On July 10, 2014 the Center for Financial Policy and The Clearing House jointly hosted “The Financial Industry in a Post-Crisis World Symposium” in Washington, DC. Panelists from regulatory, academic, and business communities exchanged views on three topics of relevance to the financial industry landscape under the impact of post-crisis regulatory changes: regulation and the shadow banking system, risks in central clearing, and post-crisis changes in bank balance sheets. Richard Berner, Director of the Office of Financial Research, delivered the keynote speech.
I. Regulation and the Shadow Banking System
Shadow banking, or financial intermediation without explicit government backstops, has declined but will likely increase in the post-crisis financial environment. Several trends support the growth of shadow banking: cyclical pressures on yield; structural changes in regulations, technology, and demographics; and developmental factors of emerging markets.
The demand for safe assets has driven yields steadily lower. Some believe that average institutional hedge fund return expectations are inconsistent with unlevered global risk premium and alpha opportunities. This search for yield can lead funds to increase their leverage and total portfolio risk, or to engage in shadow bank activities. The potential profit gained from creating new safe assets via risk transformation may drive hedge funds to create products they cannot guarantee in a crisis. The issue for regulators is whether that risk is then being passed onto the government through backstops.
Structural changes after the financial crisis to Basel III capital and liquidity requirements make traditional banking more expensive, thus some forms of banking are moving to shadow banks. Technological advances have helped new business models emerge to perform traditional bank activities, such as peer-to-peer lending companies Prosper and Lending Club in the US, and Zopa in the UK. At the same time, the aging world population means more investors are searching for yield to help them save for retirement. This is especially a problem in emerging market countries, where shadow banks have proliferated to meet demand. Products like sweep accounts, which let investors lend in the money markets overnight, can end up financing mortgages or risky local government debt. Wealth management products, private finance companies, and real estate investment trusts (REITS) have all grown significantly in emerging markets, outside the traditional system of regulatory oversight and support.
The panel agreed that improved governance using both pre-emptive measures and backstops is needed to allow shadow banking to help finance economic growth. Establishing the appropriate interaction between macroprudential policies (leverage and liquidity ratios), fiscal/monetary policy balance (interest rates and the supply of short-term government debt), and the role of the regulators is crucial to mitigate the risk of another crisis.
II. Identifying Risks in Central Clearing
The standardization and netting of obligations can improve the position of clearinghouse members, but central clearing also concentrates the risk of default within a single central counterparty (CCP). The panel discussed the potential evolution of the clearinghouse system, as the thrust of the regulation in the wake of the crisis has been on banks and their interconnectedness. The possibility of moving to a single CCP for each product or perhaps even across all products has been floated as one solution. In a bilateral world it is relatively easy for a bank to estimate their exposure to each of their counterparties across product lines. A system of central clearers means at least one entity in the economy (the CCP) has a broad view of the whole market, which can allow them to spot market shifts or crowded trades that previously no one could individually perceive, but regulators would still have to aggregate the central clearers exposures. It is also significantly more difficult to model and estimate whether a CCP is adequately capitalized versus a bank. Individual banks would previously choose their counterparties and then dynamically hedge their exposure though credit default swaps. In a CCP system, risk is managed through a default fund that isn’t dynamically calculated, leaving counterparty risk management fundamentally less responsive to market conditions. Regulators continue to focus on the robustness of the CCP system, and to improve pricing and transparency.
III. Post-Crisis Changes in Bank Balance Sheets
Cash and cash equivalents have grown in a huge amount from Q2 2007 to Q2 2014, with more punitive requirements on supplementary leverage ratio. Regulatory changes such as Basel III risk-based capital ratio and the leverage ratios, along with other liquidity ratios are just a few of the changes prompting shifts in the bank’s business models. Many of the regulatory ratios are deliberately set to discourage products that are (and were) perceived as risky investments. Banks can no longer in a position to take directional or proprietary risk, which has hindered their ability to facilitate market transactions in some cases, but also caused their daily value-at-risk (VAR) to steadily decline. Traditional activities, such as mortgage servicing, have or are moving out of the banking sector and into nonbanking entities. Banks must adjust their business models in order to move closer to compliance. As banks exit businesses or products with outsized operational risks, these activities will likely migrate to the shadow banking sector. The traditional banking system is undoubtedly stronger since the 2008 crisis: banks have raised over $500bn in capital, Tier 1 capital ratios have tripled and overnight repo is down 40%. It’s not clear whether some of the post-crisis changes to the banking system, such as improved asset quality and declined risk-weighted asset density are due to regulatory changes, or simply due to banks’ learning from past mistakes and re-assessing risk. Meanwhile, from the bankers’ perspective, convergence among the globally systemic banks is more likely than divergence. All will likely continue to stockpile cash, minimize their use of overnight repo, exit non-core businesses and perhaps even discontinue business with select clients.
Office of Financial Research (OFR) Director Richard Berner commented on the ongoing work at the OFR to improve analysis, data, and policy tools for financial institutions. He noted that regulation of banks is pushing services to the shadow banking system, fueling capital arbitrage, which can ultimately transmit and amplify the effect of financial shocks. At the same time, tools for analyzing shadow banking are not as developed as for banks. Director Berner recommended the starting point for regulators should be to focus on the activities in which shadow banks engage. Significant data gaps in the shadow banking arena make it difficult to even quantify this activity. OFR is working to implement and expand a funding map across the financial industry, to help identify what the specific gaps are, as well as analyze the counterparties in shadow bank relationships to monitor and understand financial vulnerabilities wherever they arise.
To date, his Office has focused their shadow banking efforts on identifying risk in short-term wholesale funding markets, including repo and securities lending. OFR is seeking to fill major gaps in US repo data, particularly bilateral repo, as well as gaps in securities lending data and separate accounts holdings. At the same time, OFR is engaging its global counterparts to facilitate data sharing across countries, such as by leading the global Legal Entity Identifier initiative that helps standardize data collection across the financial system.
Director Berner also commented on the three main topics of the panel sessions. He noted that a CCP system doesn’t eliminate risk, and that significant creditor default risks as well as operational risks remain. He highlighted how changes in bank business models simply mean more services will move to shadow banks. Leveraged lending, mortgage servicing, and market making were three specific activities leaving the banking system, so financial economists should pay attention to what institutions an activity is moving to and what that means for our ability to monitor risk. Director Berner closed his remarks by noting that positive economic conditions may mask risk, but OFR and its counterparts’ job is to identify those vulnerabilities, to be forward-looking while acknowledging we can’t be predictive.
The CFP thanks Robert H. Smith School of Business Finance students Julia Zhu (M.Fin) and Ben Munyan (Ph.D) for their significant contributions to this article.