The future looks a lot like the past

Future1Bigger“Regulation of shadow banking is starting to look more and more like regulation of traditional banking 100 to 150 years ago, when it took decades of runs on banks, bank failures and economic agony before  Congress in 1933 finally approved FDIC insurance paid for by the banks, limits on bank size, and other safeguards.” –RepoWatch.


After five years of angst, it’s clear that Congress, regulators, and bankers will not set up a framework to prevent the kinds of runs that devastated financial markets in 2007 and 2008.

They will not solve the conflict between growth and stability that is inherent in 21st Century banking.

Instead, they’re going for growth, without putting a new structure in place to prevent the next bubble, bust, and recession.

They’re betting they can do now what they have not been able to do for 30 years – spot trouble as it’s brewing in shadow banking and head off a financial crisis.

This means the financial future will look a lot like the past. More runs on shadow banks, though not imminent, will be inevitable. In these panics, financiers will look to the Federal Reserve for protection. And Americans will desperately need sophisticated business reporters  who claw daily into shadow banking. That means repurchase agreements, securities lending, securitization, derivatives, rehypothecation, and the companies that use these tools.

Treasury Secretary Timothy Geithner confirmed that leaders have selected this future in a January 17 interview with Wall Street Journal economics editor David Wessel:

We’re in a much better position to withstand pretty severe stress going forward. But all systems are vulnerable to crisis – inherently vulnerable. And no one could ever tell you with any credibility that our system today, or any financial system, is invulnerable to a future shock of the magnitude of what we experienced in ’08. …

But we’ve protected and preserved the absolutely essential ability of the central banks to provide funding on a broad scale to, again, reduce the risk that liquidity crises turn into systemic financial crises, and that’s very powerful.

(Editor’s note: “Liquidity crises” are runs on banks.)

This future is perilous, the president of the New York Fed said two weeks later. William C. Dudley told a bankers’ association in New York that serious dangers in the financial markets are still unresolved and that the Dodd-Frank Act has made it harder for the U.S. central bank to intervene. He asked:

How comfortable should we be with a system in which critical financial activities continue to be financed with short-term wholesale funding without the safeguards necessary to reduce the risk of runs and the fire sales of assets that can threaten the stability of the entire financial system?

(Editor’s note: “Short-term wholesale funding” is repo and other borrowing in the shadow banking system.)

Dudley also said there’s little agreement on how to fix these problems and it’s possible we’ve made them worse.

Worthwhile as the steps taken thus far are, we have not come close to fixing all the institutional flaws in our wholesale funding markets. … one could argue that the risks have increased compared to prior to the crisis.

Regulation of shadow banking is starting to look more and more like regulation of traditional banking 100 to 150 years ago, when it took decades of runs on banks, bank failures and economic agony before  Congress in 1933 finally approved FDIC insurance paid for by the banks, limits on bank size, and other safeguards.   This framework fostered 50 years of stability before it began to unravel.

Recent reports

Occasionally an economic study or business press report reminds us of how far we are from fixing the dangerous currents that flow under the surface of today’s credit markets.

Here are three, from economists, regulators, and …. China:

(1)  In “Shadow Banking: Economics and Policy” published Dec. 4 by the International Monetary Fund, four economists describe the main functions of shadow banking, tell about its problems, and argue that we need to fix them, even though we can’t agree on what to do.

Authors of the study include two of the leading international shadow banking experts, Zoltan Pozsar and Manmohan Singh, along with lead writer Stijn Claessens and Lev Ratnovski.

They note that experts have many, but “polar,” views on how fix shadow banking, and they review these ideas. Congress and federal regulators have embraced none of them, hoping instead that by setting new rules for various pieces of the financial markets they can head off broader dangers while letting shadow banking recover to fulfill its potential as a powerful engine of the world economy.

Meanwhile, “urgent” solutions are still needed, to stabilize broker-dealer banks, money market funds, and tri-party repo, the authors say. Also needed are better data collection and regulation, a bigger supply of safe assets for investors, and a better understanding of the interaction of shadow banks and central banks like the Federal Reserve.

With these improvements, shadow banking may be smaller but still useful, the authors claim. Without them, central banks and taxpayers may face even bigger bailouts in the future.

From the study:

… a multifaceted policy response to systemic risks arising from shadow banking is necessary. Such responses, if effective, may make the shadow banking system smaller in size but able to perform its useful economic functions in safer ways. Since not all components of the response are yet clear, more policy-oriented research is needed….

Unless the systemic risks in shadow banking are addressed, these contingent liabilities will remain in place, with perhaps larger actual costs in future crises. 

(2)  Nine days later, on Dec. 13, the Financial Times published “Fed begins stress tests on bank liquidity.” Reporter Shahien Nasiripour writes he learned from sources that the Fed has begun testing some of the largest U.S. and foreign bank companies to see if they’ll be able to get their hands on enough cash to stay solvent during a 30-day panic.

This could be good news, except for the following from Nasiripour:

The tests are intended to guide bank supervisors and the results will not be made public. There is no pass-or-fail level that banks must reach, but if a bank’s liquidity is called into question, Fed examiners could use the results to push them to adjust their funding or increase their stock of easy-to-sell assets.

In other words, regulators are going to let some of the most complex companies in the world continue to hide vital financial information, even though the crisis in 2007 and 2008 proved repeatedly that a company’s opaque financials are a key reason lenders and investors spook and run (for example, see  here,  here and here).


Nasiripour said the new liquidity stress tests follow a June meeting in New York where the Financial Advisory Roundtable, a group of international bankers and economists who advise the New York Fed, urged the Fed to test banks’ resilience to runs. 

(Editor’s note: See below for a list of the members of the Financial Advisory Roundtable.)

From the minutes of the meeting:

Members highlighted the importance of stress testing banks’ liquidity and access to funding during adverse periods. It was noted that the recent U.S. supervisory stress tests … focuses on capital adequacy, rather than liquidity. Members noted that bank access to funding can deteriorate rapidly, even for well-capitalized institutions, and that uncertainty and feedback loops make it difficult to model liquidity risk and liquidity stress events.

Here’s what that means:

Last year the Federal Reserve began annual “stress tests” of the major bank holding companies, by setting out a variety of crises and checking to see how each company would fare in each circumstance. These tests focused on whether the company had enough of its owners’ money, called capital, to be able to keep operating through these crises.

But in June the Financial Advisory Roundtable was asking the Fed to check something else. Its members wanted to know what would happen if a bank company’s lenders suddenly panicked and demanded their money back, or if a bank company’s trading partners suddenly demanded their securities back, as happened in 2007 and 2008. Would the bank company have enough securities and cash, or safe securities it could quickly sell for cash, to meet those demands?

That’s called having liquidity. According to bank regulators, “Liquidity is a financial institution’s capacity to meet its cash and collateral obligations at a reasonable cost.”

Companies with capital but not enough liquidity can quickly be bled dry by panicked shadow banking lenders who run, as we saw for example at Continental Illinois in 1984, American Savings in 1988, Orange County in 1994, Asia in 1997, Long-Term Capital Management and Russia in 1998, financial institutions throughout Wall Street, Fleet Street and Europe in 2008, MF Global in 2011 and right on down to Italy’s third-largest bank,  Monte dei Paschi di Siena, in 2013.

The members of the Financial Advisory Roundtable disagreed on secrecy, according to the minutes of the June meeting.

Members expressed a range of views about the costs and benefits of greater disclosure of  stress testing models and results. It was noted that the disclosure of stress testing results could trigger a bank run or loss of confidence unless accompanied by a plan to stabilize firms facing financial distress. It was also suggested that supervisors should be transparent up-front about what type of information is to be made publicly available at the conclusion of the tests. Members also suggested that disclosing a large amount of information about failed firms could be beneficial.

Spilled ink

European and U.S. regulators have spilled a lot of ink over liquidity. Here are some examples:

     — February 2008: European regulators in Basel, Switzerland, publish 13 pages on how banks should manage liquidity. 
     — September 2008: Basel regulators update with a 35-page report. 
     — March 2010: U.S. bank regulators spend 10,000 words laying out what they consider “sound practices for managing funding and liquidity risk.” 
     — December 2010: Basel regulators propose two important rules to address liquidity issues, the Liquidity Coverage Ratio, which would start Jan. 1, 2015, and the Net Stable Funding Ratio, which would begin Jan. 1, 2018..
     — December 2011: U.S. regulators issue their own  proposed liquidity standards and specifically embrace Basel regulators’ Liquidity Coverage Ratio and Net Stable Funding Ratio.  (These proposed U.S. standards are still pending.)
     — June 2012: UK regulators loosen their liquidity requirements in order to not impede “the ability of banks to support lending to the real economy.” 
     — January 2013: Basel regulators soften implementation of their Liquidity Coverage Ratio, saying they’ll certify a broader range of assets as being liquid, albeit with restrictions, and start the phase-in on time but delay full implementation until 2019.  They say the Net Stable Funding Ratio is still set to start in 2018, but some experts said changes in the Liquidity Coverage Ratio will inevitably force changes in the Net Stable Funding Ratio.

When he introduced the Basel changes January 27, Bank of England Governor Mervyn King said:

Since we attach great importance to try to make sure that banks can indeed finance a recovery, it does not make sense to impose a requirement on banks that might damage the recovery.

From the Basel report:

The (Basel) Committee (on Banking Supervision) remains firmly of the view that the Liquidity Coverage Ratio is an essential component of the set of reforms introduced by Basel III and, when implemented, will help deliver a more robust and resilient banking system.

However, the Committee has also been mindful of the implications of the standard for financial markets, credit extension and economic growth, and of introducing the Liquidity Coverage Ratio at a time of ongoing strains in some banking systems. It has therefore decided to provide for a phased introduction of the Liquidity Coverage Ratio, in a manner similar to that of the Basel III capital adequacy requirements.

Much of the business press presented these Basel changes as a serious blow to reform of the financial markets. Analyses by Financial Times reporters and by the finance lawyer who blogs at Economics of Contempt concluded that the changes weaken the Liquidity Coverage Ratio somewhat but leave important provisions intact.  RepoWatch thinks liquidity is nice, but 30 days is not enough to stop a systemic run. Let’s face it: In the U.S., only the Federal Reserve and the U.S. Treasury have that much liquidity.

(3) Then came The Financial Times’ latest updates (see here and here) on shadow banking in China, with their implications for unprotected global financial markets.

From the January 27 story by reporter Simon Rabinovitch:

Western rating agencies have warned that a rapid rise in off-balance-sheet banking activity is a threat to China’s financial stability. But Chinese regulators have countered by saying the risks are manageable. With the country’s financial system long dominated by state-run banks, they also view shadow lending as a byproduct of their attempts to unleash more market forces in the allocation of capital in China.

“… their attempts to unleash more market forces in the allocation of capital ….”  It appears that China, like the U.S., is going for growth over stability.


The Financial Advisory Roundtable

Here’s how the New York Fed describes the Financial Advisory Roundtable:

A group of distinguished economists, risk management professionals and other experts in the financial markets meet twice a year with the president of the New York Fed to discuss financial stability issues and present their views on financial policy.

Current members are:

Amherst Securities Group, Laurie Goodman
Goldman Sachs, Charles Himmelberg
JPMorgan Chase, Terry Belton
State Street Corporation, Andrew Kuritzkes
UBS, Darryll Hendricks
Columbia University, Tano Santos
Duke University, Katherine Shipper
Harvard Business School, David Scharfstein
MIT, Andrew Lo
New York University, Stephen Ryan
Princeton University, Markus Brunnermeier
Princeton University, Hyun Shin
Stanford University, Darrell Duffie
University of Florida, Mark Flannery
Yale University, John Geanakoplos
Yale University, Gary Gorton


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s