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Unfinished business: Banking in the shadows

volckerPaul Volcker gets it. Will anyone listen?

Here’s what he wants Americans to know:

The main danger in the financial markets is not banks getting too big. The main danger in the financial markets is non-banks borrowing short to lend long.

Borrowing short to lend long is what made the banking crisis in the 1930s so devastating. We fixed it mainly with FDIC deposit insurance. Borrowing short to lend long is also what made the financial crisis in 2008 so devastating. We haven’t fixed it.

Put simply, absent more assertive action, short-term debt is likely to again trigger massive panics and bailouts.

This is the simple but powerful message carried in a new report “Unfinished Business” issued Dec. 5 by the Volcker Alliance, a think tank that former Federal Reserve chairman Paul Volcker founded in New York three years ago to promote effective public policy and help rebuild public trust in government.

The report continues:

Eight years after the crisis, and in spite of significant reform efforts by regulators, the risk of busts and bailouts remains all too real. The fundamental reason is that highly interconnected nonbank financial institutions—or shadow banks—remain heavily reliant on runnable short-term debt to finance their portfolios of longer-term and relatively illiquid investments and loans.

The instruments that Volcker includes as short-term debt are repos, securities lending agreements, secured and unsecured commercial paper, uninsured deposits and eurodollars.

Highly leveraged and interconnected financial firms continue to rely on panic-prone funding structures, posing the clear risk of contagious “runs,” the central and highly damaging characteristic of the 2008 crisis. Many other documented crises in history, including the banking collapse in the early 1930s in the United States, demonstrate the fragility of borrowing short to lend long.

Today, it is not the heavily regulated traditional commercial banks that are the main source of concern. Rather, it is the lightly regulated nonbank financial institutions that are deeply reliant on uninsured short-term debt that pose significant risk.

Suggestions for remedies

The report proposes that the following remedies be “seriously discussed.”  None are new. RepoWatch readers will be well acquainted with these ideas. What’s stunning is that eight years after the financial crisis we’re still “discussing” them.

* Require all money market funds to publish a floating share price.

* Require money market funds to hold ample easy-to-sell investments.

* Let the bankruptcy courts freeze repo and derivative transactions, as it does other claims, unless the collateral for the transactions is backed by the full faith and credit of the U.S. government.

* Lengthen the maturity of transactions backed by non-government collateral.

* Limit the rehypothecation of cash collateral.

* Develop ways to safely close major, troubled, non-bank financial institutions.

Deeper regulation could include:

* Limit short-term debt to a certain percent of all debt.

* Limit its use to financing high-quality assets.

* Require non-bank financial institutions to hold enough assets at the Federal Reserve to cover their short-term debt.

* Let the Fed supply the collateral that the financial markets need, instead of non-banks.

The report also makes the following recommendations:

* If we’re going to put derivatives through clearinghouses, the clearinghouses need to be a lot stronger financially.

* The regulatory structure for the financial markets needs to be streamlined. It is fragmented, duplicative and outdated.

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