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.

Carry-trades into Latin America

With the spectre of the 1980s hunting emerging markets, stronger interconnectedness may mean higher volatility across global financial architectures. Some interesting data capturing cross-border exposures for Chile, Colombia, Mexico, Brazil and Peru (LA5).

 

Debt held by non-residents fell by an average of 30% across LA5 after Lehman, to then double (Colombia) or triple (rest LA5) in volume (here are the carry-trades Paul Tucker talked about ). In an effort to stem currency appreciation, central banks intervened in currency markets, leading to large sterilizations of an average of 20% of GDP across the group between 2010 and 2012. Despite these interventions, exchange rates appreciated by around 30% for Chile and Colombia, 25% for Peru and 10% for Mexico.

Shadow interconnectedness

Research on the political economy of shadow banking, a fast growing area, typically explore the regulatory angle to explain shadow banking as regulatory arbitrage. What this type of argument does not take into account is a important, new phenomenon of shadow intermediation: interconnectedness generated through repo markets. Rather than tracing institutions crossing porous regulatory perimeters, analytical efforts would be better placed to theorize collateral networks, the institutions that act as key nodes in those networks, and the common exposure they generate. The collateral intensive nature of shadow banking underpins  two mechanisms of interconnectedness: the risk management framework and the re-use/re-hypothecation channel. Both have systemic implications, together generating an important political conflict for the management of shadow banking because private leverage is born in, and can destabilize, government debt markets. Collateral-intensive finance thus confronts central banks and governments with a deeply political question: what governance arrangement is best suited to manage the systemic risks generated through shadow activities that blur the lines between financial stability policy and fiscal policy? Institutional innovations that ensure coordination between the central bank and government work best to manage ‘shadow’ interconnectedness.

The full paper here. 

The (shifting) French position on the FTT

Cornelia Woll's analysis of hedge fund regulation in Europe points to a French puzzle: whereas UK and Germany behave in negotiations as expected to defend their type of financial capitalism, France changed positions ' as a result of electoral and geopolitical considerations'. The same occured with the French position on including repos in the perimeter of the FTT.

First, the French government, then led by Sarkozy, was the only government to offer an official reponse to the consultation that the European Commission initiated on a financial tax in Europe in 2011. In that response, the French government said :

Les repos, particulièrement lorsqu’ils sont conduits avec des entités non régulés, peuvent effectivement être à l’origine de vulnérabilités du secteur bancaire. Toutefois, le marché interbancaire joue un rôle très important de réallocation de liquidité. Une taxe qui découragerait l’usage de ce type d’instrument serait par nature peu discriminante et ne constitue pas le meilleur moyen de réduire ce risque, qui relève plutôt d’une amélioration de la qualité du collatéral et des incitations données aux contreparties non bancaires. En particulier, une interdiction de la collatéralisation par des instruments financiers sans prix de marché clair (niveau 3 de valorisation selon les normes IFRS) pourrait être envisagée.

Paraphrased shortly, repos  generate banking vulnerability, (as it is well established since the collapse of Lehman Brothers). Yet we cannot tax it because the repo market plays a key role in the re-allocation/distribution of liquidity. Instead impose limits on the type of collateral acceptable.

That position changed radically  in September 2011. The French and German 'engine' behind the FTT co-signed a letter to the European Commission urging it to tax repos/securities lending, particularly when 'these serve the purpose of short-selling'.  The context made all the difference: the turmoil in European financial markets throuhghout the summer of 2011 prompted France, alongside Italy, Belgium and Spain, to ban short-selling of financial shares, in France for eleven of its largest financial institutions.

Then, in September 2012, when the German and (now socialist) French governments were trying to harness support for a regional rather than European implementation of the FTT (through the enhanced cooperation procedure),  their joint letter again supports taxing repos.

But once the European Commission publishes its draft FTT directive in February 2013, the French government shifts position again. By June 2013, Pierre Moscovici joins the widespread view that taxing repos is a step too far, agreeing with the ECB that to include such transactions will simply pose a major risk to the functioning of the credit market. Clearly successive French governments need not share their assessment of the link between repos and systemic risk.

Put this in the context of deliberations of reform for the shadow banking system. The recent FSB recommandations describe repos as the shadow banking activity, linking it to leverage, asset bubbles and financial instability. Recently, the Financial Times threw its weight behind a tighther regulatory regime for repos. 

 So, how do we make sense of the shifting French position? One answer may be that the French government is now prepared to back away from its promise that it would get a much stronger FTT regime at European level compared to the narrow French FTT on equities (that excludes repos). A broader answer may be that such radical measures as taxing repos (with the trade-offs it involves for liquidity of securities markets, including government bonds markets) can only be conceived and adopted during crisis times. The European Commission certainly designed an increasingly radical FTT during moments of unprecedented turmoil in European finance. Yet adoption may be far more difficult during a benign environment, as Europe seems to be enjoying at the moment. If the later is true, we should expect that after the September elections, Germany will join the French position on repos. The difficult questions of the systemic consequences of repo markets will then again be only asked by the FSB.

Change at the IMF: interconnectedness, financial fragility and global banks

I attended recently a workshop organized by Cornel Ban and Kevin Gallagher, with support from Governance, at Boston University on how the crisis has changed the IMF.

My presentation explored the way in which the IMF has grappled with financial innovation since the crisis, both theoretically and in its policy advice.

This is important, it argues, because the global economic crisis has brought an important shift in the IMF’s understanding of crisis, its triggers and its actors. Its research on macro-financial linkages now identifies large capital inflows as the main conduit for the transmission of global shocks, in contrast to previous concerns with current account dynamics; and transnational banks as the key carriers of capital flows across borders. With this, the IMF has included private financial institutions in its analytics of crisis, previously focused on governments (fiscal policy), central banks (monetary policy) and trade union/state-owned companies (structural reform).