What a difference a decade makes …. or not
In his speech to the Institute for International Finance, Bank of England Governor Mark Carney favorably reviews the new post-financial crisis regulations. But in doing so, he inadvertently reveals why this effort has been a complete waste of time and served only to increase financial instability rather than decrease it.
Mr. Carney summarized the condition of the global financial system pre-crisis.
A decade ago, regulatory frameworks in advanced economies had become light touch and ineffective. Looming risks in the financial system were ignored. Markets were fragile and unfair, plagued by numerous instances of misconduct and insufficient market discipline on large firms.
This is a description of a global financial system that was becoming increasingly opaque. For example, why was there “insufficient market discipline on large firms”? The only reason the market would not exert discipline is opacity prevented investors from performing their own risk assessment and adjusting their positions to what they could afford to lose.
He then went on to discuss the global financial regulators’ response after the crisis started.
In Washington in 2008 in the aftermath of the Lehman debacle, G20 Leaders committed to radical reform of the financial system, and they charged the FSB with fixing the fault lines that caused the financial crisis.
The comprehensive reform programme had four main components:
- – Creating resilient banks
- – Ending too big to fail
- – Transforming shadow banking into market-based finance; and
- – Making derivative markets safer.
A decade on, this programme has largely been achieved. The financial system is safer, simpler, and fairer.
These fault lines did not cause the financial crisis. Fault lines do not cause an earthquake, but rather earthquakes occur along fault lines. Similarly, the financial crisis occurred across each of these opaque areas of the global financial system as markets realized they could not assess these securities and froze.
Falsely blaming the fault lines for the financial crisis makes it easy for Mr. Carney to claim reform of the global financial system has “largely” achieved its goals.
Just like the authors of the Dodd-Frank Act, he would like to claim too big to fail has been ended. However, there is no one outside of a few regulators and politicians who thinks this is true. Does anyone expect Goldman Sachs not to be bailed out if its failure, even if temporarily slowed down under the regulator controlled orderly liquidation process, would potentially trigger a second Great Depression?
Mr. Carney explained why he thought banks were now more resilient.
A central achievement has been the transformation of banking.
A decade ago, banks were woefully undercapitalised (some were levered over 50 times), with complex business models that relied on the goodwill of markets and, ultimately, taxpayers.
Large global banks are now considerably stronger. They can stand on their own.
With capital requirements for the largest that are ten times higher, banks have raised more than $1.5 trillion of capital. And they are disciplined by a new leverage ratio that guards against risks that seem low but prove not.
If large global banks can stand on their own, why do regulators need to announce the results of annual stress tests? Markets know announcing the results morally obligates taxpayers to bailout investors for any solvency problems with a bank that passed.
If large global banks can stand on their own, why don’t they provide transparency so the market can confirm this is true? A bank that is unwilling to disclose its current exposure details is a bank with something to hide.
Everyone knows leverage ratios don’t guard against risk. Risk is a function of each bank’s choice of asset and liability exposures. In theory, and it is only in theory, leverage ratios set an upper limit on how much total risk a bank can take through its choices.
Mr. Carney goes on to claim the financial system is simpler.
The system is simpler in part because, a decade on, banks are less complex and more focused. They lend more to households and businesses, and less to each other.
Business strategies that relied on high leverage, risky trading activities and wholesale funding are disappearing, as intended. Trading assets have been cut in half, and interbank lending is down by two- thirds.
Why might interbank lending have declined since before the crisis? When the crisis hit, banks with deposits to lend realized opacity prevented them from assessing the ability of the borrowing banks to repay the loan. So they stopped making interbank loans. This opacity hasn’t been addressed. Over the last decade, this hasn’t been a problem since central banks have pursued policies that have flooded the banking system with liquidity. This has substantially reduced the need for banks to borrow in the interbank market.
Mr. Carney acknowledged opacity had a role in the financial crisis. He gave examples of two opaque areas where he felt new regulations addressed the problem caused by opacity.
A decade on from the ABCP crisis, the toxic forms of shadow banking at the heart of the crisis – with their large funding mismatches, high leverage and opaque, off-balance-sheet arrangements – no longer represent a global stability risk….
And …
A decade ago, OTC derivative trades were largely unregulated, unreported and bilaterally cleared. Uncertainty about such exposures contributed to the panic.
Uncertainty about OTC derivatives is part of the reason the interbank lending market froze. Banks with deposits to lend had no way of assessing the risk of the borrowing banks’ derivative exposures.
To his credit, Mr. Carney hedged as to just how successful the new complex regulations really were in addressing the problem of derivative opacity.
[Central Counter Parties] reduce contagion risks in banking, and they make the massive derivatives markets more robust. The extent to which they reduce overall systemic risks, however, depends on their resilience and resolvability.
In short, regulators created a new too big to fail entity without addressing the issue of how much risk is hidden in each bank’s derivative portfolio.
Finally, Mr. Carney moved on to what is always the Achilles’ Heel of regulation and regulatory enforcement.
Implementation must not only be effective; it must also be dynamic. That is, authorities must learn by doing and make adjustments, as necessary, to optimise our efforts, without compromising on the level of resilience the reforms are intended to achieve.
By definition, regulation trails innovation in our financial system. At the same time, due to politics, regulatory enforcement waxes and wanes over time.
In short, regulators are not up to the task of ensuring financial stability. Hence, all this effort at writing new regulations rather than bringing transparency to the opaque corners of the global financial system has effectively been a waste of a decade.
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