Phew…We dodged a bullet. FTX went under before it could become so connected with banks and markets that it became systemic.
This was more luck than skill on the part of our regulators. In 2021, the Fed welcomed into the federal system the very small Washington state rural bank FTX had purchased in 2020. This gave the bank access to the Fed settlement system. Alameda Research started investing in it. The bank, originally named Farmington State Bank, was renamed Moonstone Bank. FTX must have had big plans.
Concurrently, FTX , which had been spending millions lobbying both parties, had also been lobbying the CFTC to allow it to offer non-intermediated, margined clearing of BTC futures. Some of the biggest names in finance, academia and the think-tank scene wrote to the FTC in support of the application.
But FTX went under and withdrew its application before the CFTC could make a decision.
The FTX saga may well turn out to be the proverbial canary in the coal mine. We are, after all, coming out of decades of low rates, ending with the pandemic’s monetary easing on steroids. As Minsky (who must be turning in his grave since the advent of QE) and many others since have pointed out, loose financial conditions breed financial excesses.
Since the GFC, the Fed has prided itself on greater vigilance in monitoring financial sector risks. It has implemented an extremely tight regulatory framework for the banking system. Under the eagle-eyed surveillance of our eager supervisors, banks cannot, and will not, repeat the mistakes of the past.
Call me skeptical, but I have some old-fashioned ideas about capitalism and risk. For instance, the former cannot exist without the latter. If you try to scrub the banking system of risks, they will not disappear but instead migrate outside the regulator’s searchlight.
And since the GFC, the shadow banking system has received much less regulatory scrutiny than the banking system, which has allowed the former to pick up business from the latter. Since 2010, credit to the private non-financial sector from the shadow banking system has represented $6.9tn, against $6tn from banks (Chart 1).
In theory, the shadow banking system is less systemic than banks since it does not carry the payments infrastructure. In practice, the administration is trying to re-establish the oversight of the shadow banking system that had been eased under the Trump administration. This suggests our regulators have some concerns.
Given how fast the shadow banking system has grown, I would be surprised if banks had not been involved in some way or another. Banks could be exposed through direct funding. Archegos, a hedge fund that last year inflicted large losses to its bank lenders, comes to mind. Alternatively, banks could be exposed through lending to borrowers propped up by shadow banks, for instance the highly leveraged corporates taken over by private equity firms.
In addition, bank balance sheets may not turn out to be squeaky clean after all. For instance, very low rates have allowed the proliferation of zombie borrowers that may not be able to survive an increase in their borrowing costs. Or take the very large holdings of government papers foisted on banks by the post-GFC regulations. At many banks, capital losses on these represent a sizeable share of equity, and it is only accounting rules that have protected banks from having to mark down their capital.
All in all, I would be surprised if banks were able to go through this tightening cycle without having to raise equity.
Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)