A new game: spot the most innovative argument against financial reform

Six years after the collapse of Lehman Brothers, those interested in the dynamics of financial regulation can play a new game: spot the most innovative argument against the litany of reforms introduced since the crisis. Traditional ones such as the impact on lending, economic growth, liquidity do not count. Floyd Norris, of the New York Times, does well here: in the US debates over identifying some non-banks as systemically important, 'mutual fund industry says that designating a fund manager as systemically important could raise its costs. Those costs could be passed on to fund investors, who are taxpayers, and so would amount to a taxpayer bailout'.  Taken to its logical conclusion, this argument says forget about systemic risk, macroprudential policies, Basel III, since the taxpayer always pays, now or later. Of course, the mutual fund industry doesnt bother itself with internal consistency of the argument (which taxpayers would pay and how much in a regulation now, smaller crisis late). 

I have come across another innovative narrative: that regulation creates systemic risk. The view was put forward in a recent paper "Collateral is the new cash: the systemic risks of inhibiting collateral fluidity", written by the European Repo Council (ERC), the trade body representing the views of European repo participants, and presented at an ERC seminar on Friday the 16th of May, in London. The paper will also be presented in France, in partnership with Banque de France, that is to announce new ways to help market-driven manufacturing of high-quality collateral through Euro Secured Notes.




When applied to the repo market, the 'regulation creates systemic risk' argument is innovative for two reasons: (i)  while central banks recognize that repo markets are systemic, breeding ground for fire sales and liquidity spirals, repo market regulation has not advanced at the pace warranted by this systemic importance.  Jeremy Stein, then of the US Fed, argued in October 2013 that even new tools 'fall short as comprehensive, marketwide approach to fire-sales problems associated with securities financing transactions'.  (ii) we have both theoretical and empirical backing for the opposite argument, that repo markets, left unregulated as they were before Lehman , generate systemic risk by sharpening both pro-cyclicality and interconnectedness through the market-driven regime of collateral management practices.

Collateral, it is broadly agreed, is becoming increasingly important, for securities financing transactions (SFTs or repos), for margining derivative trades and for meeting new regulatory requirements. It is essential for liquidity and risk management.

Collateral fluidity, the paper argues, is 'the ability to use and re-use' collateral. Regulation that impedes the free flow of collateral includes:

• Basel III leverage ratio: without risk-weigthing for one-way client flows, the incentives are for institutions to shift to high-risk repos 
• Basel III net stable funding ratio: including matched-funded SFTs between banks and non-banks financial institutions in the NSFR undermines banks' market-making and pushes non-banks to lend high-risk securities
• Mandatory clearing for SFTs: CCPs should not clear low grade or illiquid securities to reduce risk, but bilateral trades should be allowed to 'optimize bilateral risk exposures'
• Shadow banking: as SFTs become more expensive for banks, non-regulated institutions with higher risk appetite, such as hedge funds, will become key players
• Mandatory (FSB) haircuts: - enforcing haircuts in the interbank repo market would have little or no impact given that banks both lend and borrow securities with each other. (as if it didn't make the cost of repo-based leverage higher)

The narrative trick is to include, for each regulatory initiative, a mention of 'shift to high risk' activities. From this, there is a small step to inferring the 'systemic risk' impact, which the paper does not shy away from taking.  Even more, the paper is silent on the effective lobbying that has systematically watered down regulation with impact on repos, particularly those undertaken by banks. The FSB, that has an entire Working Group dedicated to repo markets, has dropped the idea of countercyclical haircuts applied across the market, and is now only targeting a small part of the repo universe, where non-bank financial institutions post non-sovereign collateral. The leverage ratio provisions were watered down in January 2014, to allow netting of interbank repos. The European Commission has signaled that improving transparency - shedding light on the 'shadow' repo transactions - is as far as they are prepared to go with regulating repos. The inclusion of repos in the European Financial Transactions Tax proposals was quickly shot down by the ECB and European governments who were threatened with loss of liquidity.

The paper modestly ignores the successes of the bank repo lobby in watering down regulation. Instead, it warns that  a 'perfect collateral and liquidity storm' is looming on the horizon, since higher demand for collateral during episodes of market stress cannot be met if fluidity is restricted (see the Figure 4 from the paper below).

Put differently, it is not the architecture of the repo market that generates these externalities - the paper makes no reference to fire sales, pro-cylicality (except to say that higher haircuts would not reduce it) and liquidity spirals, nor the moral hazards that the central bank accepts when taking on the market-maker of last resort role* - but regulation.


As lobbying goes, this is simply brilliant. The paper deflects attention from the regulators' intention, which is to reduce that component of demand for collateral that is linked to leveraged business models, excessive reliance on short-term market funding, pro-cyclical collateral practices (for the skeptical, Bank of England provides a great analysis of how haircut practices of  LCH Clearnet, Europe's largest CCP, made life very difficult for Irish and Portugese governments) . Instead, ERC comes up with a new concept (derived from Manmohan Singh's velocity of collateral idea) and peppers the 'paper' with regulation = systemic risk (as in the box below). Will regulators fall for this? The Bank of England rep at the ERC seminar, voiced one concern related to the paper: it did not consider pro-cyclicality. Hear hear.

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* Thorvald Grung Moe just published an interesting reflection on that at the Levy Institute, warning that  ' It would indeed be ironic if central banks were to declare victory in the fight against too-big-to-fail institutions, just to end up bankrolling too-big-to-fail financial markets.'