A Fetish of Illiquidity Is Driving Finance
Reprinted from the FT – 12/07/2021
History repeating itself as banks and pension funds bet more on private assets. You may well have worried more about illiquidity if he were still around today.
John Maynard Keynes famously declared in his General Theory of Employment, Interest, and Money that “of the maxims of orthodox finance, none, surely, is more antisocial than the fetish of liquidity”. If the great economist were around today, he might have worried instead about the fetish of illiquidity.
The vulnerability of the banking system before the financial crisis was partly attributable to a dramatic liquidity decline. In the 1960s, commercial banks in the UK and much of the developed world held 25 per cent or more of their assets in cash and short-term government paper that was free of default risk. This pained the banks because the return on cash was nil, while the return on assets such as Treasury bills was only marginally above money market rates. So the UK clearing banks ran down liquidity to about two per cent before the crisis, without protest from the Bank of England.
This adjustment meant that they were increasing their exposure to higher-risk private assets when they happened to be funding their business increasingly from volatile wholesale deposits. This left them dependent on the central bank to sort out the mess in the event of any shock to the system. In effect, they outsourced liquidity management to the central bank with liquidity risk ultimately falling on the taxpayer.
Under the rules of the Basel Committee on Banking Supervision, liquidity has since been rebuilt, though nowhere near to 1960s levels. Yet history seems to be repeating itself. Ultra-low interest rates have imposed a tight squeeze on bank profits. This, according to a recent report by the EU’s European Systemic Risk Board, has forced banks into a new search for yield and led them to tilt the composition of their assets towards riskier market segments such as commercial property. They have also increased their exposure to interest rate risk by granting fixed-rate loans at longer maturities.
Now a deeper move into real estate is afoot. Lloyds Banking Group announced last week that it was embarking on direct ownership of residential properties for letting, in some cases taking on development risk. Time was when the directly owned property was not regarded as fit for bank balance sheets because real estate is relatively illiquid, especially in a downturn.
There is added piquancy given Lloyds’ ruinous 2009 acquisition of HBOS, which incurred heavy write-downs in its directly owned residential land and housebuilding operations in the crisis. The wider financial system has seen a similar retreat from liquidity.
Consultants Willis Towers Watson’s latest Global Pension Asset Study shows that pension funds’ asset allocation to private assets including private equity, real estate, and infrastructure has gone from seven per cent to 26 per cent over the past 20 years. These funds have sought to harvest an illiquidity risk premium, the extra return above that on quoted equities.
The trend is set to continue — witness the C$221bn Ontario Teachers’ Fund’s decision to invest C$70bn in private markets over the next five years. The financial empowerment of private funds that this will all entail points to further shrinkage in the total pool of equities as private equity re-liquefies the market in corporate control.
A new report from the OECD on corporate governance and capital markets after the Covid-19 crisis points out that since 2005 more than 30,000 companies have been delisted from stock markets globally. These exits have not been matched by new listings, so there has been a big net loss of publicly listed companies.
That is not all the work of private equity.
Among other things, it reflects the ready availability of super-cheap, tax-privileged debt and the low capital requirement of tech companies. Interestingly, the OECD report records that 23 per cent of all equity raised in the US between 2010 and 2019 went to tech companies. This high number seems counter-intuitive until you recognise that much of that figure relates to phoney tech companies like Uber and Lyft, which rely on labour market regulatory arbitrage to extract value from pedestrian businesses in which technology plays a purely ancillary role.
Increasingly the function of the primary equity market is to fund operating losses until such companies achieve profitability (or not as the case may be). And the structure of capital markets generally is dictated increasingly by ultra-loose monetary policy. The message, once again, is that the Gadarene search for yield inevitably leads to phenomenal mispricing of risk. The risk premium in private markets is dwindling and, in some areas, may even be illusory.