Capital Markets Union - the view from London

Today, I attended a CMU event organised by Bruegel and HM Treasury at Westminster. The keynote address from the City Minister Harriet Baldwin was followed by a panel with market participants (the buy side – asset managers and insurers – and a credit rating agency), a Commission official and a Treasury official. The view from the government: UK a staunch supporter, celebrating the CMU as an excellent initiative of the type that Brussels and the EU should be generating more often. Having a UK Commissioner in charge of CMU clearly helps. Beyond the consensus 'CMU is a good idea' and between the lines, I noticed three issues.

1. ‘It is our strong belief that institutional change is not required to achieve the objectives of the CMU. Single supervision would not add anything’

This is one of the sensitive points in CMU, and a lot of energy spent in documents and meetings to pretends that's not the case. Although the Commission and several member states (see the 5 presidents report) would prefer to create a supranational regulator for integrated capital markets, UK opposes it strongly. According to this view, ESMA - the candidate for a pan-European regulator - is best placed to ensure that national regulators implement supervision effectively. In the context of the Brexit referendum, ‘the last thing we need is institutional change’ captures well the British politics of the CMU.

Is there a danger that European states repeat the pre-crisis mistakes with cross-border banking? The banking crisis demonstrated that the prevailing regulatory nationalism  was ill suited to deal with the coordination issues between home and host regulators. Ask any Eastern European banking supervisor.

The pessimistic British response to this question points to the foot dragging on the institutional architecture of the Banking Union. The hesitations and compromises there are steadily eroding (market) confidence in the ability of European politicians to create strong pan-European regulatory bodies. The optimistic view is that supervisory convergence that harmonizes rules would be enough to put the CMU on strong foundations.

One of the panelists questioned the premise of the optimistic view that for a single market it is enough to have common rules (and I would add, a rather fuzzy notion of ‘convergence’). In accounting, the application of rules (international standards) is not uniform – the fragmented enforcement of rules effectively entrenches the type of cross-border barriers that CMU aims to remove. The Commission recognises the validity of this point but is prepared to put the question aside because it wishes to avoid politically divisive topics.

So instead of calibrating the regulatory architecture to integrated markets, CMU envisages as next step a comprehensive review of post-crisis regulation. Given the complaints from the industry on the post Lehman ‘regulatory tsunami’ (loud and clear at this event too), expect this ‘proportionate regulation’ agenda to accelerate the process of watering down regulation that is already unfolding.

Recall this argument when your UK pension fund with exposure to German SME securitisation takes a massive hit due to large defaults in a market illiquid during crisis. And pray that ECB has normalised ABS purchases.

2. ‘CMU will not harmonize borrowing costs for SMEs until there is a mechanism for rebalancing sovereign risks in Europe’

Market participants typically focus their CMU interventions either on deploring ‘regulatory tsunamis’ or identifying CMU areas that would improve synergies of their business model. In an unusual departure from the script, one panelist sought to make constructive criticisms. And it picked the elephant in the CMU room: government bond markets.

It is surely a measure of the creative genius of European regulatory politics that a project on furthering the integration of debt markets manages to say nothing about the largest debt markets in Europe (in Eurozone, EUR 6.8 trillion out of EUR 14 trillion outstanding in August 2015). Before Lehman and the sovereign debt crisis, the European agendas for financial integration used to stress the critical role that government bond markets play in financial markets, as proxy for risk-free interest rates, benchmark and hedging instrument for positions in other fixed income markets, and reserve ‘safe’ asset. The ECB made the integration of sovereign bond markets a priority, and used its lending collateral framework to accelerate it (by treating all Euro sovereigns as identical in terms of credit risk). The 2002 Collateral Directive was designed with the same ambition in mind – to allow private financial institutions to raise funding cross-border regardless of what sovereign collateral they use.

So can we have integrated capital markets with fragmented government bond markets? One of the panelists argued that  securitisation performance across countries reflects credit differences between sovereigns (the graph below, in a rather bad photo, mea culpa). So much for reviving the European securitisation market.

Yet the CMU authorities have tended to fudge this question because answers are as politically divisive as the issue of supranational regulator. If CMU was to make government bond markets a priority, what would concrete policy measures look like? Put differently, if CMU is about persuading German savers to give money to Portugese corporations without a bank in between*, what would it take to persuade that German saver to give money to the Portugese government? Or even more complicated, how much would a Portuguese SME need to pay a German saver to borrow when that saver is reluctant to lend to the Portuguese government?

Here the CMU official supporters answer the usual European way – not a priority to think about it.

3. ‘ As public policy makers we have to deal with competing objectives, and balance them carefully. The FTT / CMU is a good example’

Private finance agreed that the FTT plans are at odds with CMU. Putting the FTT genie back in the bottle has been a priority, particularly for the European banking lobby**.

Yet the FTT genie has proven more resilient than many expected. Recent statements suggest a new impetus to finish negotiations, as France independently decided to extend its own FTT to intraday trades. This raises interesting questions of coordination between DG FISMA, that is designing CMU, and DG Taxud, that designed and (still) defends the FTT in the working groups of the 11 member states. The best that the former can do is to follow negotiations closely and ensure that member states are aware that the tax should minimize impact on market liquidity and NEVER EVER include the repo market.

The repo market has always enjoyed a privileged position in the minds of European regulators – particularly the ECB***. The Green Paper on CMU made some oblique references to it, stressing the importance of collateral fluidity to ensure that securitization activities can be funded in cross-border repo markets. ‘Fluid’ collateral appeals to the pre-crisis image of the repo market as an engine for financial integration that led European regulators to endorse the creation of a market architecture governed entirely by private rules. Since the crisis, we know that private architectures creates systemic vulnerabilities – this is why the FSB has identified repo markets as markets systemic to shadow banking. Yet so far the only reform European regulators are prepared to contemplate has been increased transparency of repo transactions, despite warnings from the ECB that 'The interaction between CMU and shadow banking reform needs to be addressed. This interaction is not addressed in the Commission’s Green Paper, but it is relevant.'

The priority remains funding for SMEs. Repo, shadow banking, government bonds, and supranational regulation, are not a priority of CMU. The art of political compromise in Europe rests precisely on that ability to postpone critical questions. If we try very hard to ignore these questions they may go away.

* best translation I've heard of the CMU ambitions.

** the EBF response to the CMU Action Plan stresses that ' If European lawmakers are indeed serious about CMU, they also need to recognise the importance of liquidity in financial markets. Proposals such as the Financial Transaction Tax (FTT) and Bank Structural Reform (BSR) are at odds with the objectives of CMU. Dropping these proposals will greatly enhance the chances of success for CMU'.

*** for those interested in the FTT on repo markets, you can read more here: A step too far? The European FTT on shadow banking. Journal of European Public Policy http://www.tandfonline.com/doi/abs/10.1080/13501763.2015.1070894

Daniela Gabor

The politics of public debt - Wolfgang Streek

Just came across this paper by Wolfgang Streek, The Politics of Public Debt, finishing in a palpable sense of rage directed at the Fed:

Does this sound outlandish? Consider the current state of the distributional game in the United States, a country that, unlike Ukraine or China, is still considered a democracy by many. According to Emmanuel Saez, in 2010, the Year Two after the crisis, at a time of high unemployment and record public debt, 93% of all income gains in the US, i.e., almost the entire amount by which the national income increased , went to the top one per cent of the income distribution. What is more, the top 0.01%, about 15,000 households, received more than  a third, 37%, of those income gains (Saez, 2012).31  There is no reason not to call this an asset stripping operation of epic dimensions perpetrated by a tiny minority benefitting, among other things, from the deepest tax cuts in history. Why should the new oligarchs be interested in their countries’ future productive capacities and present democratic stability if, apparently, they can be rich without it, processing back and forth the synthetic money produced for them at no cost by a central bank for which the sky is the limit, at each stage diverting from it hefty fees and unprecedented salaries, bonuses and profits as long as it is forthcoming –  and then leave their country to its remaining devices and withdraw to some privately owned island?

The European Repo Market, the FTT and Moscovici, new Tax Commissioner

The European repo market was last in the news when the Commission issued its FTT proposals last year in February.  France, through the voice of the new Tax Commissioner Pierre Moscovici, then Minister of Finance, immediately questioned the inclusion of the European repo market in the FTT plans:

To include such [repo] transactions will simply pose a major risk to the functioning of the credit market.

Yet it turns out that  the European repo market is European but in name.

Consider the membership of the European Repo Council (ERC), the private lobby that champions the interests of the repo market players in Europe. Of its 75 members in September 2014, 19 sit on the European Repo Committee, the governing board of the ERC.  Eleven of these – five headquartered in the EU - are on the FSB’s 2013 list of Globally Systemically Important Banks (G-SIBs). 

Table 1 Membership of the European Repo Committee, September 2014

Headquarters	G-SIB	Not G-SIB
Eurozone	Societe Generale (Newedge), Deutsche Bank, Unicredit	Caixabank, Bankia, Intesa Sanpaolo, Commerzbank
Europe	UBS, HSBC, Credit Suisse, Barclays
US	JP Morgan, Goldman Sachs, Citigroup
Asia		Nomura, Daiwa

 The ‘European’ repo market captures the systemic footprint of global banks headquartered in Europe and elsewhere. Its growth has been driven by what Haldane called the ‘collective migration’ of bank business models to interconnected, leveraged, high-yield trading activities. 

SFP vs Reverse Repos vs Fed bills

Remember the fuss around the Fed's RRP change of heart earlier this month?

According to the Treasury Borrowing Advisory Committee, the Fed could have chosen a different sterilization approach: it could have issued its own debt instruments or extended the Supplemental Financing Program, a misnomer for  the Treasury playing at central banking (issuing Tbills for sterilization purposes, for which banks pay in reserves that are held by the Treasury at the Fed).

For TBAC, a committee that brings the Treasury in dialogue with powerful market players (zerohedge calls it the Supercommittee that Really runs America), identified several criteria:

To sum up, the criteria can be grouped in:

- liquidity effects (for Tbills)
- institutional constraints (debt ceiling)
- shadow banks' access to Fed (the 'portable' reserve creation)
- theoretical (ideological) concerns with central bank independence.

Missing from that list is displacing the private repo market...

The topsy-turvy world of the Fed's exit strategy: all too familiar to emerging countries

Jon Hilsenrath, of Wall Street Journal, reflects on the details of the Fed's exit:

• The Fed’s primary tool is an interest rate it pays banks for the money they have on deposit with the central bank, known as interest on excess reserves, or IOER. This will be the upper end of the band. This rate is now 0.25% and seems likely to go to 0.5% with the Fed’s first rate increase. The lower end of the band will be interest the Fed pays money market funds and other nonbanks for cash not on deposit at banks (known as the overnight reverse-repo rate, or ON RRP in Fed lingo). This is now 0.05% and seems likely to go to 0.25% with the Fed’s first rate increase. “Most participants anticipated that, at least initially, the IOER rate would be set at the top of the target range for the federal funds rate, and the ON RRP rate would be set at the bottom of the federal funds target range,” the minutes said.

The big winners, he argues, are foreign banks, who earn nice returns from this band: borrowing from money market funds at or around ON RRP, and then placing it with the Fed at the IOER rate. Domestic banks cannot play this game because fees to the Deposit Insurance Corporation eat in the spread.

Two observations:

1. The band -  - the corridor set by the IOER rate and the ON RRP - under QE is functionally different from the band set by the standing facilities under 'normal' interest rate policy. In the latter case, the upper limit is set by the rate at which the central bank lends to commercial banks. Currently, both the upper and the lower ends are rates at which the central bank mops liquidity from the system. Hence foreign banks' behavior. 

Carney's ambitions for shadow banking reform: empty promises?

Shadow banking is back in public light. The FT has just started a series on it. On the pages of the same FT, Mark Carney, Bank of England governor and crucially, chairman of the Financial Stability Board (FSB), recently outlined the reforms that the FSB has introduced to transform shadow banking into governable market-based finance:

1. Curtailing the links between regulated and shadow banking.

2. Regulating the two shadow banking markets: better incentives for safer securitization structures (think ABS initiatives by Bank of England and ECB) and minimum margin requirements (haircuts) for securities financing transactions in repo markets.

3. Improved transparency and monitoring. 

The reader will be tempted to believe that reform of repo markets, six years after the fall of Lehman Brothers and the run on repo it triggered, is progressing smoothly. This is an important front in the macroprudential battle, according to Carney, because:

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.

Mark-to-market (the politics of)

Digging around for my paper on the political economy of the repo market, I came across a 1999 position paper from theJoint Group of Banking Associations on Financial Instruments, that at the time opposed the international homogenization of mark-to-market accounting, eerily anticipating the fire sales/liquidity spirals of 2008:

Stock and bond prices exhibit considerable randomness or ‘noise’ unrelated to

identifiable economic fundamentals. This includes exaggerated price swings caused

by disproportionate changes in market sentiment and speculative activity. Recent

examples of market movements provide ample evidence of the extent to which markey prices can move, particularly in thin markets, without economic justification.

Reading this, it remined me of the European Commission's notion of  'virtual/excess' liquidity at the core of its rather radical FTT proposals.  Also of the 2013 FTT critique from the private repo lobby:

          Concepts such as [...] ‘virtual liquidity’ have no little or no foundation in academic research, regulatory analysis or market experience.

The side of the fence clearly matters.