The latest legislative offering in the U.S., the Financial CHOICE Act
, does nothing for securities finance. Nothing in the bill provides an exemption to the funding markets from the crushing weight of regulatory reform. At present, both political parties in the US seem willing to accept an outcome where the global funding markets are road kill from the reform steamroller. Many experts believe this legislative failure is due to analytic omissions on the regulators’ part. In that scenario, regulatory analysts simply don’t understand the global funding mechanism. Therefore, it is thought that regulators have not advised the legislators to offer relief, notwithstanding a steady chorus of complaints from securities lenders and borrowers. However, there is no omission. The regulators are fully aware of the effect of the impact of their rules. They simply choose to leave the new rules intact.
Regulators believe that the securities finance markets are dangerous, a volatile source of contagion risk in the form of potential liquidity squeezes and collateral fire sales. As far back as 2009, the IMF warned of systemic risks from linkages among financial firms. Analysts at the Fund feared that feedback loops reacting to the rising solvency concerns of individual firms, could bring down the system again.
The Bank of England was equally aware of the risks. The Bank announced that it was enhancing the underlying models in its Risk Assessment Model for Systemic Institutions (RAMSI) system, so as to factor in the effects of closed funding markets on financial institutions. As described, “RAMSI employs elements of traditional stress testing combined with theoretical work on modeling systemic events.” However, as of 2010, the RAMSI model didn’t have the capability “to analyze banks’ cash flow constraints” or to determine “how mitigating actions in light of funding stress may affect the wider economy.”
In other words, the main risk system used by the Bank of England to assess risk in the critical funding markets still couldn’t model, two years later, the same cash flow crisis that killed Northern Rock, much less Bear Stearns and Lehman, nor the knock-on crisis that killed the Reserve Fund and AIG. However, “It is envisaged that RAMSI’s analytical framework will become a key part of the analysis of systemic risk in the UK.”
At the Federal Reserve Bank of New York, a great deal of post-crisis research has been conducted into the potential for fire sales of collateral in the funding markets. None of the research has discounted the threat of systemic disruption arising from the securities finance and funding markets.
Similarly, the consortium of central bankers at the Financial Stability Board in Basel, Switzerland, has ignored industry calls to relax the constraints on global funding.
So, there has been no failure of regulators to consider securities finance in their risk models. Their work has simply confirmed an initial conviction that the short-term markets, i.e., the shadow banking system, must be reigned in before it triggers another crisis. And yet, the preponderance of evidence, in the form of unanticipated adverse consequences, is seen by industry analysts to presage not safety, but rather a growing fragility and loss of liquidity in the larger capital markets that are supported by securities finance.
Ultimately, the legislators are taking the more conservative tack. As of 2017, there was still no certainty that central banks could predict and prepare for another funding crisis. Therefore, rule makers have not acted to remove the constraints from securities finance. The models used by academic advisors to the regulators continue to warn of systemic danger by oversimplifying the financing lattice. In response, industry experts argue that, without an accurate model, any restraint on the securities financing markets is, by definition, just an exercise in trial and error.
Given that the latest round of regulatory reform has not changed the rules’ restraints on securities borrowers due to the Net Stable Funding Ratio and Liquidity Coverage Ratio; or on lending agents due to the Single Counterparty Credit Limit and Leverage Ratios; or on lenders due to the automatic stay provisions in resolution; or on bank holding companies from the Risk Weighted Asset calculations due to the implied credit extensions that will soon make institutional lenders unwilling to lend; given all that, and unless someone else can model this systemic risk, the impact of those experimental rules will remain just that, i.e., trial and error — until the systemic damage is felt someday. Nevertheless, the industry must comply with the rules. It only remains to be seen, not whether there are creative solutions to compliance in the form of risk mitigants, but that the regulators agree to accept mitigants in lieu of capital.
It is still possible for regulatory capital relief to be granted to securities financiers, in light of the rule calibration agenda now being introduced by the regulators. There is a desire among both U.S. and global regulators to recalibrate and assess the effects of the new regulations
, as part of an effort to optimize capital ratios
while reducing the reporting burden
on market participants. Relief for securities finance may still be added to the recalibration agenda, although given the current reform narrative it must be assumed that the arguments in favor should be robust.
 IMF Washington, D.C., Global Financial Stability Report, Responding to the Financial Crisis and Measuring Systemic Risks, April 2009.
 Aikman, David et al, “Funding liquidity risk in a quantitative model of systemic ability," Working Paper No. 372, Bank of England, London, June 2009.