At this week’s Bank and Fund meetings, it was clear to me that it has finally dawned on global policy-makers that rules don’t just cure for risk – sometimes, they cause it. Focused very understandably at the start on the risks of run-amok bankers and hands-off regulators, the post-crisis framework now is replete with an array of tough standards that are made still more stringent in nations like the U.S., U.K. and Switzerland. “Big Finance” is breaking up – at least sort of – and the broader market is clearly changing, but often not as foreseen when the rewrite began in 2009. As we shall demonstrate next week in a new FedFin white paper, there are clear and even imminent signs that the corpus of all the new rules has many internal contradictions made all the more challenging due to external factors like slow growth and accommodative monetary policy. Our paper thus will lay out a set of analytics assessing how the overall new framework is faring so far, where danger signs are evident, and what risks may arise. Our goal: fix the problems in the framework before needed reform is swamped by perverse consequences.
Let me be clear: we don’t say that all of the risks we see are inevitable. We also make it clear that all of the new rules may well be worth all of the possible risk if they prevent another cataclysmic crisis. We do say, though, that the extent to which this benefit is worth all its costs is unknowable. The paper describes these risks in more detail and their warning signs, but in broad scope we see the following potential problems resulting from final implementation of the full body of post-crisis prudential regulation:
- Secular Stagnation;
- Market-Risk Transfer, in which activities and practices move from banks into the “shadows;”
- Systemic Illiquidity/Central-Bank Risk – think the October flash cash and be afraid;
- Taxpayer Risk, which arises when regulatory constraints force greater reliance on securitization channels backed by direct or indirect sovereign guarantees;
- Risk-Taking Incentives such as those embedded in the leverage requirement and those that heighten concentration either at the largest banks or entities like CCPs;
- Heightened Operational Risk, which derives in part from the inability of banks to handle all their regulatory duties and also ensure resilience to growing threat; and
- Regulatory Fragmentation, all too evident in the break-down of cross-border regulatory and resolution agreements when these go from paper to practice.
Secular stagnation was a hot topic at the Bank/Fund meetings and rightly so. Importantly, it’s also the focus of several recent Federal Reserve papers we have analyzed in a series of client reports, studies that show the linkage between the body of new bank rules and changing market funding and asset-allocation patterns. One conclusion from several of these studies is that, given how risky some of the regulatory consequences appear, it’s time to make the Federal Reserve a lender or market-maker of last resort not just for banks, but also for any financial company with a sizeable role in the U.S. financial system.
This recommendation may be the most perverse consequence of all from the financial crisis. In essence, the Fed is arguing that the sum total of all the new rules for banks means that markets are now even more dependent on the taxpayer. To be sure, central-bank liquidity isn’t per se taxpayer bail-out, but – as several of the studies rightly note – it comes darn close. The more the market expects this backstop as the Fed talks it up, the more powerful grow the incentives for regulatory arbitrage and moral hazard. Maybe banks are now better than all that, but the absence of a broader framework of prudential regulation and – far more critical – orderly resolution – means the rest of us may well be at even more risk than in 2007.