Do repo and other risks still threaten the world economy?

As regulators try to force commercial and investment banks to have more equity and less debt, by raising their capital requirements, the banks continue to find ways to evade the rules as they did leading up to the financial crisis of 2007-2008. This leaves the repurchase market as vulnerable to a run as it was three years ago.

This shortage of equity is one of many risks that still lurk in a dangerous financial world, writes Jim Tankersley in the National Journal March 10.

From his article:

In the wake of the financial bust, U.S. and world leaders adopted a series of stricter rules for financial institutions to guard against risky behaviors that could bring the system to its knees. They agreed to raise the amount of capital that banks are required to hold, through the so-called Basel III agreement.

That higher bar is an attempt to shore up a business model that matches often-illiquid assets with cheap, short-term financing. When the value of the assets falls unexpectedly, as it did quite infamously with Lehman Brothers, financial institutions cannot afford to pay their short-term debts—unless they have a sufficiently large cushion of capital.

Problem is, many economists contend that it remains relatively easy for financial institutions to elude those capital requirements.

That’s particularly true among the large foreign-owned financial institutions that buy U.S. Treasury bonds and make up much of the Federal Reserve Board’s “primary dealer” market. Many of those institutions have restructured their holdings to keep their seat in the market without actually complying with the increased capital standards, says Robert Eisenbeis, a former research director at the Federal Reserve Bank of Atlanta who is now the chief monetary economist for Cumberland Advisors.

Such evasion leaves the United States exposed to a domino-like rerun of the last crash. If asset prices plunged, debts were called in, and several primary dealers failed at once, the federal government’s ability  to borrow would evaporate.

Eisenbeis and others say that this risk gives the government a vested interest in keeping the dealers solvent, reinforcing the “too big to fail” mentality that incents the financial giants to risky behavior.

The short-term financing and short-term debt Tankersley refers to is primarily the repurchase market and the smaller commercial paper market. Both tanked in 2007-2008.

Another unsolved risk is the banks that are too big to fail, Tankersley says.

Other reforms, including the Dodd-Frank financial-regulation bill, were designed to shine a light on the risky assets in financial institutions’ portfolios. But as the law is being implemented, it’s still far from clear how much risk individual institutions—including the nation’s largest banks—are carrying.

The 10 largest U.S. banks now hold a bigger share of total bank deposits, handle a bigger share of financial transactions, and buy a bigger share of U.S. Treasuries than they did before the crisis.

Although the financial-reform law attempts to fix that risk by regulating the “systemically important” institutions much more tightly, these giant banks are fighting to wriggle free, with some support on Capitol Hill.

To make matters worse, these mega-banks are still allowed to obscure much of their business, Tankersley says.

Transparency remains a problem with regulators, too: The next round of the Federal Reserve’s vaunted “stress tests” of large banks’ ability to withstand a crisis is widely expected to result in passing grades across the board, with little documentation to back them up.

“The soundness of the largest financial institutions and the systemic risks they continue to pose is no better” than it was before the crisis, warned Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, Mo.,  in a speech on February 23. “In my view, it is even worse.”

Hoenig, a conservative, argued that the only way to reduce risk would be to prohibit banks from trading their own accounts in the securities markets.

Some economists also warn that Dodd-Frank does not go far enough to regulate capital-poor, risk-rich “shadow banks,” such as investment banks and hedge funds, and to prevent the shadow-banking collapses that fueled the financial crisis.

“We’re not dealing with the capital problems in these large institutions,” Eisenbeis says. “If you have sound financial institutions, you can weather a storm in a way that you couldn’t otherwise.”