The new global financial order: Are we there yet?
In response to the global financial crisis that began in mid-2007, governments around the world are introducing reforms designed to address the way financial markets operate. Although it will take many years to implement the multitude of rules and regulations, we know the contours and can focus on the question of whether the changes will instill a safer system. The answer is likely to be a disappointing no.
To date, reform in financial regulation and supervision has focused mainly on large, regulated institutions. Three examples are the just announced Basel III capital rules, much of the US Dodd-Frank Act, and the US Federal Reserve’s revamping of its large holding company supervision.
Some attention has also been paid to the systemic source of risk, notably in Dodd-Frank’s provisions for prudential supervision of payments, clearing, and settlement systems. Yet, shoring up the capital of the banking system is equivalent to fortifying the Maginot Line while the financial system has changed.
Understanding the Run on the Shadow Banking System by Felipe Rezende offers an insightful look at the evolution of the US financial system. The growth of new non-bank institutions- SIVs, APBC, repos, etc- that Tim Geithner, US treasury secretary, refers to as the “shadow banking system” plays a significantly larger role than depository institutions. Those institutions engaged in a big transformation of illiquid assets into liquid assets using short-term funding such. As Tobias and Shin have documented in Liquidity and Leverage, the leverage ratios and asset growth of non-bank financial institutions is much higher than the traditional banking system. Those institutions are inherently more fragile than the banking system yet in moments of stress they transfer the risk to the banking system.
As a result, the most glaring limitation is the failure of the present initiatives to address the pro-cyclical liquidity in the financial system. The problem is well known. US Fed chairman Ben Bernanke’s Labor Day Reading List includes the seminal paper by Gary Gorton titled The Panic of 2007. Gorton gives a compelling explanation of the amplifying transmission mechanism. The paper provides insights into the enormous growth of the shadow banking system generally, and the repurchase agreements, or “repos,” market specifically, dependent on the engineering of AAA-rated securities that led participants to believe they did not need to inquire into the soundness of the underlying collateral. In short, the financial engineers took illiquid assets and succeeded in amplifying exponentially the credit in the system.
Furthermore, liquidity runs compound losses, after repos and derivatives obtained strong insolvency privileges in 2002-2005. The insolvency provisions allow seizing collateral upon default, without stay. The exceptions in the priority of creditors offer a strong incentive to insolvent or illiquid firms to gamble for resurrection by pledging repo collateral. The exemption fed the acceleration in the use of repos in 2005-2007.
The repossession of collateral enabled the creditors to front run all others and shift losses and accelerated fire sales on the way down, again increasing procyclicality. In essence, when the value of whole classes of the underlying collateral was drawn into serious question, by the collapse of the subprime housing market, participants’ lack of information about the collateral they held led to a shattering of confidence in all the collateral.
Policymakers are aware of the risks. Ben Bernanke blamed the runs on a regulatory structure that didn’t encompass lenders working outside the banking system or place enough emphasis “on the detection of systemic risks.”
But despite the compelling need to address leverage in the system, the recent regulatory reforms proposed by the Basel Committee have deferred the introduction of a leverage ratio. According to the oversight body of the Basel Committee on Banking Supervision the liquidity coverage ratio will be introduced on 1 January 2015 and the revised net stable funding ratio will move to a minimum standard by 1 January 2018. Any reform proposal that defers the implementation of the leverage ratio by eight years is simply not credible.
In essence, the lines between insolvency and illiquidity get blurred when confidence breaks down between counterparties, and the opaque system of repos and tripartite repos leads to a contraction of liquidity of the type we witnessed in Bear Stearns and Lehman’s failures. Alan Schwartz, who led Bear Stearns during the crisis, has a proposed solution: to have repos cleared like any other instruments in a centralized clearing and settlement organization with adequate safeguards. The solution to eliminate counterparty risk is eminently sensible but there is nothing in the present reform effort to address the issue.
Gillian Tett of the FT has reached the same conclusion. She points out that repos need a backstop to avoid future crises. Her article points out that four months ago, New York bankers issued a report task force on Tri-Party Repo Infrastructure, on the tri-party repurchase, or “repo”, market, which described the sector’s shortcomings. The New York Federal Reserve issued additional comments and called for reform in a paper, Tri-party Repo Infrastructure Reform, and shortly thereafter the discussion disappeared from public view.
As Ms Tett writes: “Indeed, the Dodd-Frank bill barely touches them at all. And, this month, as European and US regulators have marked the second anniversary of the collapse of Lehman Brothers by unveiling new financial reforms, the issue has barely cropped up at all”.
Despite all the evidence on the need to improve transparency in the repos market and improve the institutional mechanism that reduce procyclical liquidity, measures designed to introduce transparency; such as reforms designed to improve the clearance and settlement of repos are not addressed in the Dodd-Frank legislation.
Without more efforts to address the procyclicality of leverage a reduction in systemic risk in the system is highly unlikely. Far more needs to be done in this area, particularly as new constraints applicable to large regulated institutions push more activity into the unregulated sector. So, are we going to get there? No and we are probably not going to get there before the next crisis if the international community does not introduce leverage mitigation techniques.