Are bankers just evil-doers that warrant smack-down? Or, is the financial market increasingly prone to structural weakness that poses profound systemic risk? Regulators think it’s the bad-boy bankers; markets fear the worst. In this dichotomy lies a critical question: can policy-makers count on whacka-mole enforcement actions and lengthy consultations, or should they act decisively before problems like yield-chasing go into the red zone? This may seem like a rhetorical question, but it’s a real one given the growing disconnect between what regulators do and markets fear.
Proof of the disconnect between what regulators and markets see on the risk radar comes in a survey from the International Organization of Securities Commissions research staff. In a working paper on Wednesday, the asked regulators, risk managers, traders, asset managers, counterparties, rating agencies, and others about what worries them in the 2014 securities market. Regulators cited illegal behavior, benchmarking, lax corporate governance, and opaque disclosures. Market participants cited yield-chasing, in complete resolution protocols that could lead either to panic or bail-out, CCP vulnerability, and market fragmentation (e.g., dark pools and HFT).
The contrast here is striking – regulators aren’t wrong that bad bankers need tough sanctions, but the damage done by banks that corrupt critical benchmarks or issue cloudy disclosures is negligible in comparison to what would happen if a new round of market stress like that feared in the market were to force fire sales.
One reason regulators cited the risks they did is because these are the risks with which they have learned how to deal since the crisis. All the enforcement actions wafting through corridors of power are proof that bad behavior indeed creates legal and reputational risk – maybe not as much as critics wanted and surely not as fast as it could have come, but risk nonetheless. But, where is the real, concrete, effective action on structural risk? Those the market participants cite are mentioned in reports like the OCC’s earlier this week and cited in speeches. They are also often the topic of important confabs and lengthy consultations from august bodies like the Financial Stability Board. A comparison to the named risks in the IOSCO paper by market participants and results to date is not encouraging.
The U.S. is working hard on recovery and resolution, as is the EU, but no one yet is sure any of this will work. Secretary Lew said this week that only the next crisis will prove that TBTF is a thing of the past, but more rapid and definitive action in key jurisdictions would do a lot to define the parameters to the market of what would happen to whom how and when before that. CCPs are another crucial question – will upon the markets by regulators, they are increasingly becoming systemic concentrations of significant resolution and liquidity risk, with solvency thrown in if CCP default funds don’t suffice under stress. Market fragmentation is just now being addressed – the EU has taken action on HFT and the SEC is starting to think about it.
And, then there’s yield chasing – perhaps the scariest near-term systemic challenge. Like these other risks, the search for yield is the result not of bankers being bad, but rather of the profound contradiction between one policy goal – recovery through monetary policy – with the prudential policy that knows banks must post reasonable earnings and satisfy prudent investor demands. Yield-chasing is an artifact of accommodative monetary policy that puts financial institutions into the same quandary as ordinary, prudent investors – how to make a reasonable return without undue risk. If I as an investor get nothing more than a cash-equivalent when I invest in a high-quality bond, why not try a bit of BBB at least to boost return to an above-inflation positive yield? And, if the BBBs now pay cash-equivalent too, what to do? Sit this out and draw down reserves already stringed by years of accommodative policy and slow growth? Maybe, but what of my shareholders, pensioners, policy-holders, and others who have just claims on my earnings?
The OCC, Bank of England, and other regulators can castigate search for yield, but financial institutions have little choice but to go on the hunt if they are to sustain themselves as viable financial institutions. Policy, not preaching, is the solution here. That the choices for public officials are hard is for sure; that they – not the market – must make them is also clear. Bad behavior is of a bank’s doing; tough choices between competing policy demands, not so much.