King Says Global Debt May Contain Seeds of Next Financial Crisis

Former Bank of England Governor Mervyn King says a buildup of debt needs to be more closely monitored to ensure it doesn’t spark the next financial crisis.

“The areas of weakness in the current system are really focused on the amount of debt that exists, not just in the U.S. and U.K. but across the world,” he said on Bloomberg Radio on Wednesday. “Debt in the private sector relative to GDP is higher now than it was in 2007, and of course public debt is even higher still.”

The level of bad loans in European banks and tax cuts in the U.S. mean the issue of debt buildups -- private and public -- remains a pressing one for the global economy. King said while banks are generally better capitalized in the U.S. and Europe, there could be spillovers from elsewhere.

“If there were defaults -- not very many but where people revised their view about the value of assets on balance sheets of financial institutions and intermediaries around the world -- then you would find that not only would the value of the assets go down, but also the value of the equity cushion available to absorb losses,” he said. “And that’s the kind of thing that can induce financial panic. Now I’m not saying it will happen, it may never happen. But that’s the area of weakness that I would look to.”

Fed Concerns

King also said central banks’ backstops need to be better designed and set out more clearly, so that institutions like the Federal Reserve aren’t hamstrung if they need to take emergency decisions.

“The response of Congress to the last crisis, understandably so, was to try to restrict the discretion of the Fed to provide liquidity to institutions and markets,” he said. “That is the wrong direction. The Federal Reserve would have been better served to have been given the freedom to exercise that discretion, but under a set of conditions agreed with Congress, rather than limiting the Fed from lending when it feels its necessary.”

Market volatility has erupted in the past few days amid concern that inflation is picking up and that interest rates might rise faster then previously expected. The extreme price moves even saw some financial products linked to the VIX volatility index closed.

King, a contributor to Bloomberg View, said that the last financial crisis showed that derivatives could leave institutions exposed without knowing the extent of the risks that they face. Regulators are probably already concerned about VIX-related derivatives.

Investors, however, shouldn’t worry too much about the price swings, he said.

“Short-term volatility is not the same as a risk to your investment objectives,” he said. “So go back and ask yourself what could go wrong with your investments. Don’t get sidetracked by an indicator.”