Is leverage in the financial system still posing a major risk for markets?
El-Erian: We talked about leverage, and most of the talk continued to centre around the evolution of the “Shadow Banking System,” a phrase used by Bill Gross and Paul McCulley to describe the entities and activities that took on substantial leverage backed by insufficient capital and outside sophisticated regulatory oversight. What we’ve seen is a forced deleveraging of part of the shadow banking system that has been created by a combination of mark-to-market volatility and a need to minimize losses in the context of the “just in time” risk management mindset that dominated Wall Street until last summer. There is another part of the shadow banking system – instruments that are still rated AAA but do not deserve the rating – that has yet to delever. For now, these are subject to less frequent mark-to-market and rating agency actions. Ultimately, for these instruments, it’s a horse race between continued deleveraging and the entry of new capital to recapitalize. Over the longer term, we
