I’d expect all stocks to fall sharply, even those with assumed higher liquidity. The combination of more volatile and less liquid portfolios with reduced opportunities to outperform is not a great combination for investors but is the consequence of the regulatory approach since the crisis.
The likelihood of more volatile financial markets with more ‘gaps’ in trading is highly likely to act to restrain consumer and corporate confidence leading to a weakening in ‘animal spirits’ and therefore economic activity. This is an example where reducing the level of risk in one part of the financial system is leading to greater risks of volatility in other parts of the system. It should be apparent that in an increasingly interconnected economy the result is the shifting of risk rather than the reduction.
Given the well documented fact that most employment growth and innovation takes place in smaller entities the consequences for growth and general dynamism in the economy are obvious and will become apparent over time. Essentially we will witness a changing corporate structure in developed markets in favour of larger incumbent companies who are better able to cope with increased volatility and risk as a consequence of materially altering the funding mechanisms available to companies.
The choice of regulators appears to be that we wish for fewer big shocks (in banks) but at the expense of lower overall rates of growth and more widespread volatility and uncertainty. While this might be a reasonable public policy outcome I think it advisable that we all understand the consequences of these moves and accept that the lower risk appetite has negative consequences.
One of the biggest conundrums underlying the authority’s intentions is that to return to a ‘normalised’ set of policy settings we require a ‘normal’ economy. The circumstances where we could all identify a normal economy appear very far off.
Robert Talbut is chief investment officer at Royal London Asset Management