Burgess COMMENTARY

Peter Burgess

The Institute Blog ... The Future of Financial Reform: Conceiving the Financial System of the 21st Century

Mark Carney, Governor of the Bank of England (BoE) and Chairman of the Financial Stability Board (FSB), may well be the man of the hour. When he gives a speech entitled “The Future of Financial Reform” as he recently did at the Monetary Authority in Singapore, people listen.

In his remarks, Carney emphasized curbing bankers’ compensation. It is little surprise that these particular remarks made all the headlines – this is kind of news the public has been waiting for. The fact that bankers received a record $140 billion in 2009 after banks received bailouts should enrage anyone. However, Carney offers a more subtle and nuanced understanding of the modern financial system and does not simply repeat populist anti-banker sentiments. As the head of the Bank of England he is at the forefront in conceiving a financial system for the 21st century – how to regulate it to make it safe and fair, and make it serve the needs of the real economy.

Carney describes the recent results achieved through the G20/FSB reform agenda as follows:

“The financial system today is vastly different from its pre-crisis self. That change didn’t “just happen”: it is the intended, positive result of the G20/FSB reform agenda.

The Brisbane G20 Leaders’ summit just completed was a landmark. The prudential requirements and supervisory framework for banks are largely settled. There will be adjustments, if necessary, but from a prudential perspective, banks now know what they need to do. It is now a question of implementation.”

Carney defines a successful global financial system which ensures:

• “The payments infrastructure is efficient and reliable;

• Companies can access the working capital they need to operate;

• Liquid savings are transformed into long-term loans;

• Core markets function continuously to allow risks to be diversified and managed

• Capital is allocated efficiently across the globe.

Achieving these ends requires a financial system supported by three pillars: diversity, trust and openness. Building these pillars should be the focus of the future reform agenda.”

In brief he says the system is safer because we have leverage ratios which are much lower than before the crisis. The system is simpler because of the system’s transparency: much of the risks will no longer be hidden and obscured through a vast and complex intermediation chain in an unchecked OTC derivatives market. This is being addressed through new disclosure standards, and limiting off-balance sheet operations. The system is fairer because governments are eliminating the “too big to fail” subsidies by creating resolution mechanisms which will lead to a “bail-in” of investors in case of a failure of systemically-important institution and thus reduce spillovers into the real economy (although this has yet to be tested in a real-world situation). Carney’s comments in the press comments are very helpful to understand the nuts and bolts of this point on the reform agenda.

The issues of “moral hazard”, “too big to fail”, bankers’ bonuses, counterparty and off-balance sheet risk, and leverage ratios are already well understood by analysts and the wider public and dominate the discourse. A vastly underappreciated, but important insight about the diverse nature of the credit system comes to light in the following passage:

The need to ensure resilience in the non-bank financial sector also raises questions about the nature of central bank operations. The maintenance of an effective monetary transmission mechanism now requires backstops for both banks and markets. Bagehot will need to be updated for the 21st century, with central banks standing ready to operate frequently, against a wide range of collateral and a broader range of counterparties.

Bagehot’s rule “lend freely, against what would be considered good collateral in good times at a high rate” has informed the modern lender of last resort function that has become the core responsibility of central banks in the 20th century. What Carney is saying is that we will extend this rule to all financial institutions which provide liquidity, not only banks.

Perry Mehrling has coined the phrase that “shadow banking is money market funding of capital market lending”. However, there is no such thing as a “shadow bank”. Instead there is an array of entities in the market-based credit system, which collectively replicates the traditional banking model of lending short-term and borrowing long-term that Zoltan Pozsar nicely illustrated in a recent paper. Carney recognizes this feature of the system by stating: “As such, there may be merit in this activity-based systemic risk assessment over and above a purely firm-focused approach to systemic designation.” The backstop provided by central banks will support exactly this liquidity function of the market-based credit system – this represents a paradigm shift in central banking.

Carney here is redefining the concept of liquidity provision. He is extending beyond traditional credit channels, recognizing that credit intermediation flows from both banks and market based securitization. The management of this liquidity is a new core function of central banking operations, and therefore helps to identify future sources of risk, creating additional challenges for economic policy makers: “The international community will need to shift focus to new risks and vulnerabilities, many of which will emerge outside the banking system.”

These new risks are already emerging. For instance, we are observing a surge of the bond market volume, which constitute almost the entire credit growth since the crisis. Furthermore, this growth has been largely concentrated in only a few bond funds. The illiquid nature of these markets amplifies what Shin calls “redemption risk”: withdrawals from one bond fund can lead to a huge sell-off of long-term assets to honor the immediate redemption promise. So a selloff of assets in a single large fund could drive asset prices down significantly and lead to a widespread collapse of asset sheets at other institutions. This risk is being underestimated by both the bond funds themselves and the retail investors because the “liquidity illusion”. Bond funds are making a reckless promise of immediate redemption on the assumption that liquidity is amply available and forthcoming.

Carney remarks:

“The compression of liquidity risk premia suggests that investors are assuming any future withdrawals from funds will be conducted in an environment of continuous market liquidity and that the value of their fund holdings will not fall substantially when they exit. The risks to that assumption are in only one direction.”

The level of liquidity provided by dealer activity is dangerously low. The central banks have become the primary counterparty in money market and capital market activity. What the Financial Stability Board is now recognizing and the market is not is that the exit from the QE programs will need to be carefully managed. Bringing the private dealers back into the markets will be an important challenge, as there remains considerable uncertainty as to what the true markets prices are. The BoE therefore is setting the boundaries of the markets with forward guidance and a push for transparency in order to dampen the uncertainty and bring private liquidity provision back into the markets.

The road ahead is clear and we have a much better sense of the primary challenges in our regulatory efforts and institutional rearrangements. The question as always remains one of implementation across national boundaries and staying alert to future new sources of risk. We continue to live in interesting times.

The Institute's Young Scholars Initiative is studying these phenomena in several of its initiatives. If you are interested in learning more, please contact ysi@ineteconomics.org.

Sources

The speech can be accessed here

Links

http://uk.reuters.com/article/2014/11/17/uk-bank-of-england-carney-bonuses-idUKKCN0J107J20141117

http://www.bbc.com/news/business-30079451

http://www.treasury.gov/initiatives/ofr/research/Documents/OFRwp2014-04_Pozsar_ShadowBankingTheMoneyView.PDF

http://econ.as.nyu.edu/docs/IO/26329/Mehrling_10012012.pdf

The Institute Blog Posted by Jay Pocklington at 1:34 pm Jay Pocklington's blog

Comments

Submitted by Paweł on Tue, 12/23/2014 - 5:33am.

This does not tackle the emergent source of funds, the P2P lending for both consumer and business. Although lot of the P2P funds come from the shadow banking the platforms give a glimpse into the financial services future that is not quite addressed in this view of the 21st century. reply

Submitted by francesco totino on Thu, 12/25/2014 - 5:23pm.

I think Financial system must be regulated thinking into account the following steps

Among EU countries should be accepted some common and few rules ..to share also with US and other world countries

To overcame single countries and worldwide crisis we need to move all together sinergically .

'Fiscal compact' agreement in Europe has been a good first step .... now we need

1 ) a Global ' Fiscal Compact,

2) a global Balanced Budged in any other world countries constitution

3)to abolish all worldwide Tax Havens ..( only one open is sufficient to neutralize much of the effect of tax and price policies in the rest of the world )

Fixed this worldwide FINANCIAL /ECONOMIC target any single countries should simultaneusly start to reform deeply his domestic not only FINANCIAL but also POLITICAL AND PUBLIC Structure, (the inefficient burocracy is sinonimous of corruption itself ) a structure that has gained in the last years more and more importance in the success of all the economic policy actions. In particular a factor that affects economic development and that is common to both Politics and Pubblic sector is the corruption phenomena linked to political patronage,. Corruption has blocked the efficiency of the social system at any level in some EU countries like Italy, Spain , Portugal, Greece and also in other countries

From these point of view EU and US and other worldwide countries should fix immediately some social standard measures index to be applied by the singles EU, US other country members that are particularly affected from inefficiency in political and public sector system. Most of the time Financial results in single countries come out only if some political and pubblic reforms have been done . To implement this 'Public' reorganization process ( from information, education , management and control) is strategic that 'European Digital Agenda' has been realized as soon as possible .

4) a much more active role of international institutions like IMF , UN and so on in managing international financial and economic rules from one side and reorganizing their management from the other .