Policy Research in Macroeconomics

Ten years after: is the system “Safer, Simpler & Fairer”?

On 9 August, 2017, PRIME held an event at the TUC to mark the date ten years ago when inter-bank lending froze, and the global financial system began to unravel. We invited Andrew Simms of the New Weather Institute, Frances Coppola and Prof. Daniela Gabor to take stock and assess the state of both the financial and eco systems ten years after the first signs of economic failure. The event was chaired by PRIME’s director, Ann Pettifor.

Prof. Gabor began by quoting a Reuters report of ten years ago, on August 9, 2007. The bank BNP Paribas was barring investors from redeeming cash from its funds. BNP explained their decision in this way:

“The complete evaporation of liquidity in certain market segments of the US securitization market has made it impossible to value certain assets fairly – regardless of their quality or credit rating.” (My emphasis)

Assets serve a vital role as collateral in the securitisation process. Ten years ago, sub-prime mortgages were assets used as collateral. It was the inability of those active in capital markets to value certain assets fairly, Prof Gabor argued, that led to a breakdown in the social contract around money. That was the real cause of the global financial crisis. She argued that the next crisis would invariably take place in the shadow banking system, where the actors would be different from those prominent in the 2007-9 crisis.

In explaining shadow banking, Prof. Gabor compared it to traditional banking.

In traditional banking, bank money is generated by credit creation, which in turn is based on collateral (e.g. property) and contracts used in relationship banking. Once collateral is accepted, and contracts agreed between bank and borrower, banks make loans by depositing bank money in a borrower’s account. Banks tend to hold these loans (assets) to maturity. (A loan is an asset because it is likely to generate income/rent – interest – over a given period.)

Shadow bank money arises from credit creation in securities markets. (Securities are tradeable financial assets – e.g. bonds, options, debentures, or common stocks.)  

Shadow money arises from credit creation using securities as collateral. It is a market in which securities as collateral are continuously re-priced – in what are known as repo transactions (Peer 2015).  In other words, shadow money issued against securities is a business model reliant on the daily variation in market prices of the collateral offered – securities.

In a repo, one party sells an asset (usually fixed-income securities like a bond) to another party at one price. At the start of the transaction s/he commits to repurchase (repo for short) the asset from the second party at a different (higher) price, and at a future date. The asset therefore acts as collateral and mitigates the credit risk that the buy has on the seller.

Opacity, leverage and global interconnectedness

The shadow money banking system in its use of continuously repriced collateral is reliant on opacity, leverage and global interconnectedness. It is therefore highly pro-cyclical!

Prof. Gabor noted that the Assets Under Management industry (“a key bridge between end-savers and end-borrowers, between the financial and real parts of the economy” according to the Bank of England) is large. There are 400 asset managers managing $63.3 trillion of the world’s savings/pensions. These include Blackrock that managed nearly $5 trillion in 2017, Vanguard Asset Management (nearly $4 trillion), State Street Global Advisors($2.3 trillion)..etc. These investors/asset managers are swapping ‘patient portfolio’ securities in the shadow banking sector, and lending cash by using securities as collateral in repo markets.  However, global regulators are relaxed about the activities of these giant funds, and have loosened up their regulation. The activities of these giant fund managers have not been acknowledged as systemically important – a conclusion met with relief by asset fund managers. On 26 September, 2016, Bloomberg reported that BlackRock Inc.,, Vanguard Group Inc., and Fidelity Investments

“sent letters..praising the Financial Stability Board, whose members include the US Federal Reserve and the Bank of England, for shifting its scrutiny of the industry to specific trading activities rather than the size or systemic importance of firms that manage trillions of dollars in assets.”

The companies and their main trade associations, in hundreds of pages of letters, called on the Basel-based Financial Stability Board (FSB) to fine-tune potential constraints on how firms assess market stress, to collect more data and to broaden its review to companies that can threaten asset-managers. The FSB obliged. Its previous proposals could have led to the sort of stricter oversight and even capital requirements imposed on the world’s biggest (traditional) banks.”

On 3 July, 2017 the Financial Stability Board declared the world’s financial system is:

Safer, Simpler, Fairer…..A decade on since the start of the global financial crisis, G20 countries have rebuilt the financial system so that it serves society, not the other way round. By fixing the fault lines that caused the crisis, the financial system is now safer, simpler and fairer than before.” (My emphasis.)

Prof. Gabor believes that shadow banking is here to stay; and notes that it has recently expanded dramatically in China. The market-based shadow banking model means that financial institutions are now

·      increasing their activities in securities and derivative markets;

·      operating across borders (financial globalization)

·      and operating off-balance sheet – in shadow banking.  

In other words, shadow banking, unlike traditional banking operates almost entirely beyond regulatory democracy. The challenge she believes lies not in the volume of debt created by shadow banking, but in the inability to value certain assets fairly.  To quote Jonathan Anderson, principal at Emerging Advisors Group and longtime China-watcher:

“The real issue isn’t the volume of debt but rather the liability-side ‘plumbing’ that underlies the debt boom. If there’s going to be a financial crisis in China, this is where it will come from”.

Professor Gabor shared some good news: that lessons have been learnt, and there is now “unprecedented scrutiny” of traditional banking activity and a new social contract around banks’ shadow money issuance.  She cited Basel III/SFTR, other shadow money regulation, the radical expansion of central banks’ safety net in crises to preserve collateral values and shadow ‘moneyness’.

The bad news is the ongoing structural transformation of the global finance sector towards securities market-based finance, with less systemic scrutiny. Second, there is the threat of regulatory re-capture in the United States.  Prof. Gabor referred the audience to an article by John Gubert on 8th August, 2017 on the Global Custodian website. The US could be the biggest beneficiary of Brexit, he writes, and in passing notes the

“remarkably underreported review of bank regulation by US Treasury Secretary, Steve Mnuchin.  Interestingly enough the scope of the changes proposed in US regulation are far more limited than would have been expected from Donald Trump’s evisceration of the over regulation of US markets.

“But they are significant.

“There is a wish to re-invigorate the US repo market where activity has shrunk one-fifth since 2012 quite simply by removing the safest assets, such as central bank deposits and cash, out of leverage ratio calculations. The review also looks to expand the range of assets that can be used as collateral for liquidity. Importantly it advocates more flexibility in market making and expresses concern at the thinness of markets, the balance sheet inspired shrinkage of bank lending and the market dependence on listed and unlisted corporate loans.” (My emphasis). “

Our event had marked the 10th anniversary of the day in which banks lost confidence in the ‘fair valuation’ of (‘sub-prime’) collateral used in traditional banking. We were left with concerns about the next crisis. Would it occur when markets lose confidence in the ‘fair valuation’ of collateral used in shadow banking? 

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