Wednesday, August 17, 2016
Author: David Schwartz J.D. CPA
With the fundamental elements of post-crisis global financial regulatory reform in place, financial markets and market participants are beginning to experience more fully just how heightened capital requirements and leverage and liquidity restrictions are affecting their operations, business models, and products. While global financial markets are safer and global banks are more stable as a result of these reforms, it is becoming clear that the benefits of these regulatory solutions are not without significant costs. Some of the more obvious costs of bank capital reform were fairly easy to anticipate; and the cost-benefit models employed by the Bank for International Settlements (BIS), Financial Stability Board (FSB), IOSCO, and their teams of academics and economists astutely captured and factored those costs into their considerations. We are now beginning to see, however, that by employing a one-size-fits-all and overly macro approach to their cost-benefit modeling, these experts may have been too focused on the forest and missed the trees. In an article in the forthcoming September issue of the RMA Journal, CSFME’s Executive Director Ed Blount examines how regulators’ reliance on models that failed to account for the complexity of global finance may have unleashed forces more damaging than those their regulatory reforms were targeted to prevent.
Economic Theory versus Banking Practice
Mr. Blount examines the limits of the models relied upon by BIS when developing their bank capital reforms, noting that the Basel Committee’s "Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements,” (LEI Report) correlated higher levels of capital with less severe banking crises, but did not consider the possibility of damage to markets from excessively restricted liquidity. This blind focus on how much more capital would result in what degree of crisis avoidance ignores how higher capital requirements could (and have) affected the economics of business lines outside a bank’s traditional loans, investments, interbank claims, and trading positions. Blount points out that in the modern banking environment many assets at global banks are actually by-products of fee-based services, and in some cases it is nonsensical to apply higher capital reserves to these assets. For example, in the case of assets associated with securities lending, mechanical application of reserve requirements is unnecessary for practical reasons and the economics doing so ultimately may drive away lenders:
"The new regulations require banks to reserve capital against the risk of borrower default, even though the loans are over-collateralized by 2% to 5% and marked-to-market daily. No capital had been previously reserved because there had never been a loss from default in 40 years of bank-managed securities lending services. In light of the new rules, many bankers feel that indemnification will be too expensive going forward, and the service is expected to be abandoned. At present, customers are still deciding whether to continue lending securities. Research shows that markets will become even more volatile if lenders withdraw from the market."
In another example, Mr. Blount observes that leverage rules are jeopardizing traditional broker activities and in the process changing the behavior of brokers themselves:
"The brokers, many of whom are subject to the same Basel III leverage rules in their new identities as subsidiaries of bank holding companies, are also required to consider any cash collateral provided by their customers as a short-term liability. That counts against their NSFR. As a result, they are turning away customers, including hedge funds that provide price arbitrage services."
According to Mr. Blount, the net result of this unintended consequence is an even more dire unintended consequence: an overall diminishing of liquidity, resulting "in fragmented and volatile markets, which increase[s] risk not only for the participants, but also for their dependent economies."
Securities Financing and Liquidity
Mr. Blount also points out that higher capital requirements have already begun to affect wholesale securities financing. He posits that because regulators did not fully understand how wholesale funding markets like repo work, they did not anticipate that by requiring banks to meet higher reserve requirements, regulators effectively were forcing banks to hoard significantly more high-quality liquid assets, assets that were formerly used as collateral by other market participants. By creating incentives for banks to remove these assets from markets and warehouse them on their balance sheets, regulators have removed huge amounts of necessary collateral from the financial system. Along with unconventional monetary policies that were not and could not have been anticipated by the models, the artificially short supply of collateral created by new regulations could at some point not only seriously imperil market liquidity, but also make it more difficult for banks to weather future liquidity crises. He also warns that fragility in channels of liquidity like repo increases rather than decreases the risk of financial contagion during a market crisis. This result is clearly not what regulators had in mind.
"Active repo markets can dampen the transmission of risk-premium adjustments by adding liquidity along the yield curve, while active securities lending and collateralized nance markets can also make existing liquidity more resilient by providing safe harbors for money market fund assets in a financial restorm. In the absence of such cushioning, banks operate (in the IMF model) to try to pass higher funding costs along to customers. However, falling demand hurts profits and reduces capital buffers. The situation is made worse in emerging economies, since deterioration in currency exchange rates can raise debt servicing costs for commodity producers. As the vicious cycle continues, customers in developing markets start to default at ever-increasing rates, leading to 'suppressed economic risk-taking worldwide.' That dark scenario is not inconceivable in today’s 'anything goes' market system."
A Call for Research
Despite a reticence among regulators to admit openly that some post-crisis reforms are having some less than beneficial consequences, Mr. Blount notes that William C. Dudley, president of the Federal Reserve Bank of New York, has called for research into the very kinds of liquidity issues Blount raised in his article; issues like whether the limitation of securities financing services by global banks as a result of bank capital reforms is harming liquidity, and if so whether regulations should be modified or scaled back.
Read the full text of Mr. Blount’s article: “Unanticipated Adverse Consequences of Bank Capital Reform” (Republished with thanks to the RMA Journal).