The next financial crisis is … 2015?

Oliver Wyman launched a new report at Davos last week that has garnered a few headlines.

Titled: “The Financial Crisis of 2015: An Avoidable History”, they suggest that although financial services executives and regulators have worked hard to design a more stable financial system, they might fail as there are other market stresses that could occur.

The report “stress tests” the current financial system by describing a possible scenario for a financial crisis in 2015. Under this scenario, risk is forced out of the Western banking sector but it immediately flows into the shadow banking sector and emerging markets forming bubbles in commodities and related assets. The bursting of these bubbles then triggers sovereign debt restructuring in vulnerable markets, and a crisis in global finance by 2015.

“During phase 1 we distinguish between two sources of demand affecting commodities prices: demand for use in the production of other goods (“real” demand) and demand for the purpose of price speculation (“speculative” demand). There are three major groups of players in our scenario. Firstly, there are economies, such as Latin America, Africa, Russia, Canada and Australia, which are the largest commodities producers. Secondly, there is China, which is now the world’s largest commodity importer. Thirdly, there are the developed world economies, such as the US, which are pumping liquidity into the financial system through their loose monetary policies.

“As with any bubble, our scenario contains a compelling narrative that allows investors to convince themselves that “this time is different”. In this case it is a story of strong economic growth coming from China creating a sustainable increase in demand for commodities.

“However, it is already apparent that increasing commodities prices are also creating inflationary pressure in China, which is exacerbated by China holding its currency artificially low by effectively pegging it to the US dollar. This makes commodities look like an attractive hedge against inflation for Chinese investors. The loose monetary policy in developed markets is similarly making commodities look attractive for Western investors ...

“Based on the currently inflated commodity prices, commodity producers in countries such as Brazil and Russia have clear business cases for investing in projects to dig more commodities out of the ground. As competition to launch such projects increases, the costs of completing them also starts to rise, with the owners of mining equipment and laborers capitalizing on the increased demand by charging higher rates. Because a portion of the demand for the projects is not coming from the real economy, an excess supply of mining capacity and commodities will be created.

“As with previous asset bubbles, we expect much of the debt financing for these projects to come from banks. And much of this bank financing is likely to be supplied by Western banks that are eager to preserve their diminishing return-on-equity and need to find lending opportunities that are sufficiently lucrative to cover their own increasing cost of funds.”

That cheered us all up.

Download a copy of the full report.