A partially written symphony with too many conductors:

Stumbling toward a safer financial system

As the U.S. unemployment rate dropped below 6 percent in September 2014, The Federal Reserve began to acknowledge that the Great Recession might finally be over and that it would end its program of Large Scale Asset Purchases, commonly known as QE3.

In essence, the Fed was finally willing to bet that the economy and the financial system had recovered sufficiently to stand on their own with a reduced dosage of monetary stimulus. Nonetheless, the Fed promised to maintain its zero interest rate policy until sometime in 2015, and would not begin to increase its policy rate above the zero lower bound unless the economy continued to improve.

On Nov. 17, 2014, the Fed commemorated its 100th anniversary. Founded in the turbulent days of the early stages of World War I, the Fed was brought into existence with the goal to improve financial stability, improve the health and resilience of the banking system, and to develop a more uniform and efficient payments system to foster a growing economy across the vast continent that included New Mexico and Arizona, which both became states in 1912.

Among these three goals, the Fed has clearly accomplished the challenge to provide an improved and efficient payments system. There is, however, considerable debate about whether banking and financial stability have materially improved over the last century.

The Fed was founded seven years after the Financial Panic of 1907. By coincidence, it has been seven years since the onset of the 2007-2009 financial crisis, six years since Fed monetary policy rates hit the zero lower bound in December 2008, and four years since President Obama signed into law the Dodd Frank Act.

The goals of Dodd-Frank were quite straight-forward; it was touted as an act to end ‘too big to fail’ (TBTF), to end government bailouts, and to end the exposure of taxpayers to the costs of mismanagement of giant financial companies. 

Financial crises have been a recurring theme over the roughly 300 years of the history of capitalist economies. To state the obvious – and sometimes the obvious needs to be stated and repeated if the lessons are to be learned – financial crises are very costly events.

The author’s estimates of the cost of the 2007-2009 financial crisis amount to one-to-two years of U.S. output down the drain.1 The benefits of avoiding or at least delaying and minimizing the impacts of future financial crises are enormous.

This article reviews the key steps that the Fed and other key regulatory agencies should take, and indeed should already have taken, to reduce the likelihood of another major financial crisis.

Common elements of financial crises

All financial crises share some common elements, each of which begins with ‘C.’ In short, excessive ‘confidence’ breeds ‘complacency;’ this leads to a belief that less ‘capital’ is needed to absorb losses that are deemed less likely to occur. Furthermore, reliance on regulation to reduce risk-taking is undermined by regulatory capture as regulators begin to advocate on behalf of regulated firms, instead of the taxpayers they are supposed to represent.

To push the use of alliteration one step further, leverage is lethal, especially because a firm’s sources of liquidity diminish and disappear as its leverage increases.

It has been said that one can summarize the Bible in two sentences.

“Treat others as you would want to be treated. All the rest is commentary.”

Could it be that addressing the causes of financial crises could be summarized equally succinctly? If every financial crisis shares in common excessive leverage and market reluctance to fund overleveraged, illiquid companies, wouldn’t it be simpler to reduce the likelihood of future crises by adopting enforceable leverage and liquidity requirements?

If so, all the rest is commentary! Clearly, there is more to ending TBTF and providing financial stability in a global, networked economy, but a focus on leverage and liquidity could have reduced the pages in Dodd-Frank by at least 95 percent. More importantly, by focusing on the proper role of private-sector capital to absorb potential losses, the costs of failures of a large financial institution could be internalized to its shareholders and creditors, and not “put to” the taxpayers.

Bailouts: Will they or won’t they?

One of the foremost questions on the minds of customers, creditors and shareholders of financial institutions is how they will be dealt with by government officials if their financial institution gets in trouble. Will government policy indirectly come to their rescue at the expense of taxpayers, or will they incur substantial losses?

Nobody knows the correct answer to this question; consequently, many counterparties who do not have explicit safety net protection often infer, based on broad extensions of the safety net granted in the midst of the 2007-2009 financial crisis, that they are fully protected. The “temporary” deposit insurance protection given to shareholders in money market mutual funds is just one example. Not knowing the rules of the game creates a destabilizing situation. This lack of clarity on the part of the regulatory agencies that are mandated with the goal of financial stability actually fosters the instability they are supposed to prevent.

If creditors of the largest financial institutions assume they will be protected from losses by government actions, the largest financial institutions will grow ever-larger, thanks to cheaper funding, unrestrained by market discipline. When these giants ultimately fail, the losses to creditors and/or taxpayers will be far greater than would have been the case had there been a well-articulated and credible policy of absolutely no bailouts.

The comforting thought of government protection may provide the perception of greater financial stability in the short run, but by magnifying the ultimate losses and misallocating resources, explicit or implicit protection of financial institution liabilities undermines financial stability in the long run. Several studies published by the Richmond Fed over the last few years demonstrate that the U.S. federal financial safety net has expanded by 27 percent in the last dozen years and now covers nearly three-fifths of financial sector liabilities.2

Protections offered to the liability holders of several giant financial institutions by the Federal Reserve and the U.S. Treasury in 2008 and 2009 have made it nearly impossible to make statements of future non-intervention that would be deemed to be credible.  As a result, the uncertain and ambiguous nature of the size of the implicit safety net increases the likelihood that it will grow ever-bigger and de facto more explicit in the future.

The solution hiding in plain sight: Higher capital and liquidity standards

Is there a way out of this dilemma? Ironically, the solution, already stated above, is well known and has been around quite a while.

Even more ironic, and a sad commentary on the state of global financial regulation, is the fact that it has taken the Financial Stability Board, a global group of banking regulators, six years since the 2008 peak of the financial crisis to propose credible rules on equity and debt capital for the world’s 30 largest banking institutions.3

The FSB’s proposal – and at this stage it is only a proposal – would impose significantly higher capitalization requirements. It would double the Basel 3 Tier 1 leverage ratio requirement from 3 percent to 6 percent.

In addition the 30 giant global banks would be required to hold 16 percent to 20 percent of risk-weighted assets as equity, or long-term debt subject to bail-in losses during an institution’s failure resolution.

While this proposal represents an improvement over the status quo, it does rely excessively on risk-weighted capital, which has been subject to massive gaming for over two decades. Moreover, liquidity and funding issues are addressed only tangentially, and no verifiable and observable guidelines to reduce the reliance on short-term debt, have been proposed.

Emblematic of the cavalier lack of urgency in implementing solutions to reduce future financial instability, no concrete near-term date has been established for compliance with the proposed rules. 

And if these proposed rules go the way of other similar regulatory proposals, it will be 2020 before the world’s giant banks will be under pressure to have sufficient private-sector, loss-absorbing capital in place to minimize the call on taxpayers to defray the costs of banking institution failures. Given the usual foot dragging and negotiating that will take place between the banks and their regulators, it is not only conceivable, but highly likely, that the proposed capital and liquidity regulations will not be implemented before the next financial crisis occurs.

Sadly, we know what has to be done and that it should be done soon; all the rest is commentary.  Moreover, all the positive energy that could address preventing the next crisis will be squandered debating the details and minutia. The predictability of this perverse outcome should not be surprising. 

Most of the rules that must be written by the banking regulatory agencies to implement Dodd-Frank are behind schedule but are almost 60 percent complete; however, the rules to implement the Orderly Liquidation Authority which is supposed to end too-big-to-fail, are only one-third of the way to completion.  It was not supposed to be this way, but too-big-to-fail is alive and well, and, it seems, always will be.

 

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Michael Klein
Michael Klein Editor Pinnacle Media Group Ltd. PO Box 1365, Grand Cayman, KY1-1108, Cayman Islands T: 345-326-1720C: 345-815-0064 E: mklein@pinnaclemedialtd.com Michael is a financial journalist and copywriter.  In the past he has been responsible for the Risk Management and Corporate Finance sections of a British monthly Corporate Treasury publication.  He has written various financial handbooks, notably on European Banking and Cash Management and the Debt Capital Markets.   In addition he has worked as a copywriter for banks and investment funds and served as corporate communications consultant to US and European blue chip companies.   Michael holds an MA in Political Science and International Law from the University of Bonn in Germany. 

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