There’s yet another collision coming among careening financial-market reforms, this one joining other well-intentioned rules that may well prove disastrous when considered in concert with equally noble proposals. Now, a locomotive is barreling down the tracks pulling freight cars loaded with rule after rule requiring banks to hold lots more sovereign debt and similarly “safe” collateral. Sitting on the tracks in the happy hay ride: other rules premised on the ability of the biggest banks to rely far more on their own capital at risk so that we finally end too big to fail. I’ve highlighted similar pile-ups in the past, but the collateral-vs.-capital one could be the mother of all unintended consequences – literally trillions of dollars are at stake and, with them, the structure of the financial market.
Why this apocalyptic assessment? Let me first describe the collateral locomotive and the freight it pulls. Then, to the hayride, on which sit a lot of sweet kids: the hoped-for end to TBTF, money-market fund reform, the Fannie/Freddie redo and even the FRB’s exit from QE3.
Global regulators in fact foresee many of these collisions – they are catalogued in a new report from the BIS Committee on the Global Financial System (CGFS) we analyzed in depth for clients a week ago. However, even as these distinguished officials hear the whistle down the tracks, they can’t decide how to slow down the train or whom to push from the wagon. Instead, their proposed response is the increasingly common lowest-common denominators that characterize all too many BIS reports: more study, international cooperation and, perhaps, some new disclosures so regulators can better count the casualties.
Casualties? The collateral quandary arises because, rightly, regulators want systemic banks to buttress their balance sheets and reduce the risk they pose to counterparties. Good so far, as are the remedies when taken on their own. They include new capital rules designed to force larger holdings of “high-quality assets (HQAs),” the liquidity standards that similarly demand big HQA books and all of the new derivatives-trading standards pushing over-the-counter activities into central counterparties (CCPs) backed by big margins comprised of HQA. If the deal is still done outside a CCP, then even more gigantic amounts of the same HQAs must be posted to cure, it is hoped, contagion risk across the financial market.
These standards combine with a few others to create an HQA shortfall of about $4 trillion. A lot, but CGFS calmed itself – if not me – by positing a new set of “collateral transformation” structures that will more than offset this shortage. It notes that this cure could be worse than the disease – collateral transformation is a polite term for high-flying financial engineering. Thus, this study lays out a few ways transformation could mutate into systemic risk. But, then, the study suggests no substantive action. This raises my first fear about a very dangerous unintended consequence of HQA shortfalls: a round of systemic risk sparked by the transit of HQAs into higher-yield, higher-risk obligations facilitated by “shadow” entities.
Before going on to another frightening systemic scenario, let’s turn to the conflict between collateral demands and other top-priority regulatory reforms. First, there’s the smash-up between a requirement that banks hold lots of HQAs – forcing them to issue lots more secured debt and the single-point-of-entry (SPE) resolution protocol on which the FDIC is hard at work. SPE is designed to make Dodd-Frank’s orderly-liquidation authority work for even the most complex BHCs. But, these same BHCs will have to issue lots of unsecured debt to form the cushion essential to ensure recapitalization without resorting to taxpayers. As CFGS drily notes, they can’t do both at the same time.
As for other reforms? Can the SEC force floating net asset values (NAVs) on prime MMFs without exacerbating collateral shortfalls? In short, no. While the floating NAV seeks to flummox systemic risk at MMFs, the proposal released on Wednesday pushes cash-equivalent investors into government funds. These can hold only sovereign and agency HQAs, thus hiking demand for them and making it harder for banks to get what they need to meet all of the new rules forcing bigger buckets of these same HQAs.
Fannie and Freddie reform? Together with the Home Loan Banks, the GSEs have issued about $7 trillion in obligations now deemed very HQAs. Take Fannie and Freddie out of conservatorship into something private – urgently needed – and about $5 trillion of HQAs go bye-bye. Legacy assets will remain for a while, but a serious shortfall nevertheless will quickly emerge not captured in the CFGS’s already large $4 trillion projected problem.
And, last and far from least, the central-bank exit conundrum. As part of their innovative accommodative policies, central banks around the world were led by the Fed into purchasing trillions of HQAs ordinarily available for private investors. As economies recover, central banks will need to restore their balance sheets to something like normalcy. In theory, this would alleviate the HQA shortage because central-bank holdings will come to market. But, at a time of rising rates, who will buy what the Fed has? Perhaps desperate for HQAs, banks will help out the Fed, but only at the risk of yet another systemic scourge: interest-rate risk of what Jamie Dimon this week called “scary” proportions.
So, what to do? None of the initiatives I’ve cited is wrong on its own, the problem with them is that taken together, they lead to overdose. I’ve called in the past for a prioritized regulatory policy with modest ambitions supplemented by measurable goals backed by meaningful enforcement. I’ll do it again now, buoyed by the really dangerous prospect made clear by what may soon become an insatiable global thirst for high-quality assets.