Efforts to improve the resilience of the financial system since 2008 have worked for some of its core elements, but risks have been pushed elsewhere, Yale University’s Andrew Metrick warns.
Speaking in the latest episode of the CB On Air podcast, the professor of finance welcomes the Basel III framework’s capital measures to strengthen the core banking system. But he warns the liquidity measures may have had unintended consequences.
“I think the transformation of long-dated assets into short-dated liabilities is a primary function of what the overall financial system does, so to the extent that we restrict that activity in banks, it will move, and it has moved, into less-regulated entities,” Metrick says.
With that in mind, he urges authorities to take actions to rein in risks in the non-bank sector, building a set of regulations that would be “congruent” with those for the banking sector.
One possibility, an idea Metrick developed with Yale colleague Gary Gorton, is for authorities to impose haircuts on repo transactions that perform a similar role to capital requirements in the banking sector.
On the need for global co-operation, Metrick acknowledges some recent political forces have sought to undermine global agreements on regulation. But he argues central banks have considerable flexibility within their mandates to maintain sturdy regulations, which should help insulate against short-term pressures.
Hello, I’m Dan Hinge, news editor at Central Banking, and you’re listening to CB On Air.
This week, we turn to the global regulatory landscape, which has changed almost beyond recognition in the past 10 years. Is the financial system safer, and if it is, will it stay that way?
Once again, I’m joined by Andrew Metrick, Janet Yellen professor of finance and management at Yale University.
Andrew, welcome back.
Andrew Metrick: Hello
DH: So to start with perhaps the obvious question, is the global financial system safer now than it was, and perhaps more importantly, is it safe enough?
AM: We get a complicated answer to a simple yes or no question – from a structural perspective, from an understanding of the types of risk we face perspective, we’re safer. Some of the rules that were put in place are really good rules for preventing another financial crisis, and the understanding of the top central bankers I think puts us in a better place.
So there, I would say the answer to the first question – ‘Are we safer now than we were?’ – the answer would be yes, in that structural way.
The answer, however, is no when we take into account the political and social realities that we have right now. There’s just a whole lot less room to manoeuvre both on the fiscal side because of the additional debts we have, and on the monetary or rescue side, because of the strong backlash to the way the last crisis was fought. So, in that respect, if we were to need the kind of concerted and international response that we made 10 years ago, I don’t think the political capital exists to be able to do that.
In terms of whether it is safe enough, on the structural side, even though improvements have been made, I don’t think those improvements are sufficient to enable us to deal with a very large crisis. I think we took away some of the powers we had to deal with an emergency while it was happening, and we’ve greatly emphasised the prevention side. That’s all nice – it’s good to prevent – but I do not think we have made ourselves safe in the instance where we would have a crisis, and I do not believe that we have prevented them out of all existence.
DH: That leads me neatly on to the next question, which is how do you rate global efforts to improve stability, such as Basel III. Obviously some people say that it has gone too far, banks complain it is too onerous on them, and others are saying you should crank up the leverage ratio to 20% or something and then we’ll be safe for good. So how do you think about that?
AM: Well I think that on average, in general, it is better for our banks to have more capital than less capital. The banking system, the traditional banking system, because of the new capital rules, and also because of the clever ways that some debt-like instruments have been made bail-inable, the traditional banking system, I believe, is safer and the Basel rules have made it safer.
I am concerned, however, about two things, and those concerns are large. One is I do not think that the liquidity rules – while they have been well-meaning – I do not think that they really adequately take into account the substitutability of liquidity transformation from the traditional banking sector to the shadow banking sector.
That is, effectively the liquidity rules that have been put in place as part of Basel III are things that are trying to limit, in the aggregate, how much traditional banks can transform long-dated assets into short-dated liabilities. But I think the transformation of long-dated assets into short-dated liabilities is a primary function of what the overall financial system does, so to the extent that we restrict that activity in banks, it will move – and it has moved – into less-regulated entities.
And that brings up the larger point, that capital in banks is good, and it still remains the case that in many countries of the world we have bank-centred systems, but it has to be coupled with a parallel effort to have congruent regulation as much as possible on non-banks. Sometimes that’s institutions and sometimes that is markets. So capital may not be tremendously expensive, not as expensive perhaps on an individual basis as somebody at a bank who doesn’t want capital ratios might say it is, but it is not free, and even a small additional cost of capital from having to have more equity, or equity-like instruments on your balance sheet for a bank is enough to move some of that traditional banking activity outside of traditional banks into shadow banks.
So I think that Basel III as a partial equilibrium move on the capital side is good, and is part of what a comprehensive solution would have to look like. But we still have not focused on the other side of that comprehensive solution, and on the liquidity side, I think these liquidity rules are well meaning but ultimately may prove counterproductive.
DH: So do you have any thoughts on the kinds of things regulators should do to make the shadow banking system more robust, more resilient?
AM: I think the types of things that are discussed at the Financial Stability Board level, with their real focus on short-term wholesale funding markets, are going down the right direction. They are just hard things to implement.
Among those things are thinking hard about what actually is, looking at all points in time regulators don’t look at institutions necessarily, but need to be focused on what is currently serving as short-term wholesale financing. Where is it happening? And where it is happening, to do what they can to eliminate regulatory arbitrages. They are never going to eliminate all of them, but they need to be cognisant of it.
So a specific thing that in the past [Yale finance professor] Gary Gorton and I have suggested is that for example for the very large repo markets that are out there, that we use a variety of carrots and sticks to impose minimum haircuts on repo transactions that are equivalent to, and congruent to, the kinds of capital ratios you would place on those same assets if they were held inside of banks.
That’s one thing. Another thing you can do is just pay attention to things like money market mutual funds. There have been some reforms in the United States that have done some good things and some bad things, and have pretty strong connections with Europe, but you can pay attention to the fact that when money leaves banks, you look where it goes. Sometimes we see trillions of dollars moving from one part of the system to the other, and you ask: ‘What is it that is maintaining some kind of parity between this new part of the system – for example, some parts of money market mutual funds – and the traditional banking system?’. And you try to put in some sort of parallel regulation.
It is not a one-off thing, it requires vigilance on the parts of authorities about where things are moving, and most recently that is a movement in the United States between prime money market funds and government money market funds.
DH: Interesting, OK. And in terms of the big post-crisis agreements, do you think those will prove durable? We’re already seeing a few forces in the US looking to ‘tailor’ the regulations.
AM: I do think in the short run we’re certainly having an anti-regulatory push in the United States, and an anti-globalist, and global co-ordination, push worldwide. From my perspective those are not good things, those are not helpful. But so far neither of those two things has gone that far on the financial side – there are other parts of the policy world that I think are under much greater strain.
And the leaders of the global central banking community, that I know, I have been very impressed by and I do not believe they themselves in their technocratic processes are pulling back, and that intellectually there continues to be a lot of progress that is made. So I am hopeful that while we are seeing a bit of a pull-back right now, the long-term trend is quite a good one, and our ability to co-operate across borders is continually improving.
I am doing my best to be an optimist in this area, but nobody can deny that the very recent news has not been great.
DH: And if I force you to be a pessimist and get you to imagine that global agreements do come under threat, is there anything we can do about it?
AM: I think that the global agreements themselves, at this stage, on the financial regulatory side, are not necessarily the things that have the most teeth.
But individual countries and individual central bankers still have in their national authority the ability to do most of the good things that we need to get done, and you don’t need that many countries, that many central bankers – you can fit them around one conference table – to agree to do things in a certain way under their own authority.
This is not, I think, any kind of violation of the political process, this is effectively technocratic decisions that need to be made about things like bank capital and how to impose liquidity rules and whether or not we should have central bank swap lines, that are very much outside the political process, where we can continue to make progress on them.
And so, I certainly don’t want to see the global agreements unravelling, but I think in the case of financial regulation, there is much more that we can do just in an informal way, than for example in areas like climate control, where you need to impose some kind of different system with teeth to be able to keep the international momentum going. On the financial regulation side, we can do a lot of it just with central bankers being smart about it and co-operative using the authority they already have.
DH: That’s an encouraging thought. Andrew Metrick, thanks very much.
AM: You’re welcome.