Is the financial system any safer now than in 2008? There’s been some progress but less than you might think. I argued last week that regulators should put in place much tougher bank capital requirements than planned, for instance, and step up efforts to segregate different kinds of financial business to suppress contagion.
Measures such as this, however, don’t directly confront the biggest gap in the emerging regulatory system: the treatment of wholesale short-term lending. This is where the meltdown of 2008 started, and probably where the next such catastrophe will begin.
Traditionally, the role of banks was to convert short-term deposits into long-term loans. This so-called maturity transformation is an inherently dangerous business. If a lot of customers suddenly want their money back, banks can’t keep their promise to redeem deposits on demand and in full. Depositors know this, which is why bank runs are apt to happen -- or were, in the days before deposit insurance.
Insurance prevents bank runs, but encourages risky lending because depositors no longer care whether their bank is prudent or reckless. Once you insure deposits, therefore, you also must regulate banks more strictly (setting rules for bank capital, among other things). That’s the old model for systemic safety in finance: deposit insurance plus bank regulation.
A different kind of run brought the financial system down in 2008. In a shift that left regulators way behind, modern finance moved much of the business of maturity transformation out of retail banks and into the capital market. Banks relied less on deposits and more on short-term loans from professional and institutional investors -- wholesale funding that was beyond the reach of traditional regulation and unprotected by deposit insurance. At the same time, savers put more of their money with money-market mutual funds and other kinds of institutional investors.
The archetype of the new form of non-deposit bank funding is “repo.” In a repurchase transaction, a bank or other borrower sells a security in return for cash, promising to buy it back later at a higher price. The transfer of cash is akin to a short-term deposit; the price difference is the repo equivalent of paying interest. In addition, the loan is “collateralized,” because the bank or other borrower loses the security if it breaks its promise to repurchase. There’s an extra margin of safety because the collateral is typically worth more than the loan -- this margin, called the “haircut,” serves a purpose similar to capital for a deposit-taking bank.
So what’s the problem? Essentially, when fear gripped the capital market, securities deemed safe when they were pledged as collateral suddenly looked unsafe. The market for collateralized short-term funding therefore seized up. Borrowers couldn’t borrow and had to liquidate assets instead. As forced sellers, many lost money; with too little loss-absorbing capital, some faced insolvency. Fear spread, further driving down the prices of securities, adding to the panic. It was a run, but not one that traditional financial regulation could have stopped.
Legislators and regulators haven’t been idle lately. They’ve passed a flurry of new laws and rules. Yet Daniel Tarullo, the Federal Reserve governor responsible for financial regulation, recently said that “relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs.” That’s a pretty remarkable statement, when you consider that it’s more than five years since a run of the kind I just described destroyed Bear Stearns Cos. and started the meltdown.
What might be done? Simply turning back the clock won’t work. Securitization -- the bundling of loans into tradable assets that can be pledged as collateral -- can’t be uninvented. Even if that were possible it might not be desirable: The modern short-term funding market means cheaper and more accessible finance, which in normal times is a good thing. But, as we’ve learned, the costs can be colossal when things go wrong. The risks have to be reduced.
The leading academic analyst of the repo and related shadow-banking markets is Gary Gorton of Yale University. In a 2010 paper with Yale’s Andrew Metrick (which I recommend for its clear account of the larger problem), he suggested a two-part strategy that parallels the traditional deposit-taker approach - - combining elements of insurance on one side and extra resilience to losses on the other.
For instance, Gorton and Metrick recommend that money-market mutual funds should be told to choose: Either be a “narrow bank” that promises to redeem investments in full, and be regulated accordingly, or a conservative investment fund offering no guaranteed return. The first would be insured by the government; the second wouldn’t.
Regulating repo is more complicated. Gorton and Metrick recommend a new system of oversight of haircuts and acceptable collateral, but working out the details is hard. The Financial Stability Board -- the international coordinating body for financial regulators -- has discussed some ideas but, as Tarullo noted, there’s no blueprint yet, much less new laws or rules to put any such blueprint into effect.
“I do not think that the post-crisis program of regulatory reform can be judged complete until a more comprehensive set of measures to address this problem is in place,” Tarullo says. He’s right, but don’t hold your breath. Nobody’s in any hurry, and the complexity of the issue has shielded it from political attention.
Calling for stronger consumer protection or for the banks to be broken into smaller pieces is more thrilling than (yawn) demanding better regulation of repo and other non-deposit shadow-banking liabilities. That’s a shame. If regulators keep moving this slowly on modern short-term finance, the next crash -- which will be thrilling, but in a bad way -- is just a matter of time.
(Clive Crook is a Bloomberg View columnist.)
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