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.

The ECB, repos and financial integration

Before 2008, it was fashionable for European institutions to exalt the virtues of financial integration. Very small yield differentials between German and Greek government bond markets were approvingly cited as evidence that the Eurozone project of financial integration was progressing at rapid speed, at least in wholesale money and securities markets. Now European institutions routinely blame financial markets for failing to notice default/credit risk in sovereign bond markets.

Yet the evolution of the repo market - where financial institutions exchange collateral for cash, with a promise to reverse that transaction at a later date - suggests that European institutions encouraged markets to disregard fundamental differences. The  European Commission's 2002 Financial Collateral Directive was premised on the idea that repo integration would increase cross-border holdings of financial assets if repo market players could use these assets as repo collateral.

The ECB also got involved, through its collateral framework:

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. 

Outsourcing Financial Stability: the ECB and Cyprus

I have just finished revising a paper on the ECB's learning from the Japanese crisis management in early 2000s. The important lesson of that episode is that the shift to market-based finance confronts central banks with a trade-off between financial stability and institutional stability defined through central bank independence. To fight liquidity spirals, runs on repo and pro-cylicality induced by shadow bankign activities (as large in Europe as in the US), the central bank must abandon independence understood in the most narrow, and politically sensitive, definition of severing links with government debt markets. The traditional lender of last resort approach cannot address the systemic risks generated by market-based finance.

This matters immensly for understanding the ECB's choices since the crisis.

It is important to remember first that the ECB has no explicit mandate for financial stability of the Euro-area. European Treaties, and the ECB's institutional design, are built on the premise that national governments can, and should, provide financial stability. That design reflects a flawed theoretical assumption in pre-crisis mainstream macroeconomics that central banks could pursue price stability alone, and that would ensure financial stability. The mea-culpas from other central banks across the world, including Ben Bernanke, can be stil heard if one listens carefully. This is why those central banks abandoned indepedence and directed their considerable fire power at preserving the stability of a financial system with new sources of systemic risk.

In contrast, the ECB has played a more dangerous game that simultaneously increased its political power and financial instability. By its own addmission, the Enhanced Credit Support, and then the LTROs, outsourced financial stability to the banking sector - with fingers crossed that delevraging banks would want/be able to perform such a function. That the strategy ultimately failed became clear when Draghi announced that it would do whatever it takes (the OMT) to stabilize market-based finance. But the OMT did not solve the trade-off between independence and financial stability in the same manner that other central banks did. The OMT instrument has been designed as an  escape clause from the 'no-debt monetization rule', and the ECB gained greater political powers as a non-indepedent arbiter to impose costs (conditionality) and to verify compliance.

So the Cyprus moment is just another episode in the long struggle of the ECB to use the crisis in order to cement its power while abdicating an essential central bank function. That such a paradox is possible testifies to how dangerous this institution has become to the European project. Outsourcing financial stability to the Russian government or to the political willigness of a small country to tax the big players (those with large deposits) is a risk no central bank should take. Fingers crossed over the weekend.