Bank Reforms May Not Be Enough to Prevent the Next Financial Crisis
The Bank of England last month outlined proposals for ‘ring-fencing’ banks’ retail operations to protect them in the event of serious stress in their other activities. The BoE is inviting views on how to ensure that a troubled bank’s internal systems, shared between its retail and wholesale functions, might continue to serve retail customers in such circumstances. That might, indeed, present a real challenge. The October paper focused, though, on ‘ring-fencing’ the capital supporting banks’ retail business. This was consistent with the emphasis that policymakers have placed, since the global financial crisis, on measures to boost the capital that backs banks’ operations. It has sometimes seemed bank regulators believe that, as soon as they have enforced much higher capital requirements on banks, they will have made an adequate response to the problems revealed during the 2007-09 global financial crisis.
It is understandable that the G20’s bank regulators should have seen the crisis as resulting from inadequate levels of bank capital. Banks’ capital ratios had, by 2007, fallen to levels that left very little margin for error in their business decisions. When the markets erupted in turmoil, the authorities would have preferred banks to bear the losses stemming from their previous imprudent conduct. However, to have left banks to carry the losses might have impaired their provision of retail banking services and inflicted untold damage on the broader economy. Consequently, taxpayer bailouts became the norm for ailing banks, at substantial cost to national budgets. Another reason why enforcing more stringent capital requirements on banks might have seemed attractive to regulators is that it is a fairly simple quantitative response. Though there has been much discussion in international forums over the appropriate rules and ratios applicable to banks’ capital requirements, the problems arising have, in principle, been resolvable by reference to objective criteria.
enforcing higher capital requirements on banks is not likely to be a sufficient response to the kind of problems that arose in 2007-09Nevertheless, it should be clear that enforcing higher capital requirements on banks is not likely to be a sufficient response to the kind of problems that arose in 2007-09. Then, there were banking institutions that incurred losses which, even had they held capital sufficient to meet the requirements that regulators now plan to impose, would still have rendered them insolvent several times over. There are some courses of action a bank’s management might take that are so toxic that no capital requirements are likely to be enough to adequately ensure against potential losses. To the extent that banks are involved in financial derivatives markets, the monetary value of the losses they might suffer can, in theory and in extremis in practice, be larger than their balance sheets, let alone their capital, unless bank management exercises appropriate degrees of prudence. Yet the development of derivatives markets has served a positive practical purpose in aiding non-financial companies’ efficient use of resources. This is not to say, however, that all the financial trading activity in which banks have engaged has been socially and economically useful, as Adair Turner trenchantly pointed out in a memorable speech in August 2009. At that time, the Bank for International Settlements - the central bank for central banks - was advocating regulation of financial products as an adjunct to stiffening banks’ capital requirements. The BIS argument ran as follows. Just as a pharmaceutical product cannot be marketed until its efficacy and safety have been fully established, so trading in a financial instrument should not be permitted until its social and economic value has been proved and the risk it presents to the financial system has been shown to be within acceptable bounds. The BIS did not gain much political support for its proposal, probably because finance ministers’ primary concern was to demonstrate to voters that banks, not taxpayers, would bear the cost of future crises. They seemed to attach a lower priority to minimising the chances of fresh troubles occurring in the financial markets.
The capital-based approach to financial regulation has not been without its critics even in official circles, however. The chief problem policymakers have identified is that banks are likely to be reluctant to increase their lending, to support economic growth, when their priority is perforce to raise their capital ratios. Even now, seven years after the crisis, banks seem wary of lending when they still have work to do to strengthen their capital ratios. Despite the European Central Bank’s vigorous asset-buying this year, euro zone banks’ lending to non-financial companies rose only 0.1% in the year to September. Capital requirements bedevil the ECB’s aim of nurturing a euro-based asset-backed securities market as an alternative source of funding for companies to the traditional channels of bank finance. Banks are likely to shy away from making markets in asset-backed securities on account of the risk-weighting attached to such instruments and of the costs relating to the capital they would need to provide against such holdings. Perhaps a lesser problem is the pressure on bank profitability from regulators’ insistence on higher bank capital ratios. Banks do have an escape-route through raising the charges they impose on their customers but, even if they maintain the supply of loans while levying higher interest rates on borrowers, the demand for credit is likely to shrink as its cost rises. The negative impact on economic activity could still be significant.
Policymakers have acknowledged that they have failed to address the serious risks that might arise within the largely unsupervised ‘shadow banking’ sector
Policymakers have acknowledged that, in devising a strengthened regulatory regime for banks, they have failed to address the serious risks that might arise within the largely unsupervised ‘shadow banking’ sector of the financial system. By its nature, ‘shadow banking’ eludes definition. However, the meaning of the phrase suggests it should cover all those institutions that are not banks which nevertheless perform banking functions. Since banks nowadays operate over such a wide range of activities, ‘shadow banking’ covers virtually all of the remainder of the financial system that is not labelled as ‘banking’. Thus, insurance and pension funds, for long regarded as financial institutions that were quite distinct from banks, are now commonly treated as part of the ‘shadow banking’ system. This is not so much because of their retail activities, which for the most part remain distinct from those of the banks, but reflects the role they play in markets for financial assets. In their retail operations at least, insurance and pension funds have been required to observe strict regulations, perhaps not always well-drawn but at least providing a framework for their business. But their exposure to risks in financial markets has arguably increased as the liquidity provided in those markets by other users has shrunk. Regulators should be aware that the authorities could less readily cope with a crisis centred on the securities markets than they did the bank-centred crisis of 2007-09. This is because the adverse effects would, in all likelihood, be more diffuse and potentially longer-lasting.
It is, then, not at all clear that regulators are looking in the right direction as they scan the horizon for threats to the financial system. Their chief concern appears to be to refine the newly-devised regime of bank regulation with a view to minimising the conflicts it might generate between the various objectives of official policy. But that is probably not where the most serious dangers lie. Rather, they could arise from disorders in financial markets, where comparatively little has been done in recent years to remove risks to the system. Admittedly, the G20 have pressed for the establishment of central counterparties in markets that did not previously have them, but progress in that direction has been piecemeal. Central counterparties should reduce the chances that the distressed state of one or more participants in a market will damage others by contagion. However, they are unlikely, on their own, to ward off the negative impact on the economy of a crisis of confidence in financial markets. It is hardly likely there would not be a contraction in market liquidity and a rise in general uncertainty if there were to be a significant interruption in the smooth running of markets. The aim should be to ensure that such blows to confidence are avoided in the first place. Arguably, though, developments since 2009 have increased the risks of market dislocation. Pressure to increase banks’ capital ratios has dampened their enthusiasm for taking positions in financial markets. Accordingly, there is less to cushion those markets against shocks. Further, the monetary policies the leading central banks have pursued since 2009, with massive asset-buying as their centre-piece, have left investors unsure as to the sustainability of market prices. In this environment, investment has become a game in which the players, not trusting to measures of longer-term value, seek to snatch short-term gains where they can. This is not a healthy situation.
Indeed, possibly the greatest threat to market stability and to the future of that brand of ‘financial capitalism’ that developed out of the US Mayday reforms of 1975 lies in the attitudes of the participants that have come to dominate the markets. One manifestation of the change that has occurred is to be found in the ‘short-termism’ of market participants. Fund managers are not altogether responsible for this. They are, in many cases, in thrall to those who measure investment performance. These performance measures often have a shorter horizon than investors were wont to consider fifty years ago. The argument, of course, has been that frequent performance measurement enhances competition between fund managers and thereby improves returns to their customers and beneficiaries. It is of a piece with the notion that the aim of corporate activity is, at all times, to maximise shareholder value. However, it has had the effect, most pernicious in the markets for securities, of changing the perceptions of major financial market participants as to what it is they are doing. Whereas they may have felt, fifty years ago, that they were seeking out opportunities to support ventures that were likely to be economically productive, they cannot now escape the impression that they are high-rollers in a game, the results of which will not matter much for those who are not taking part in it. The concentration of market power in the hands of a few global players has probably reinforced this sense.
The manner in which investors view the occupation in which they are engaged is beginning to have profound consequences for conditions in the real economyThat is not all. The manner in which investors view the occupation in which they are engaged is beginning to have profound consequences for conditions in the real economy. For example, the reason why the prospect of a Federal Reserve rate increase has cast a shadow over the prospects for emerging economies is not that they would all react similarly to a Fed rate move. They are not all similarly dependent on US demand for the goods and services they produce, any more than the advanced economies are. The main reason why they face similar risks from a US policy change is that ‘emerging markets’ is an investment category for global fund managers. It is a category that is attractive when US interest rates are low and investors feel obliged to ‘reach for yield’ but loses its attraction when a rise in US rates seems imminent. ‘Emerging markets’ is not a category centred on an economically coherent core but is, rather, a product of fund managers’ marketing departments. Yet, the implications for emerging economies of the commitment or withdrawal of funds from investment products bearing the ‘emerging markets’ label can be indiscriminate and serious.
This is but one instance of the way in which fund managers play the investment game having potentially serious adverse effects on economic conditions. For policymakers who are casting about for reasons why global economic performance has been so disappointing in recent years, this is an aspect of the problem they can hardly afford to overlook. However, they show every sign of taking the current architecture of global investment in financial markets for granted. Before 2007, they took global banking attitudes and practices similarly for granted. They did not notice the threats that were developing under the surface. It is to be hoped they will be alerted to the threats growing in the financial markets without a crisis having first to erupt.
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