Tuesday, July 12, 2016

Financial Stability Reform: Lots of Activity, Not Enough Progress

There has been lots of sound and fury about improving financial regulation in the seven years since the Great Recession ended in 2009. But have the necessary changes been made? In "Financial Regulatory Reform Afterthe Crisis: An Assessment," a paper written for the 2016 European Central Bank Forum on Central Banking held at the end of June, Darrell Duffie basically says "not yet."

Duffie argues that there are four core elements of financial-stability regulation: "1. Making financial institutions more resilient. 2. Ending “too-big-to-fail.” 3. Making derivatives markets safer. 4. Transforming shadow banking." He writes: "At this point, only the first of these cores element of the reform, `making financial institutions more resilient,' can be scored a clear success, although even here much more work remains to be done."

On the first goal of making financial institutions more resilient:
"These resiliency reforms, particularly bank capital regulations, have caused some reduction in secondary market liquidity. While bid-ask spreads and most other standard liquidity metrics suggest that markets are about as liquid for small trades as they have been for a long time,4 liquidity is worse for block-sized trade demands. As a tradeoff for significantly greater financial stability, this is a cost well worth bearing. Meanwhile, markets are continuing to slowly adapt to the reduction of balance-sheet space being made available for market making by bank-affiliated dealers. Even more stringent minimum requirements for capital relative to risk-weighted assets would, in my view, offer additional net social benefits.  I will suggest here, however, that the regulation known as the Leverage Ratio has caused a distortionary reduction in the incentives of banks to intermediate markets for safe assets, especially the government securities repo market, without apparent financial stability benefits."
On the second goal of ending "too-big-too-fail":
"At the threat of failure of a systemically important financial firm, a regulator is supposed to be able to administratively restructure the parent firm’s liabilities so as to allow the key operating subsidiaries to continue providing services to the economy without significant or damaging interruption.  For this to be successful, three key necessary conditions are: (i) the parent firm has enough general unsecured liabilities (not including critical operating liabilities such as deposits) that cancelling these “bail-in” liabilities, or converting them to equity, would leave an adequately capitalized firm, (ii) the failure-resolution process does not trigger the early termination of financial contracts on which the firm and its counterparties rely for stability, and (iii) decisive action by regulators. ... [T]he proposed single-point-of-entry method for the failure resolution of systemic financial firms is not yet ready for safe and successful deployment. A key success here, though, is that creditors of banks do appear to have gotten the message that in the future, their claims are much less likely to be bailed out."
On the issue of making derivatives markets safer:
"Derivatives reforms have forced huge amounts of swaps into central counterparties (CCPs), a major success in terms of collateralization and transparency in the swap market. As a result, however, CCPs are now themselves too big to fail. Effective operating plans and procedures for the failure resolution of CCPs have yet to be proposed. While the failure of a large CCP seems a remote possibility, this remoteness is difficult to verify because there is also no generally accepted regulatory framework for conducting CCP stress tests. This represents an undue lack of transparency. Reform of derivatives markets financial-stability regulation has mostly bypassed the market for foreign-exchange derivatives involving the delivery of one currency for another, a huge and systemically important class. Data repositories for the swaps market have not come close to meeting their intended purposes. Here especially, the opportunities of time afforded by the impetus of a severe crisis have not been used well."
On the issue of transforming shadow banking:
"A financial-stability transformation of shadow banking is hampered by the complexity of non-bank financial intermediation and by the patchwork quilt of prudential regulatory coverage of the non-bank financial sector. ... The Financial Stability Board (2015) sets out five classes of shadow-banking entities: 1. Entities susceptible to runs, such as certain mutual funds, credit hedge funds, and real-estate funds. 2. Non-bank lenders dependent on short-term funding, such as finance companies, leasing companies, factoring companies, and consumer credit companies. 3. Market intermediaries dependent on short-term funding or on the secured funding of client assets, such as broker-dealers. 4. Companies facilitating credit creation, such as credit insurance companies, financial guarantors, and monoline insurers. 5. Securitisation-based intermediaries. ... While progress has been made, the infrastructure of the United States securities financing markets is still not safe and sound. The biggest risk is that of a firesale of securities in the event of the inability of a major broker dealer to roll over its securities financing under repurchase agreements. While the intra-day risk that such a failure poses for the two large tri-partyrepo clearing banks has been dramatically reduced, the U.S. still has no broad repo central counterparty with the liquidity resources necessary to prevent such a firesale. More generally, as emphasized by Baklanova, Copeland, and McCaughrin (2016), there is a need for more comprehensive monitoring of all securities financing transactions, including securities lending agreements."
Finally, I was struck by one of Duffie's comments in passing about the costs of financial regulation:
"The costs of implementing and complying with regulation are among the tradeoffs for achieving greater financial stability. For example, in 2013 (even before the full regime of new regulations was in place) the six largest U.S. banks spent an estimated $70.2 billion on regulatory compliance, doubling the $34.7 billion they spent in 2007. Compliance requirements can accelerate or, potentially, decelerate overdue improvements in practices.  The frictional cost of complying with post-crisis regulations is easily exceeded by the total social benefits, but is nevertheless a factor to be considered when designing specific requirements and supervisory regimes."
Appropriate financial regulation is an admittedly difficult policy problem. Still, it's disconcerting that seven years after the end of the Great Recession, some obvious gaps and concerns remain--and of course, the concerns that we haven't been able to anticipate remain as well.