Is The Financial System Safer Today Than It Was In 2007?

Is the financial system safer today than it was in 2007?

Introduction

Capitalism it seems is here to stay and with banks at the heart of it our financial system could hardly matter more. The safety of the financial system is a trade-off between ensuring enough capital is available to support investment and growth and enough capital is kept in reserve as a buffer for any shocks. This means the safety of the financial system is not a costless concept. Our financial system is inherently unstable as unlike cloakroom banks fractional reserve banks uses deposits to make loans which to quote Brian Scott-Quinn `makes banking systems inherently unstable in the event that investors panic.` The safety of the financial system is more complex than just capital requirements it is about creating the right incentives to promote sustainable banking. This topic is too broad to be fully explored so I have framed it by including the issues I believe to be of greater relevance.

Context of Financial System in 2007

In 2007 developed economies had been experiencing a period known as `The Great Moderation.` This is considered to be between 1986 and 2007 when new neoliberal ideas of light touch regulation and freer market policies spread globally. This new financial model seemed to have conquered the old paradigms of high inflation and deep recessions as seen below reducing both the upside and more importantly downside GDP variability compared to 1950-1985. This lead Gordon Brown to claim in 2007 `we will never return to the old boom and bust.` Confidence was at an all-time high.

The Banking Culture

A key changing point in the financial system was the replacement of Glass-Stegal with the Gramm-Leach-Bliley act in 1999. Glass-Stegal was put in place after the great depression to separate the commercial banks which take deposits and the investment banks which conduct riskier activities. One of the purposes of Glass-Stegal was to restore the public`s trust in banks by preventing commercial banks speculating with customer deposits. The repeal of Glass-Stegal allowed commercial and investment banks to merge together forming `super-banks.` As noted by Joseph Stiglitz this changed the banking dynamic as `the investment-bank culture came out on top.`

The cultural changes in commercial banking had a tangible impact. The dollar amount of the riskier subprime mortgage loans in 2006 was more than five times greater since the formation of `super-banks` in 1999. Where there suddenly five times the amount of viable subprime loans? No. Lending standards had deteriorated with banks giving NINJA (No Income No Job and No Assets) loans irresponsibly as if house prices fall lenders will default as they cannot afford to refinance. The major mortgage lenders such as the largest Bank of America have had to reach settlements over their predatory lending `deceptively putting borrowers into loans they didn`t understand, couldn`t afford and couldn`t get out of` as one attorney-general puts it.

In recognition of the cultural shift of the `super-banks` the US regulators have attempted to make commercial banks more risk conscious with the Volker Rule. This prevents commercial banks from proprietary trading in other words making risky bets with depositor`s money as was originally in Glass-Stegal. The UK has a similar but stronger equivalent with the Vickers report which aims to legally `ring-fence` the riskier bank from the safer bank. In the long run these rules should guide commercial banks back to their safer traditional role. The Volker Rule has been watered down and not go as far as Glass-Stegal in separating commercial and investments banks. The Vickers report is effectively Glass-Stegal which is arguably safer but it only has to be implemented by 2019. The lack of harmony of these rules might result in UK banks moving their headquarters to the US undermining the Vickers Report.

Financial Regulation

The regulators were playing catch up as Basel 2 was being gamed by banks. It allowed banks to calculate their own estimate of regulatory capital which gave them an incentive to underestimate their risk. It failed to properly monitor securitised assets as Archarya and Richardson put it `the purpose of securitisation was not to share risks with investors, but to make an end run around capital-adequacy regulations.` The banks did this in two ways. Firstly they used off-balance-sheet vehicles collectively known as `conduits` which are part of the shadow banking sector to hold their asset-backed securities. By taking the assets off-balance sheet it freed up room for other assets to be added to the official balance sheet. Secondly banks through the process of tranching banks created AAA-rated securities like mortgage backed securities (MBSs) which were subject to half the risk-weighted capital of the individual loans so banks decided to keep them. Both these processes increased the bank`s leverage (the ratio of total assets to risk-weighted assets) by 50% over the 3 years from 2004 to 2007 which can be seen below.

Basel 2 also lacked regulation covering banks funding liquidity. When house prices started falling there was a loss of confidence in the MBS market which forced banks to reassess the MBSs they were holding. This became impossible as the rate of financial innovation of the derivatives outpaced understanding. After all humans have a `bounded rationality.` As James Crotty notes in his paper on the Structural causes the derivatives `could not be priced correctly` so banks became insular as they could not assess the creditworthiness of their counterparties which were also likely to be holding the AAA rated securities so withdrew liquidity from the market. This meant that banks were in a rush to sell their assets to raise funds but as banks were trying to sell their assets at the same time it only amplified the problem. This resulted in a fire sale with prices far below the fundamental value of the asset which lead to the collapse of Northern Rock. The act of withdrawing liquidity is analogous to the paradox of thrift where what makes sense individually only exacerbates the problem collectively.

New international banking regulation in the form of Basel 3 aims to put right the errors of Basel 2. Basel 3 strengthens banks` capital base by increasing the size and quality of Tier 1 capital. The minimum amount of common equity (shares) which has the highest amount of loss capacity is now 4.5% of risk-weighted assets instead of 2%. Tougher quality standards mean hybrid capital instruments are no longer classified as Tier 1. The banks are still allowed to estimate their own capital requirements but are subject to stricter conditions such as increasing the length of time used for historical data to make it more reliable. It also introduces a minimum leverage ratio of 3%. This is based on both on/off balance sheet positions. 3% could be considered too low but it at least signifies regulators addressing leverage and aiming to tackle it. The risk-weights for securitised products have been increased so more capital is required to be held. Significantly to try and prevent another failure like Northern Rock new funding liquidity measures have been adopted. They target both short-term liquidity, over 30 days and long-term stable funding relative to the bank`s assets. The short-term measure is designed to meet all net cash outflows under difficult market conditions similar to those experienced in late 2007. It does not go as far as Ha-Joon Chan would sensibly like for new financial products `to be tested rigorously` like drugs before they are allowed to be used. This would enable regulators to be proactive instead of reactive in setting their risk-weights preventing any manipulation before it has a chance to occur.

Credit Rating Agencies

Credit rating agencies (CRAs) which should have questioned the complexity of the derivatives failed to understand the risk of the instruments allowing banks to continue `manufacturing` them. They literally gave the derivatives the credibility which enabled them to thrive. Their ratings are paid for by the issuer so they have a conflict of interest to give the best rating possible irrespective of whether it is deserved. This is a serious issue as their ratings are merely opinions protect legally under the freedom of speech this means they are not held accountable for their validity. How rating agencies function has largely been unchanged since 2007 as they still are paid by the issuer creating perverse incentives and they still lack accountability. There has been acknowledgement of the over reliance of CRAs by the G20 which want to stop the legal and regulatory dependence of CRAs by finding better alternatives and banks to make their own assessments not relying solely on CRAs. Unfortunately currently there are no better alternatives to CRAs and banks do not have the time to comb over the rating given by CRAs. It seems CRAs are here to stay for some time.

Over the Counter Derivatives

At the end of 2007 eighty eight per cent of derivative contracts according to the BIS were traded over the counter (OTC). As OTC contracts are agreed bilaterally they inherently have counterparty risk. This is a systemic problem as one default can cause a cascade of others if banks are not sufficiently capitalised.

In 2009 the G20 leaders agreed that all standardised OTC contracts should be cleared by clearing houses. This aims to eliminate counterparty risk because the clearing house assumes the credit risk of both parties so if one party defaults the clearing house should still honour the contract. The downside of increasing the volume of cleared transactions is that greater competition will incentivise clearing houses to reduce margin requirements to win deals. This is a serious risk and there needs to be regulation for minimum margin requirements as clearing houses are too big to fail. Unless the margin requirements are higher than they previously were in 2007 the default risk has merely transferred from the banks to the clearing house. For non-standardised OTC contracts the capital requirements have been increased. To improve the transparency of the OTC contracts counterparties must report trades to a `trade repository.` This can then be accessed by regulators to monitor any excessive risks.

Banker`s Incentive Structure

Bankers in 2007 could get bonuses which dwarfed their salary. This is not a problem if it is deserved. The issue was in most cases it was not. For instance AIG gave bonuses prematurely to bankers selling credit default swaps (CDSs) as the banks liability was still on-going. This was especially problematic for AIG then as their CDSs were like picking pennies in front of a steamroller you can make profit initially but in the long run you will make a loss. There has been some change to the banker`s bonuses. The bonuses in the EU have been capped to their salary or twice it if shareholders approve. In the UK under FCA regulations at least 40% of the bonus must be deferred over three years and at least 50% must be paid in shares, share-linked instruments like options and other non-cash instruments. These regulations are far from perfect as bankers salaries will simply rise to compensate for the capped bonuses. Deferring part of the bonus only reduces the incentive for short term risk if still does not properly portion it to the full duration of the contract. Also there is too much flexibility over the form of the bonus as options are vastly different from actual shares where there is downside risk. It would be better to use shares instead of options as bankers will be more vary of taking risk if it would reduce the value of their shares.

Too Big To Fail

By repealing Glass-Stegal the creation of `super-banks` meant that they posed too much risk to the real economy to fail. This is unacceptable as it creates moral hazard, heads they win tails they get `bailed-out` there is simply no downside for taking risk.

To avoid bank `bail-outs` regulators in the US and EU have created a `bail-in` procedure as part of the Dodd-Frank act and the Bank Recovery and Resolution directive respectively. It means `taxpayers will be last in line to pay the bills of a struggling bank` with the banks creditors, shareholders and bondholders, funds being used to recapitalise the bank. This is intuitively a fairer approach as an investor is expected to bear the risk of their investment not the taxpayer. There are also plans to add additional capital requirements for systemically important financial institutions (SIFIs).

Conclusion

It is tempting to be glib and support the view of Hyman Minsky where the financial system now is safer than 2007 precisely because it is not safe enough for it to be risky. I believe that the system is safer now though that is not a difficult feat. There has been progress internationally with Basel 3, centrally cleared OTC contracts, the separation of riskier banking activities and the `bail-in` approach. The regulation is only as strong as its weakest link which seems to be shadow-banking to quote Deloitte`s report `innovations in regulatory arbitrage may once again result in some explosive growth (of shadow banking), possibly posing increased systemic risk to the financial system.` For now the regulation seems to be working but time will tell.