Analyst Explainer: is this another Minsky Moment?
The reappearance of bank failures along with the headlines of bank runs and systemic risk has us thinking about the so-called Minsky Moment. In the 1970s, American economist Hyman Minsky developed the “Financial Instability Hypothesis”, which laid out the framework for how markets will break after a prolonged period of speculative/reckless activity during an unsustainable bull run.
His theory outlines 3 distinct phases of debt financing with increasing levels of leverage – Hedged, Speculative and Ponzi:
During a downturn, both lender and borrower are risk off, credit tightens and company cashflows are large enough to cover both debt principal and interest as both parties hold back on any new investments.
Now, as rates begin to fall to spur economic growth, both lender and borrower become more comfortable with taking risk as asset prices are rising, credit standards start to loosen, but company cashflows are now only covering the debt interest as borrowers are rolling over the principal at low rates to finance new investments, and therefore becoming levered. This boost returns, but also risk.
As we progress into late expansion, credit standards are even looser, borrowers are now rolling over both debt principal and interest to chase returns and thus becoming overleveraged, but they can afford to do this because asset prices are rising faster than their interest payments.
This is fine…until inflation turns up, central banks begin to raise interest rates to prevent the economy from overheating, credit tightens very quickly as lenders become more cautious, and the inability to refinance means that those leveraged borrowers are now forced to sell their assets as they can no longer afford to make even the interest payments on their loans. As more and more losses are realised, this only makes bank lending even tighter, and this will eventually spill over into both Speculative and Hedged financing, which ends with a recession.
Minsky’s theory only really gained attention when people realised it was the blueprint for the global financial crisis, when both lenders and borrowers became overleveraged on mortgages they simply couldn’t afford. The concerns that the recent instances of bank runs could alter lending practices and result in a shortage of liquidity has brought his work back up in discussions.
Although certain elements of a Minsky Moment are present (such as the sudden halt to liquidity and lending activity that will eventually lead to a recession), we don’t believe we have seen a Minsky cycle since the global financial crisis. The fact that multiple banks have failed in the last month without causing a wider crisis is testament to the regulations implemented in the wake of 2008. The phrase “banks are well capitalised” sends a shiver down the spine of any investor as it raises memories of that time, but so far banks have passed the stress test markets have given them. There is still a lesson to be learned however as we transition into a world of higher interest rates. You don’t have to have taken excessive risk to suffer in this environment. Practices which were acceptable, or even desirable when debt was cheap (even free) will no longer be acceptable. Adaptation is required for survival and that can have significant consequences for companies and markets.
So, is this another Minsky Moment? We don’t think so.
Nathan Chan is a Senior Investment Analyst at Astute Investment Management