The G20 Finance Ministers and Central Bank Governors get warned by the international Financial Stability Board.

By Wolf Richter for WOLF STREET.

The Financial Stability Board (FSB), an international organization that among other things sends reports to the G20 Finance Ministers and Central Bank Governors, sent a stark warning to the G20 today, ahead of its two-day meeting about the risks that have built up in the global financial system, and this time, AI, leverage out the wazoo, sky-high asset prices, driven in part by AI and leverage, and interconnectedness of everything were on top. Government debt globally – with all eyes on the US – was also on top.

Everything was on top of the list, so to speak, but AI got special treatment in the letter: AI is a risk to the global financial system in terms of cyber risk and in terms of leverage, asset prices, and “cross-investments” (circular financing) of the entities involved.

In the letter, FSB chair Andrew Bailey, Governor of the Bank of England, warned of a “potentially disorderly correction” in the markets that “could spread across borders.” And it boils down to leverage:

“As we have seen multiple times in the past, rising leverage is a feature of a maturing financial cycle. While it can reinforce rising markets, it can also intensify declines when sentiment turns, as recent weeks have demonstrated.”

“The issue is not simply that investors are borrowing more, but that leverage is interacting with high valuations and market concentration, in particular the increasing cross-investment between artificial intelligence (AI) companies and hyper scalers, in a way that could amplify a future market correction.

“I remain concerned therefore that a large shock or combination of shocks could concurrently trigger multiple vulnerabilities.”

The letter listed “fragilities” in government debt markets, such as:

• “Elevated issuance” (the US alone issues $1 trillion in additional debt every three to five months that have to be absorbed by investors).
• “Shortening maturities” (we think about Bessent’s efforts to shift some of the debt to short-term Treasury bills via issuance and buybacks; a larger share of T-bills makes the bond market riskier as increasingly huge amounts of T-bills have to be sold at massive auctions every week, now in the $500-600-billion-a-week range).
• “Leverage” (we think about the highly leveraged Treasury basis trade where hedge funds buy Treasuries and create and sell Treasury futures. They’re long Treasuries and short Treasury futures. The last time this blew up was in March 2020, and it locked up the huge Treasury market).

Bessent, who is in charge of the Treasury debt, today added his two cents to the focus on government debt: “The world is awash in debt post GFC, post COVID, and the only way for us to get out of this is to grow our way out of this,” he told reporters ahead of the G20 meeting. This is the principle of letting the economy run hot: higher inflation, higher nominal economic growth, and higher long-term interest rates. But that doesn’t address the other risks listed in the letter from the FSB.

The FSB’s letter listed “vulnerabilities in private credit,” such as:

• “Levels of interconnectedness” with banks (banks took some big hits last year when several private credit deals blew up).
• “Liquidity mismatch” (referring to the recent runs on private credit funds, when investors were trying to yank their money out, after the issues became more apparent; funds promised these investors daily liquidity within small-print limits that no one read, while the funds’ investments are illiquid questionably-valued loans made to riskier companies).
• “Opacity” (in addition to regular opacity, such as what these loans might be really worth, we think of the instances of fraud that have caused some private-credit deals to blow up in the US last year).

The letter listed “stretched” and “elevated” asset valuations, such as:

• “Particularly artificial intelligence-related investments” (here we’re thinking about stocks involved in the AI trade, including semiconductor stocks, and anything that shot up due to the AI infrastructure investment mania, and the valuations of AI-related startups, now measured funnily in the trillions of dollars each).
• “Risky assets” whose valuations are “elevated.”

He listed increased “leverage in equity markets.”

• “Leveraged exchange-traded funds (ETFs) and correlated momentum-driven investment strategies” (alas, they have become favorites for retail investors, and they blow up routinely).
• “Growing footprint” of leveraged hedge funds in the stock market, some of which are also exposed to government debt (such as those in the basis trade or highly leveraged directional Treasury bets), which “increase the scope for contagion risk” from the stock markets to government debt markets.

AI risks get special treatment. A big part of the letter was reserved for AI, which represents a pile of risks layered on top of each other, including:

• Ability of frontier models to hack financial institutions across borders: “cyber disruption can spread across jurisdictions through common technology providers, shared infrastructure, and cross-border financial activity.”
• This cyber risk “could undermine market confidence system-wide, especially due to highly concentrated third-party service providers” (we think of this market confidence being the only force that keeps asset prices “stretched,” and when this confidence fizzles, it could lead to that “potentially disorderly correction” that “could spread across borders” that he’d warned about.
• “The increasing cross-investment” between AI companies and hyper scalers “that could amplify a future market correction (we think about the vertigo-inducing amounts and complexities of circular financing and opaque off-balance sheet liabilities).
• The sky-high stock prices and valuations of companies associated with AI that could add or cause that disorderly correction.

The G20 Finance Ministers and Central Bank Governors will have a lot to mull over – not that they didn’t already know all this and saw it develop over the years, and encouraged it to happen, or made it happen. And in terms of the central bank governors at the meeting: These debt levels, leverage, asset valuations, and risks were the inevitable results of many years of their central banks’ free-money policies of QE, ZIRP, NIRP, and forward guidance since 2008. They did it. Including Bailey (BOE governor since March 16, 2020).

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