Tuesday, January 8, 2013

With liquidity coverage ratio, regulators repeat error that led to financial crisis

As pointed out by CNBC's John Carney, global financial regulators have repeated the same error that contributed to the financial crisis in specifying what assets qualified for the liquidity coverage ratio.

The error was that assets that were suppose to be low risk and liquid, aka AAA-rated structured finance securities and sovereign debt, turned out not to be either low risk or liquid as the prices on these assets drop dramatically and the markets on which they traded froze.

The only way to avoid repeating this error is to bring transparency back to all the opaque corners of the global financial system.  It is only when market participants have access to all the useful, relevant information in an appropriate, timely manner so they can assess and make a fully informed decision that markets remain liquid.

The expansion of the definition of high quality liquid assets will result in a high-level of demand for whatever types of assets have the highest haircut adjusted returns. A highly rated mortgage-backed security has a lower haircut than a similarly rated corporate bond, which will create additional demand for those mortgage-backed securities. Likewise, banks are likely to crowd into the lowest rated corporate bonds included in the bucket to increase the after-haircut yield.  
The market is likely to respond to these regulatory driven changes in demand by creating more of these assets. This increase in supply can happen in at least two ways. In the first place, lenders will make more of the preferred loans. That could be a positive for the housing market, although it risks being too positive—possible leading to another credit-driven bubble.  
What's more, the market can create more high quality liquid assets by gaming the ratings system—as we saw during the last credit bubble. Banks will seek to put riskier assets into safer categories, putting pressure on the ratings agencies to do the same. The fact that the new rules rely on the judgment of rating agencies—who screwed up royally during the bubble—should be ringing alarm bells around the world, but hardly anyone seems to have noticed. 
This brings us to the fat-tail problem with the liquidity coverage ratio. 
Banks and bank regulators have now agreed on what constitutes a high-quality liquid asset. The entire financial sector will quickly become more exposed to these assets than it would have been otherwise. We will generate more of these assets globally than we would otherwise. If the banks and the regulators are right that these assets are stable enough and liquid enough, then the system should be safer. 
But there is good reason to think that the banks and regulators are wrong. 
For one thing, as Nassim Taleb is constantly warning, the world is less predictable than their models assume, and unexpected changes have significant impacts. How can regulators possibly model the effects on asset quality of increased demand for their favored assets? Can they predict the deterioration of ratings quality? Have they modeled the fact that regulatory-driving pricing creates misinformation about risk?  
Which brings us to the overarching problem of financial monoculture. The entire financial system is rendered riskier when all of the largest institutions are cajoled by regulators into adopting a similar view of asset risk—which is exactly what led to our recent financial crisis. 
The cost of error is greatly increased. Instead of disparate failures, we invite system-wide failure from errors in risk assessment. (Arguably, the expansion of assets included in the liquidity ratio and the lowering of the outflow forecast somewhat reduce the monoculture problem. But only somewhat.) More worrisome still, there is no sign that the Basel folks or the bankers understand the monoculture problem at all.
The FDR Framework addresses the financial monoculture problem.

By combining the philosophy of disclosure with the principal of caveat emptor (buyer beware), the FDR Framework places the burden on each market participant to bear both the gains and losses from their exposures.  As a result, market participants limit their exposures to what they can afford to lose given the risk.

This builds resilience into the system.

Can complex regulations that require banks to hold similar assets undue the benefits of the FDR Framework?


The reason is the market participants who are exposed to the banks, including the banks themselves, will limit each bank's exposure and the industry's exposure to these assets.  The way they will limit exposure to these assets is by increasing each bank's cost of funds to reflect its increasing risk from having higher exposure to these assets.
Neither the bankers nor the regulators understand how our last financial crisis was engineered.
Indeed, they seem incapable of anticipating even the highly predictable risks of worldwide financial homogenization outlined above. Which makes it very hard to take seriously their claims that the new rules the regulation peddlers have pulled from their sack will do very much to create a more resilient financial system.
Right.  They fail to understand that the last financial crisis showed that complex rules and regulatory oversight is not a substitute for transparency and market discipline.  Complex rules and regulatory oversight creates instability.  Transparency and market discipline creates a resilient financial system. 

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