What will cause the next financial crisis?

The bursting of interrelated credit and property bubbles has caused financial crises in the US and certain European countries, including Cyprus, in recent decades.

The epicentre of the global financial crisis of 2006/07 was the meltdown in the sub-prime mortgage market in the US, that affected most of the financial industry and eventually spread around the world triggering a deep global contraction in economic activity.

In Cyprus it was the banks that increasingly wasted their ample financial resources on extending credits in speculative property ventures, which contributed importantly to the financial crisis of 2012/13, that was highlighted by a devastating run on bank deposits.  

In the aftermath of the global financial crisis the focus of regulators has been primarily on strengthening risk management and addressing the excessive loan concentration of banks so as to ensure the stability of the financial system and avoid the onset of new financial crises. Indeed, safeguards were put in place to curtail the risks regulated banks were taking.

However, with non-bank financial institutions hardly being regulated, shadow banking systems have become much more prominent in providing private credit in many countries over the past decade.

In the US, entities, such as large asset management funds like ‘Apollo Global Management’ have become important players in the booming private credit market, while FinTech firms have become increasingly engaged in online lending to the real estate sector and in financing foreign trade. And with their greater lending to perceived less creditworthy customers it is contended that shadow banks pose risks to the US financial system.

In Europe, shadow banks in recent years have become a significant part of the financial system, with entities like investment funds, hedge funds, insurance firms, and pensions funds controlling assets exceeding €45 trillion in 2024, more than the double the amount since the global financial crisis, and compared with the traditional banking industry’s holding of assets worth just over €41 trillion.

Elizabeth McCall of the Supervisory Board of the ECB has said that “the growth of hedge funds, private credit providers and other sources of financing outside the regulated bank system is the largest threat to Europe’s financial landscape”.  

Future financial crises?

There is much debate as to where future financial crises will come from. It is the growing view that the policies of the Trump administration in the United States, with its reckless increasing of the government deficit and borrowing to unsustainable levels, are raising the probability of a sovereign debt crisis and a related economic downturn.

Would an economic recession and the weak regulation of shadow banks trigger a financial crisis emanating from risky lending to the private sector? Leaders of many large shadow banks, such as James Zelter of ‘Apollo’, argue that even in the event of economic decline their firms would not incur substantial losses and precipitate a financial crisis.

But, a number of analysts consider that there is a likelihood of destabilising financial tensions stemming from asset bubbles in the private sector in the United States.

In fact, Laurent Maural of GoldBroker.com has stated that “the US housing market is showing more serious signs of distress than in 2008. Mortgage defaults are on the rise, even exceeding the levels seen during the global financial crisis. The situation is exacerbated by a number of factors: record-high property prices, making buying a home unaffordable for a number of Americans; mortgage rates, property taxes, and insurance at levels not seen in recent years; and a collapse in the commercial real estate market, marked by empty offices and plummeting rents. If the US sovereign debt crisis intensifies, it could lead to the bankruptcy of several financial institutions exposed to the real estate sector”.  

For Europe, the ECB in their recent strategic reviews has become particularly concerned about the financial stress passing from non-bank financial firms to regular lenders in periods of market stress, noting that shadow banks are more opaque and don’t have access to central bank liquidity facilities.

That is, the ECB is seeing potential risks to financial stability from the fast- growing activities of non-bank financial intermediaries, particularly during periods of market stress stemming from the US.

Cyprus

Could Cyprus experience another financial crisis as happened in 2012/13 coming largely from the deflating of interrelated bank credit and property bubbles?

Notably, in spite of the fast growth in the construction of apartments and commercial buildings in recent years, property prices have continued to rebound since the 2012-2013 banking crisis.

Heightened demand for housing by younger persons and foreigners, especially Israelis and the Lebanese, have lessened the probability of a property bubble and its prospective bursting.

This time seems to be different in that Cyprus banks do not appear to be contributing to a credit bubble with excessive financing of the real estate sector. But currently, it is the activities of shadow banks or non-bank financial intermediaries that are most likely to pose risks to financial stability in Cyprus. 

Since the bank crisis of 2012/13 the debt situation in Cyprus has been dramatically transformed with credit extended and outstanding of non-bank financial intermediaries massively exceeding that of banks.

Financial statistics of the Central Bank of Cyprus indicate that credit (loans and debt securities) outstanding of ‘monetary financial institutions’ (traditional banks) fell from €76.0 billion at end-2013 to €50.6 billion at end-2024, that is, a decline of 33.4 per cent. In striking contrast credit outstanding of ‘other financial institutions’ (OFIs) rose by over 300 per cent from €44.2 billion at end-2013 to €136.1 billion at end-2024.

While a sizable part of the latter increase is attributable to the profound shifting of NPLs off the balance sheets of banks to other financial intermediaries such as “credit acquiring companies” there is the question of where these shadow banks are allocating much of their loans and investments.

What is shown in the balance sheets of OFIs is that their debt has increased from €98.2 billion at-end 2013 to €140.6 billion at end-2024, probably indicating that there is considerable internal borrowing between these financial intermediaries.

On the possibility of shadow banks in Cyprus contributing to destabilising the financial system there are many issues that need to be addressed. Most importantly, are there maturity mismatches between the large debt liabilities and loan assets of OFIs? Do they borrow short-term to lend long-term to the real estate market?

And what are the prospects for credit acquiring and other companies being able to collect much of the debt owed to them from their vast holdings of NPLs and in selling related property collateral without incurring losses?

These issues will become particularly pertinent for financial stability if property prices reverse and show a significant decline since in addition these non-bank institutions are unlikely to have sufficient capital to cover their financial losses and don’t have access to central bank liquidity. Furthermore, such financial stress could in turn spread to related banks and the economy and possibly contribute to the onset of another financial crisis.

In trying to reduce the likelihood of a financial crisis emanating from shadow banks, regulators in Cyprus and other countries would need to have detailed information on the activities and financial transactions of these institutions, so as to detect areas where there is exposure to risk and the need for remedial action.

A key issue for regulators is to prevent an excessive concentration of loans in any one sector of the economy such as in real estate.

With information on the activities of largely unregulated shadow banks being very sparse in Cyprus, the scope for detecting areas of risk to financial stability is rather limited.

In fact, the IMF in their latest report on Cyprus stated that “more information on leverage and investor composition of NBFIs, in particular on links to the domestic banking sector would enhance risk assessment” and add that “consistent monitoring of NBFI investments in specific sectors of the economy (notably the real estate sector) – which have increased significantly over the last two years will help track (loan) concentration and interconnected risks”.

Given the above analysis it can be concluded that the Cyprus authorities should not be complacent about the prospect of a financial crisis that could emanate from the concentrated activities and financial operations of shadow banks.

In addition, with debt-fuelled property “development” continuing to rapidly expand and pre-empt considerably the real and financial resources of the economy, productive investments such as for upgrading infrastructure for ensuring water and electricity supplies are crowded out, and the natural environment further degraded and diminished.