Regulators tend to try to clamp down on what they think are risky assets, risky financing, risky deals. But in the financial crisis of 2007-2008, it was the “safe” elements that caused the trouble, say New York University professor Viral Acharya and Northwestern University professor Arvind Krishnamurthy in an opinion piece in the Financial Times March 18, 2010.
The systemic risk was in the AAA-rated tranches of mortgage-backed securities funded mainly through secured repurchase agreements, write Acharya and Krishnamurthy. What could be safer than AAA-rated paper and secured loans?
Regulators need to keep this anomaly in mind, say the authors.
From the Financial Times article:
AAA rated tranches and repo financing were never supposed to experience such stress in the bankers’ view of the world. Bank risk management had considered stress scenarios in which unsecured financing through interbank markets would freeze, but secured overnight funding through repos was deemed to be essentially risk-free. …
Regulation charged with the macro-prudential objective of containing systemic risk should be more concerned about seemingly fail-safe assets and secured financing, rather than worrying much about riskier assets and unsecured financing.
It is striking this is the opposite of how Basel capital requirement works. It gives a big capital advantage to AAA rated tranches of mortgage backed securities compared to lower-rated tranches and corporate bonds. And it ignores the risk of liabilities altogether. …
The moral of the story is that regulators need to impose tighter constraints, such as higher capital requirements, on activities such as holdings of AAA rated tranches and repo financing of risky assets where there is a conflict of interest between the privately optimal and socially optimal choices.
Bankers will fight such a proposal. But it should be well understood that they have all incentives to ignore the attendant systemic risk.