Thoma: “Critical vulnerabilities remain”

Get ready for the next financial crisis, cautions University of Oregon economist Mark Thoma in his April 23 blog Economist’s View. That’s because we have not taken, and are not likely to take, the needed steps to prevent runs on the shadow banking system, he writes.

Separating retail and investment banking, setting higher equity requirements, and forcing firms to devise resolution plans so the FDIC can dismantle them when they fail, will not prevent runs on financial markets like those that caused the financial crisis in 2007-2008, writes Thoma.

Those runs, mainly on the repurchase market, occurred in the shadow banking system. They can be prevented only by regulating the shadow bankers and insuring the shadow lenders, similar to the way the FDIC regulates traditional bankers and insures their depositors, Thoma writes. But the government is not going to insure shadow bankers, so the best we can do is require the institutions to have lots of equity, says Thoma.

But that’s probably not going to happen either, he writes.

From Thoma’s column:

The only way to effectively stop runs in the shadow system is to provide some sort of deposit insurance coupled with strict regulations on how much risk can be taken by these institutions (along the lines of how deposits are protected in the traditional system). We can separate retail and investment banking, impose higher capital requirements, and force firms to have explicit resolution plans in the event of failure, and this will help, but these measures can’t always prevent bank runs and systemic failure in the investment banking sector (and hence does not eliminate the need for a bailout).

To stop runs in this sector, there are two main types of proposals, The first is to enhance the quality of the collateral held against deposits in the shadow/investment bank system — the collateral plays the role of insurance and is intended to prevent runs. But since the value of these assets cannot be guaranteed a priori (even government bonds could be a problem in the right circumstances), full protection cannot be guaranteed and runs are still a problem.

The second proposal is to provide explicit, government insurance on deposits in the shadow system along with strict limits on risk taking behavior. It worked in the traditional system, and it can work here too. …

But the reality is that the government is not going to provide explicit deposit guarantees in the shadow system, and bank runs leading to systemic collapse will remain a possibility.

The runs that caused the financial crisis in 2007-2008 occurred mainly on the repurchase market, when repo lenders stopped making repo loans amid doubts that repo borrowers and the mortgage-backed securities they sometimes used as collateral were sound. Smaller runs also occurred on asset-backed commercial paper, unsecured commercial paper, securities lending, and shares of money market funds. For details on these runs, please see the About Repo tab at RepoWatch.org.

If we can’t eliminate financial crises, we need to make them as mild as possible, writes Thoma. One way to do that is to impose equity requirements considerably stronger than those currently being proposed by Basel III, but that probably won’t happen, says Thoma.

The requirements as currently constituted are too small, come online too slowly, and do not offer the protection we need. I doubt very much, however, that we will see any increases in these requirements. With the political power of banks we’ll be lucky to maintain the increases that have been proposed.

So where does that leave us?

Thus, despite all the calls to shore up the financial system to prevent another crisis, critical vulnerabilities will remain.