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The crisis fix needs to be fixed

Adair Turner, chairman of the Financial Services Authority which regulates financial services in the UK, does not believe new laws and regulations passed since the financial crisis of 2007 and 2008 will prevent the next blow-up.

Financial institutions need a lot more equity and a lot less debt, banks have to be able to fail, and the shadow banking system with its repo funding and dangerous interconnectedness must be corralled, he said in a Cambridge speech today.

Some of his comments:

-Global regulators … would be wise to choose capital ratios far above even Basel III levels, something more like the 15 percent to 20 percent of risk-weighted assets which David Miles illustrates in his recent paper. … Before the last 40 years or so, banking systems ran with much higher equity capital ratios, much lower leverage and yet economic growth was as high as it is today and investment as a percentage of GDP as high if not higher.

-While therefore the debate about ‘too big to fail’ banks often seems to imply that we will only have been truly radical when we have seen a major bank fail with losses imposed on debt holders, the truly radical and ideal solution remains one in which there is enough equity or close to equity instruments in the funding mix as to reduce to a minutely low level the probability of us ever having to impose losses on the debt holders of large banks.

– … we must not focus exclusively on specific institutions, such as banks, but on total financial systems and markets. In the two years since the crisis, global regulators have focused primarily on the capital and liquidity regimes for banks, both in general (Basel III) and for big banks in particular (the Systemically Important Financial Institutions’  agenda). But what is striking when one looks back at the events of the initial year of the crisis, 2007 to 2008, is that it did not look at all like a familiar banking crisis, but something entirely new, a crisis of ‘shadow banking’.

– … it might indeed seem odd that so much of the regulatory reform focus over the last two years has been on the capital and liquidity position of commercial banks. In fact, that focus can be justified: banks, as leveraged, maturity transforming and credit providing institutions, play an absolutely central role in the system, and it was when the crisis spread from ‘shadow banking’ to the core banking system in Autumn 2008 that it threatened major macroeconomic harm. But we certainly need to understand the nature and consequences of these shadow bank developments, and identify the fundamental drivers which could in future lead to the re-emergence of ‘shadow banking’ or the risks it created, in new forms.

– … while it was in part a parallel system of credit, it was also deeply entwined with the classic banking system – with money market mutual funds providing funds into the banking system and with the banking system via repo and other secured finance markets providing funds to structured investment vehicles (SIV), conduits, hedge funds and other investors.

– two recent papers argue persuasively that among the most fundamental drivers was investor demand for very low-risk debt instruments; a demand, however, which exceeded the quantity of truly low-risk instruments which could objectively exist.
Thus:
*Gorton and Metrick’s analysis (2010) focuses on the dramatic development of the repo market from 1990 to 2010, with huge increases in total values transacted, but also a huge widening of the classes of collateral used in repo transactions.
*Gennaioli, Shleifer and Vishny’s analysis meanwhile, illustrates how the ‘tranching’ of credit securities met investor demands for an apparently low or zero risk debt instrument (the triple A tranches of structured credit products) delivering attractive yield uplift versus pure risk free Treasury bonds.

– …risks can exist in interconnected markets as much as in specific institutions, and those risks could exist even if we were able to resolve all banks, or even indeed if we broke up large banks into smaller ones. A system of multiple interconnected players could be as risky as one with large specific institutions.

– … we may need to regulate the level of collateral haircuts/margins in the repo and other secured finance markets. Which is to say, to regulate leverage at the contract specific level within the market, rather than at the institutional bank level.

-there has also been rapid growth of interbank claims, both via repo and derivative markets, and via interbank markets in unsecured deposits.The overall effect of these developments is that major bank balance sheets are now dominated by claims against other banks and other financial institutions. This development is in part a by-product of the development of securitised lending.

-There is therefore a strong case that regulators should focus on the interconnectedness of the financial system as a crucial issue in itself, separate from and in addition to the soundness and resolvability of individual institutions.

-And the implication of the shadow banking story, of Gorton and Metrick’s analysis as well as Shleifer’s, and of the fundamental nature of credit and asset price cycles, is that we face deep and complex drivers of instability, which could exist even in a world where we had the operational capability to resolve all banks, and even in a world of multiple small banks rather than large banks. As a result, no single unchanging set of rules is likely to be sufficient to ensure stability: discretionary tools to lean against emerging excess credit extension will also need to be part of the policy armoury.

– … measures to reduce interconnectedness will tend to make some markets less liquid: so too will measures to regulate margins in repo markets, so too will further possible increases in trading book capital.In the past, proposals for such policy measures were often countered by the argument that they would have a ‘chilling effect’ on liquidity, product innovation, price discovery and market efficiency.

-The size of the financial sector, the volume of trading, and the pace of product innovation, should therefore never be seen, as they were before the crisis, as always positive indicators of policy success.
 

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