This week we mark the first anniversary of one of the more monumental financial events in recent history--the collapse of
What's different?
--After the G-20 finance ministers meeting on Sept. 4-5, the Bank of International Settlements issued a comprehensive response to the global banking crisis, which reviews the current regulation, supervision and risk management of the banking sector with respect to capital adequacy.
--Moreover, the G-20 finance ministers vowed to align remuneration incentives with the long-term performance of banks.
--OTC Derivatives Central Counterparties: There is new consensus that a central counterparty is necessary to reduce potential knock-on effects (systemic risk) from the failure of a large player. However, the riskiest products are not standardized enough for a clearinghouse and therefore remain exposed to bilateral counterparty risk, which regulators want to mitigate by imposing higher capital charges and disclosure of aggregate position holdings.
--Update: The replacement of a large quantity of interest rate swaps with another counterparty has led to the negative swap spread phenomenon in the U.S. 30-year government bond market. Some of the same technical distortion was also observed in the CDS market.
--There is new recognition that derivatives can have an economic impact. One transmission channel from derivatives to real economy includes, for example, corporate credit lines, which are increasingly based on CDS performance. Furthermore, there is the empty creditor phenomenon that provides "overhedged" bondholders with an incentive to push for bankruptcy instead of restructuring.
--A new paradigm of economic thought is voiced by economist Keiichiro Kobayashi at VoxEU: "The existing theoretical structure of macroeconomics is incapable of addressing macroeconomic performance and the stability of the financial system in an integrated context." The author proposes a paradigm shift to explicitly include the financial sector, credit markets and asset/collateral prices in standard economic modeling.
What's still the same?
--Too-big-to-fail banks are now even bigger and leverage has increased across the board. With the incorporation of insolvent competitors and the forced re-intermediation of formerly off-balance sheet vehicles, the leverage ratio of global banks has jumped to around 40-50 in the U.S., Europe and the U.K. in 2008, according to InvestorsInsight. In 2010, up to $900 billion of remaining off-balance sheet vehicles will have to be consolidated.
--While systemic banks benefit from implicit and explicit government backstops, a resolution regime for all systemically large and complex institutions like Fannie and Freddie, for example--arguably one of the most important measures--is stalling in Congress amid waning political support. Moreover, there is strong lobbying against the Consumer Protection Agency, whose fate is unclear. It is not decided yet who will be the systemic risk regulator: the Fed or the Systemic Risk Council.
--The lack of any disciplining mechanism represents an incentive for large players to engage in risky trading activities with value-at-risk (VaR) measures back at record levels in Q2 2009 for the top five banks, with $1.04 billion at risk to be lost at any given trading day, according to press reports.
--The TARP Oversight Panel mentioned in its August 2009 report that toxic assets are still on banks' books. They are likely to be found in the Level 3 accounting category (mark-to-model) due to valuation difficulties. As of Q1 2009, the large banks have $657 billion of Level 3 assets on their books.
--Commercial Real Estate (CRE) Risk: Fitch reports that "while CRE loans, excluding the more problematic construction and development portfolios, represent more than 125% of total equity for the 20 largest banks rated by Fitch, the risk is even higher for banks with less than $20 billion in assets, as average CRE exposure represents more than 200% of total equity for these institutions." Fitch also announces ratings review by September.
--Dependence on wholesale funding markets is likely to remain an issue. The financing shortfall from the lack of securitization left a funding hole of about US$2 trillion and the market is still damaged from an overhang in legacy assets.
Roubini: One Year After Lehman
Looking forward, here are the three reform priorities that Roubini Global Economics analysts see as the most important:
1. Resolution Authority
From a systemic perspective, the establishment of a new resolution mechanism outside of bankruptcy for systemically important institutions, including non-banks, bank holding companies, or insurers like
Oliver Hart and Luigi Zingales of Harvard and the University of Chicago, respectively, propose an innovative regulatory approach for too-big-to-fail banks in general: "To ensure that LFIs [large financial institutions] do not default on either their deposits or their derivative contracts, we require that they maintain a capital cushion sufficiently great that their own credit default swap price stays below a threshold level. If this level is violated the LFI regulator forces the LFI to issue equity until the CDS price moves back below the threshold. If this does not happen within a predetermined period of time, the regulator intervenes. We show that this mechanism ensures that LFIs are solvent with probability one, while preserving the disciplinary effects of debt." Willem Buiter (of the London School of Economics) proposes a similar approach for insolvent institutions, where creditors are in line for a haircut according to their seniority.
2. Countercyclical, Macro-Prudential Regulatory and Policy Framework
The root of systemic instability lies in leverage and pro-cyclical herding behavior. While economists including William White, the former chief economist at the Bank for International Settlements, have pointed this out for years, the recognition is finally setting in that ensuring the stability of each financial institution by itself (micro-prudential regulation) is a necessary but not sufficient condition to ensure the stability of the financial system as a whole (macro-prudential regulation).
One way to internalize externalities are systemic risk insurance premiums charged to any institution engaging in risky activities as a form of compensation to society should a public bailout be required. Applied to the economy as a whole, a macro-prudential policy framework aims to prevent imbalances from building up in the first place. This would represent a paradigm shift for central bankers, in that it would require active engagement to monitor not only inflationary pressures as measured by consumer prices, but also asset prices.
3. Systemic Risk
Another key feature of this crisis is how quickly stress spreads from one institution to the next, even across national borders. One explanation is the increasing reliance on uninsured wholesale funding as a share of total bank liabilities. Once market liquidity in securities markets, which is used for repurchase agreements and short-term securities lending, dries up, the institution is immediately exposed to a potential liquidity mismatch. Unless the institution has access to a lender-of-last-resort facility, contagion can spread quickly through the repo channel. After the demise of the shadow banking system, it is not yet clear how the up to US$2 trillion financing shortfall can be met as policy makers slowly withdraw their support.
In the OTC derivatives markets policymakers and academics are promoting central counterparties and exchange-trading with strict margin requirements as a possible solution to reduce the pro-cyclicality and systemic risk inherent in the OTC trading activity. The strand of research that analyzes how contagion spreads through complex and interconnected systems--and how to stop it--is the network theory literature, featuring for example Andrew Haldane from the Bank of England and Rama Cont, Andreea Minca and Amal Moussa of Columbia University. The latter suggest that sound CDS risk management by a central counterparty requires liquidity reserves proportional to gross rather than net exposures in order to address systemic risk efficiently.
Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes. (Read all of his columns here.) Elisa Parisi-Capone, a senior analyst at Roubini Global Economics, assisted in the writing of this column.
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