So far, global financial markets have held up, but the intensifying conflict in the Middle East poses a growing risk to financial stability, global policymakers are warning — sparking a call for greater vigilance.
In a letter to the G20 finance ministers and central banks, the chair of the Financial Stability Board (FSB), Andrew Bailey, called for vigilance amid tightening conditions in financial markets, and the rising risk that multiple strains converge at the same time — ramping up the threat to financial stability and the ongoing provision of financial services.
“Financial markets are experiencing heightened volatility and tightening conditions. When combined with existing vulnerabilities — such as stretched asset valuations, concentrated leverage in the non-bank financial sector, liquidity mismatches and increasing market complexity — these factors could lead to multiple shocks materializing simultaneously,” the letter warned.
“I call this the risk of a double or triple ‘whammy’,” it said.
At the same time, the conflict in the Middle East has made the global financial environment “more uncertain and unpredictable,” it warned.
So far, financial markets have absorbed the negative shock to the global economy arising from the situation in the Middle East, the letter noted. However, one of the key triggers for financial stability risks would be financial markets starting to price a much larger impact on global economic growth from the conflict.
Markets have largely focused on the impact to inflation, but if markets switch their focus to risk assets, amid a growing concern about the conflict’s impact on growth — an “abrupt re-pricing in equity prices could coincide with the already greater focus on valuations in private assets,” it said.
Against that backdrop, Bailey called for regulators to step up surveillance on sovereign bond markets, private credit and asset valuations.
“Global asset prices remain elevated by historical standards,” he noted — adding that sectors where valuations were stretched before the conflict “are particularly vulnerable to sharp adjustments if economic conditions deteriorate.”
Similarly, investors were souring on certain risky markets, such as private credit, before the conflict. The conflict could increase the pressure on leveraged borrowers, and could reduce asset quality, increasing pressure on private credit funds.
“There is also a heightened risk that the opacity of these markets could trigger a broader loss of confidence even when the issues are limited to particular borrowers,” it noted.
In government bond markets, the FSB said that the use of high leverage by funds with correlated strategies has increased the risk of a disorderly unwinding of those funds’ positions, which could hurt liquidity in sovereign bonds and spread across borders.
“If the size and economic impact of this shock continues to increase, the risk that it interacts with known vulnerabilities will also increase,” it said. “We will monitor closely how this shock develops, including the potential of more than one vulnerability crystalizing at the same time, leading to broader effects within the system, and a loss of confidence.”
In particular, the FSB noted that it is planning to publish a report on the vulnerabilities arising from the growth of private credit in the near future. It’s also working on an analysis of the channels that enable risks to spread and intensify, including work on foreign exchange derivatives.
To that end, Bailey stressed the need for close monitoring of foreign exchange and derivatives markets, and it’s keeping a close eye on repo markets, “which are critical for market liquidity,” it said.