A “Commentary” piece in the Telegraph by Lord Turner, Executive Chair of the FSA, was published on September 8, 2012. While a lot of it is hashing what we already know, there are some hints of how the British regulators will go after shadow banking and in particular securities financing.
The principals that guide the FSA’s approach to shadow banking are:
- Banks are highly specific institutions that create risks that can only be controlled by appropriate regulation.
- Non-bank credit supply can in principle help to reduce systemic risks.
- Big problems arise if there are financial activities that create bank-like risks but that escape bank regulation. Shadow banking entails such activities.
Turner does not take a fundamentalist approach toward shadow banks. He does not want to regulate shadow banking out of existence. He says, “…A vibrant system of non-bank credit supply – corporate bond markets, infrastructure finance and direct purchase of securitised credit – can in principle make the financial system more stable and less subject to the risks that banks introduce. Indeed, the role of non-bank credit supply may need to increase as enhanced bank regulation constrains banks’ ability to extend long-term finance on the basis of risky short-term funding. Financial regulation must support long-term debt finance provided via non-bank channels…”
But left to its own devices, shadow banking can get out of control. Turner argues that when shadow banks practice maturity transformation, the risks are the same as when banks do it – only without the regulation and safety nets. He gives the following example, “…If an individual holds an instantly available cash investment in a money market fund, which in turn buys 30-day commercial paper issued by an SIV, which buys a mortgaged back security created out of a structured package of 25-year residential mortgages, that multi-step chain is functionally equivalent to bank maturity transformation…And because it is functionally equivalent to banking, it can create the same risks – surges of confidence, credit supply and asset prices which become self-reinforcing and sudden losses of confidence which provoke the equivalent of deposit runs, fire sales of assets and a downward spiral in asset prices…”
The article does say that some of the excess in the shadow banking sector have receded. Securitizations are a fraction of what they were prior to the crisis. Money market funds have shrunk and shifted to less risky assets. But Turner is worried that when credit supply needs to grow again, shadow banks will fill the void, especially in a world of capital and regulatory constrained traditional banking.
The reforms look like they will be in three flavors:
- Risk assessment
- Non-transparent maturity transformation
- The risk of increased volatility in credit supply and asset prices
Bad risk assessment is exacerbated by pro-cyclicality and compounded by financial intermediaries not really caring what happens when the asset is sold off (“skin in the game”). Interestingly, Turner said that bankers who rely on benchmarks – he specifically mentioned credit default swap levels – to replace fundamental credit analysis further exacerbate the cyclicality issues. We wonder what he wants to do about that?
While maturity transformation happens within traditional banking, but when it is outside of traditional banking channels, Turner argues, it is harder to monitor and control. He specifically mentions money market funds giving a false sense of liquidity to their investors, while in the meantime they buy assets that might not be liquid when they need to be. Turner again writes about money market funds, “…it looks like a bank and quacks like a bank [it] ought to be subject to bank-like liquidity and capital constraints…” The juxtaposition of this comment just after the SEC refused to clamp down on the same issue in the US, indicate that the issue has hardly gone away and perhaps only moved venues. We wrote about that in the SFM post on August 27, 2012 in “Why US money market reform isn’t dead and may just be beginning.”
Turner looks at volatility in credit supply and asset prices in the context of haircuts on financing transactions. The article seems to take a “damned if we do, damned if we don’t approach” here. High asset prices can release greater borrowing power for an asset unless haircuts are increased to counterbalance. Only, as any credit officer will tell you, the credit risk of an asset is part of how haircuts are determined – the better the assets, the lower the default risk, the lower the haircut. Regulators, in what seems to us to be not so well thought out, seem to advocate higher haircuts to when credit quality improves. On the flip side, there is equal confusion. Turner writes, “…As asset values fall, borrowers have to put up more collateral, investment positions have to be liquidated and further asset price reductions result. Secured lending contracts and daily collateral calls and mark-to-market accounting can make credit supply more volatile…” Regulators want to avoid the cliff/bank run risk that comes when assets prices and credit quality fall, haircuts go up, forcing asset liquidation. If the solution is to lean again rising asset prices by increasing haircuts but not raise haircuts when the market goes the other way, we wonder exactly how that will work? Regulating haircuts by fixing levels and limiting market dynamics isn’t workable and ultimately adds systemic risk. We need only to look back at fixed foreign exchange rates and see how that worked out.
On pro-cyclicality, Turner cited the “…Independent Commission on Banking (chaired by Sir John Vickers) recommended, to regulate the quantity of bail-inable unsecured debt which banks must issue, limiting the extent to which secured finance can encumber the balance sheet…” First, someone better tell the ECB. Second, we thought the move toward collateralization was a good thing. Sure, doing more business on an unsecured basis will bring fundamental credit analysis bank in style, but it seems somewhat of a pyrrhic victory.
Turner will go after securities finance. He wrote that further reforms aimed at “…the complex web of secured funding markets – repo, prime broker finance, securities lending and cash collateral reinvestment – which interconnects commercial banks, broker dealers, asset managers, money market funds and hedge funds…” are being contemplated. This is a broad catchall and not in a good way.
Perhaps the answer is increased capital allocated to financing businesses? Given thin spreads and continuing deleveraging, this won’t be greeted with open arms either…but is more intellectually defensible than slapping some haircut number that made sense to someone once upon a time or the regulators getting into the balance sheet allocation business.
A link to the article is here.