According to one analyst, the Swiss National Bank’s stunning decision yesterday to lift the franc’s cap is a 35-standard deviation event. That means forex-market volatility like Thursday’s happens about once a millennium. However, it takes a look back only to 1974 to find a systemic crisis sparked by high-flying in the foreign-exchange market. Herstatt was different than what’s afoot now in the market, but it’s a critical reminder of how often markets are doomed to repeat the history they and their regulators forget.
After Herstatt’s smoke cleared, regulators decided to build the Basel Committee and start the decades it has taken to bring us to Basel III’s capital and liquidity standards. These may well insulate big banks from systemic shock arising from the Swiss franc, but they’ll do nothing about all the risk lurking in all the non-banks that bet so big and now are falling so fast. The lesson here: resolution protocols that prevent bail-outs are vital across the financial system, not just for big banks.
To be sure, the resolution protocols for the biggest banks remain incomplete. However, many – especially those in the U.S. – have dramatically ramped up their capital and liquidity buffers since the crisis, making them far better able to handle all the volatility now roiling currency markets and, I hope, the still more worrisome stress it could engender.
Big banks had better have these buffers in place. One benefit of consolidated regulation is that – we all hope – non-bank activities in big banks – think prime brokerage looking at big forex losses right now – are insulated by their BHC parent. A lot needs to be built out to deal with the fact that big banks these days aren’t traditional institutions largely dependent on traditional deposit and lending activities. But, traditional or not, big banks are still protected by all the buffers demanded of them in the wake of the crisis.
Non-banks, not so much. Non-banks – even the very biggest – are largely exempt from prudential capital and liquidity standards and no one knows how to shutter any systemic ones without a big bail-out. Indeed, one reason for forex volatility – or at least the 35-standard deviation market it hit – could well be scant liquidity in the foreign-exchange market — allowed to operate in the prudential equivalent of the wild west. Brokers – some call them bucket shops – are allowed to offer leverage of up to 500:1 in the EU and none is required to have anything like a meaningful buffer with which to ensure it can clear trades when investors can’t honor their obligations.
Of course, financial markets should discipline themselves, and forex brokers and their investors should learn lessons from having taken so much risk. The problem, though, is that without prudential rules or systemic-resolution standards, the rest of us could learn hard lessons all over again on their behalf.
The Financial Stability Board has finalized protocols for handling risk like that now upon us if it morphs from market to systemic magnitude. It’s also laid out resolution protocols for central-clearing organizations, protocols supposed to work for forex as well as derivatives. Each of these protocols would be mighty handy right now, and not just on paper.
One view of market stability – especially at the FRB – is that it can largely be won if big banks are wrestled into bullet-proof form. Another view – mine, for what it’s worth – is that putting big banks in a bubble will drive risk into far less-regulated venues with even more catastrophic effect if we do not know how to ensure that losses – no matter where they start – cannot be passed on to the rest of the financial system and, after that, to the rest of us.
Resolution protocols are hard to draft and even more complex to implement. As all the hard work trying to turn OLA into a meaningful regime for banks shows, opening the resolution box reveals a lot of complex legal questions that require careful attention before anyone can credibly represent that TBTF for big banks has been finally resolved.
But, that it’s hard doesn’t mean that it shouldn’t happen fast. Final engineering down to every footnote takes time, but critical safety features – the equivalent of sprinklers in a building for the financial system – have yet to be put in place six-plus years after the last near-death experience. Hope it’s not too late.