Policymakers are still operating in a liberal market paradigm that sees market failure as exceptional, regulatory intervention as costly and uncertainty as quantifiable risk
On 16 November, the European Union agreed a Regulation on Securities Financing Transactions (SFT Regulation). It will increase transparency in the obscure ‘repo’ market, which allows institutional investors, large corporations and broker dealers with spare cash to lend money out on a secured and very short-term basis to those who need it, such as banks and hedge funds. This is a really significant regulatory move by the EU.
Why so? Repurchase (or ‘repo’) agreements take the form of a sale of an asset, commonly a government bond or other liquid security, coupled with an agreement to buy it back at the end of the repo period. Repos normally last 24 hours, but are commonly rolled over, often for months. In substance, repo transactions are secured lending, with the seller of the asset being the borrower and the buyer being the lender. If the borrower defaults, the lender can sell the security. Lenders impose ‘haircuts’ on assets, protecting themselves against falls in asset prices.
The repo markets are enormous and, before the adoption of this regulation, no one really had any clear idea of their size. US repo markets were estimated at between US$3 and 10 trn in 2012, while the Euro repo market was estimated at €7 trn in 2010. This new regulation will now give regulators a much better idea of the size and concentration of the repo market, since under its terms parties to repo transactions are required to report information, which is then published in aggregated form and made available to various European and national authorities.
So why are repo markets suddenly being subjected to disclosure obligations? The Liikanen Report of October 2012 noted that, before the crisis, banks were over-reliant on short-term repo funding to finance long-term illiquid mortgages. It viewed repo markets as part of the shadow banking system and noted that, despite its much-trumpeted liquidity benefits, the repo market can also ‘pose potential threats to long-term financial stability’.
Like the EU’s Alternative Investment Fund Managers Directive, which regulates hedge-fund and private-equity managers, the SFT Regulation aims to ensure the stability of the financial system, focusing on the problems caused by the widespread use of leverage, which can create risk through the credit channel (endangering systemically important banks) and the market channel (driving asset prices up and down as liquidity ebbs and flows). Both instruments assume that, provided regulators have sufficient information and a clear instruction to consider the macro-prudential implications of patterns of leverage, they will be able to identify when leverage poses a threat to systemic stability. Indeed, the two instruments are complementary: since hedge funds borrow heavily on repo markets, regulators will be able to use information disclosed under the SFT Regulation to enhance further their oversight of hedge funds.
Both instruments were shaped by a new post-crisis international consensus surrounding financial stability. As I show in a recent article, the European Commission initially planned to impose a cap on hedge-fund leverage in order to ensure systemic stability. However, that approach was effectively side-lined as a result of lobbying by the hedge-fund industry and the UK government and the associated development of an international consensus within the G20, IOSCO and the Joint Forum that systemic stability could be achieved simply by imposing registration and disclosure requirements on hedge funds and giving discretionary intervention powers to regulators.
The same approach has now been taken in relation to the repo market. In its 2012 Green Paper on Shadow Banking, the Commission emphasised that regulators must have ‘accurate information to assess … leverage, the tools to control it and to avoid its excessive pro-cyclical effects’. Similarly, in a March 2013 paper, researchers at the European Systemic Risk Board (ESRB) stated that repos ‘can be relatively low-risk transactions by themselves’, but noted that their ‘pervasive use may give rise to systemic risk’. Rather than considering a full range of regulatory options, that paper identified an ‘information gap’ that needed to be closed in order for regulators to be able to assess ‘the financial stability risks associated with SFTs’ and then carried out a cost-benefit analysis of the different methods by which this might be done. This analysis was subsequently echoed by the Financial Stability Board (FSB), which pinned the blame for regulators’ failure to identify the dangers posed by the repo market on ‘gaps and lags in the information available’, and the European Commission.
However, for all the high-level consensus, there is little reason to be optimistic about this scheme. Even though there is widespread recognition that shadow banking can endanger global financial stability, repo markets will continue to operate as before. It’s true that the FSB has developed minimum standards for haircuts on some assets, but, at present, government bonds are excluded, as are repos to which banks are not a party. There are also moves to restrict bank use of repos to transactions based on the highest quality collateral. However, financial stability will remain dependent in large part on discretionary intervention by regulators. In many cases those regulators have been restructured and rebranded; they are generally better funded; they have been given an explicit macro-prudential mandate; and they have access to more information than before the crisis. Yet we still need to ask: is there any reason to believe that, even with these changes, regulators would have been able to anticipate the financial crisis before it struck?
This scheme shows that policymakers are still operating within a market liberal paradigm that sees market failure as exceptional and regulatory intervention as costly. More importantly, they remain wedded to the same model of financial risk management that failed so spectacularly before the crisis. Despite paying some lip service to Minsky’s financial instability hypothesis in 2008, policymakers still refuse to embrace the fact that instability is endogenous and the future evolution of the financial system radically uncertain (in the Knightian sense of there being no objective basis on which to assign probabilities of particular outcomes).
The future evolution of the financial system depends on the specific structures of asset finance that have been put in place. However, it is impossible for anyone to look into the future and predict that those financial structures pose a threat to the stability of the system. As the ESRB’s researchers put it, systemic risk ‘may’ arise where the use of SFTs is ‘pervasive’. Even leaving political pressures aside, this is not a clear touchstone for intervention. Just as central bankers regularly admit that they cannot identify asset-price bubbles before they collapse, so regulators cannot identify when leverage has become so pervasive that its pro-cyclical effects have driven asset prices to unsustainable levels, thereby creating a risk that, when the leveraging process goes into reverse, there will be fire-sales of assets, driving down prices and weakening balance sheets, and ultimately threatening systemically important financial institutions.
Unable to identify bubbles, central bankers have to intervene after they collapse, using tools such as quantitative easing which are far from costless. Under this regime, regulators are called on to intervene while the leveraging party is in full swing. However, like central bankers, they have no objective basis on which to justify any such decision. In all likelihood, then, the reluctance of policymakers to impose a stricter regime means that central bankers will be called on, once again, in the perhaps not-too-distant future to clean up the mess.