Financial reforms have not fixed the problems

The recent financial reforms are focused on making commercial and investment banks stronger, but they ignore the real problem in the financial crisis of 2007 and 2008, which was runs on the shadow banking system, banker Michael Pomerleano wrote in the Financial Times’ Economists’ Forum June 5.

Pomerleano has advised a number of banks including the Bank of International Settlements, the World Bank and the Bank of Israel.  His piece adds to a pile of recent articles from economists who believe the Dodd-Frank Act and Basel III will not fix the problems that felled the financial markets in 2007 and 2008 because they don’t deal adequately with shadow banking.

From Pomerleano’s article:

The problem with the recent regulatory measures is that they have focused on the formally regulated financial sector, while the financial crisis erupted in unregulated shadow banking which plays an increasingly large role in the US economy. There are numerous possible explanations for this neglect: there isn’t adequate data on the shadow banking system; it’s heterogeneous; the operations are opaque; and the Basel committee – whose core constituency is central banks and banking regulatory agencies – lacks expertise in the shadow banking, as evident in the crisis.

Shadow banking is where financial companies borrow and lend outside the safety net of FDIC insurance and the Federal Reserve discount window. Much of the borrowing in shadow banking is done on the repurchase market, and in the lead-up to the crisis banks used that money to make loans and securitize them.

Of particular concern is shadow banking’s vulnerability to fire sales, notes Pomerleano. An example was when repo lenders suddenly demanded repayment in 2007 and 2008 and forced investment banks into fire sales of their holdings to raise cash to repay their repo loans.

Liquidity grew within in the shadow banking system, and once liquidity evaporated, fire sales led to downward revaluations of collateral assets. In a financial system increasingly dominated by market instruments, a collapse due to rapid revaluations or counterparty risk is a very high prospective risk. The liquidity and leverage ratios proposed by the Basel committee do not address the problem.

The financial crisis illustrated examples of both counterparty risk, where the lender loses confidence in the borrower, and rapid revaluations, where the lender loses confidence in the collateral.

During the crisis, the counterparty risk of a Bear Stern or Lehman hinders their capacity to mobilise funding and leads to fire sale of marketable assets.

Similarly, it is enough for a small change in valuations in the prospects for credit card debt (consumer credit), auto, housing, and commercial real estate in a leveraged financial pyramid to trigger a cascading chain of revaluations, forcing rapid fire sales and in turn leading to calls for additional collateral that amplify the vicious cycle.

To achieve financial stability, regulators need new tools to deal with fire sales, as discussed in the December 2010 paper “The Macroprudential Toolkit” by Anil K Kashyap at the University of Chicago Booth School of Business, Richard Berner at Morgan Stanley, and Charles A. E. Goodhart at the London School of Economics, writes Pomerleano.

From The Macroprudential Toolkit:

Most treatments of financial regulation worry about threats to the banking system and the economy from defaults or credit crunches. This paper argues that the recent crisis points to fire sales through capital markets as another source of financial and economic instability….

Many accounts of the crisis, especially after the failure of Lehman Brothers in September 2008, point to fire sales as having occurred. For instance, Federal Reserve Chairman Ben Bernanke, in summarizing his lessons from the crisis for economic research said “a vicious circle sometimes developed in which investor concerns about the solvency of financial firms led to runs: To obtain critically needed liquidity, firms were forced to sell assets quickly, but these ‘fire sales’ drove down asset prices and reinforced investor concerns about the solvency of the firms.”

This type of problem can be expected to grow, because as regulators clamp down on the traditional banks, bankers are going to move more activity into the shadows, Pomerleano believes.

The solution is to focus less on regulating banks and more on regulating bank activities, for example  like securitization where transactions occur in both traditional and shadow banking, he writes.

It is important to note that prospectively shadow banking is bound to take on a greater role in lending vis-à-vis the banking sector because banks will be limited by the new capital regulations. Therefore more stringent measures are needed to harmonise the regulation of the shadow-banking and traditional-banking sectors. Among them there is need for a new approach to supervision that focuses on markets and instruments as opposed to institutions. For instance, there is a need for examination “through instruments” from origination to distribution to identify vulnerabilities. Policy makers need to redouble efforts to address the excessive liquidity build up in shadow banking.

Shadow banking  is important, and it needs attention, Pomerleano writes.

The sector finances more than 30 per cent of assets in the US, yet limited data is available and very little has been done to regulate it. We are far from the point where regulators and markets participants can be confident that they will have secure access to liquidity at times of systemic crises.

* Shadow bankers include money market funds, securities broker-dealers, investment and commercial banks and their holding companies, finance companies and mortgage brokers, issuers of asset backed securities (ABS) and asset backed commercial paper (ABCPaper), derivative users, hedge funds, and off-the-books businesses variously known as trusts, special purpose entities, special purpose vehicles, variable interest entities, conduits and structured investment vehicles.