This weekend, the world’s largest banks will do something many thought they never would: abandon near-term self-interest in favor of long-term, collective financial stability. They will do so when they commit to abide voluntarily by contractual terms obliging them to stay their hand when a counterparty goes into government-dictated resolution. By agreeing to do so, big banks are making markets a lot safer, but also giving yet another market edge to non-banks. If central banks compound this advantage by giving these non-banks access to liquidity facilities – as contemplated now by the Federal Reserve and Bank of England – counterparties will have a clear reason to bypass banks in favor of asset managers they know will act only to advantage themselves. Should markets then crumble, the Fed has their back.
In a speech I gave earlier this week, I tried to lay out the broader context of this critical development. It includes many other policy drivers that are pushing key business lines out of banks and, as with leveraged lending, encouraging them to take more risks in a desperate bid to keep what they can before it’s gone for good. Many of these policy drivers derive from the post-crisis regulatory framework laid out in more detail in a May paper we prepared for the Federal Reserve Bank of Chicago, and we’ve seen them full force in our proprietary work advising U.S. banks on market reconfiguration in the wake of these new standards and those yet to come.
Often, market-share statistics don’t show dramatic shifts – its takes an in-depth dive to see how adroitly non-banks are cherry-picking core products to take the high-profit stuff. The seemingly low-volume of non-bank business has encouraged regulators to prioritize bank regulation ahead of SIFI designation – the wrong approach – and ahead also of a far more effective policy of regulating activities and practices regardless of who does them so that like-kind risk comes under like-kind rule. The bank-first and, so far, only strategy is thus crafting a wholly asymmetric framework in which banks are increasingly competing against powerful financial institutions with little, if any, prudential-regulatory constraint.
Regulators privately acknowledge the dangerous path they run, but hope that squashing banks stifles risk. Maybe it will in bank-centric markets like the EU; for sure it won’t in the U.S. Regulators also believe that derivatives trading won’t flee banks if they relinquish their safe harbor while others still enjoy it. Again, maybe in Europe; almost surely not here, where non-bank asset managers are already formidable market participants.
If I am an informed institutional investor who knows that one agent on my behalf protects my own self-interest while another – the bank – nobly sacrifices it in concert with its own for the greater good, will I stick patriotically by my bank. I like to think I’m that selfless, but I doubt it. I know for sure most institutional investors must or will act to save themselves and, thus, do business with the counterparty they know will stand by them under duress.
In fact, my not-so-noble self has one other reason to love a non-bank asset manager: I can expect a bail-out. If a bank is my buddy, it will permit stays, with regulators hoping either that liquidity support will turn matters aright or – if needed – layers of bail-in debt will satisfy counterparties. However, as I read the draft FSB consultation on loss-absorbing capacity, that’s far from assured. Further, like all the other resolution protocols, it would apply only to big banks. If an asset manager runs aground, there’s nothing for it but government support because the alternative would be too catastrophic to contemplate.
Already fearful, the Fed is now considering the prevention of non-bank liquidity crises from spiraling into systemic ones through the aforesaid access to the discount window. The more talk of this, the more markets will expect it. The more they expect it, the faster the flight from big banks to big non-banks in the still opaque world of derivatives trading.
A perverse result indeed from such a grand agreement.