One way to spot a bubble

One way to spot a developing financial bubble would be to track the non-deposit liabilities of banks, including repos, says Princeton University professor Hyun Song Shin in a November 22, 2010, study, “Macroprudential policies beyond Basel III.”

Financial Times columnist Gillian Tett discusses the report and its application in South Korea in a January 13, 2011, column.

Banks’ non-core funding rises in a lending boom, because deposits are generally stable and don’t grow rapidly. Setting limits on non-core funding, or taxing it, would be ways to control for bubbles, Shin writes.

Non-deposit liabilities are funding for banks that comes from sources other than depositors, such as repos, commercial paper and foreign currency debt.

From Shin’s report:

Excessive asset growth and greater reliance on non-core liabilities are closely related to systemic risk and interconnectedness between banks. In a boom when credit is growing rapidly, the growth of bank balance sheets outstrips available core funding, and asset growth is mirrored in the greater cross-exposure across banks. …

The growth in non-core liabilities is accompanied by the shortening of maturity of the liabilities. …

Securitization is a way for intermediaries to tap non-deposit funding by creating securities that can be pledged as collateral. The demand for collateral assets is therefore a demand for leverage. In this respect, subprime lending in the US can be seen as a
reflection of the wider principle that the growth of non-core funding is a sign of excessive asset growth in a lending boom.

Shin is not optimistic that Basel III – the new capital standards for banks – will limit financial crises.

From his report:

The centerpiece of the new capital and liquidity framework for banks known as Basel III
is a strengthened common equity buffer of 7% together with newly introduced liquidity
requirements and a leverage cap, to be phased in over an extended timetable running to
2019.

Under its current agreed form, Basel III is almost exclusively micro-prudential in its
focus, concerned with the solvency of individual banks, rather than being macroprudential,
concerned with the resilience of the financial system as a whole.

The elements that were most promising in living up to the macroprudential aims of
regulatory reform – the countercyclical capital buffer and the capital surcharge for the
systemically important financial institutions (SIFIs) – proved most controversial and have
yet to be finalized.