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Does Bank Regulation Really Just Push Risk to the Shadows?
Much ado about nonbanks
Under every system of banking, … there will always be a class of persons who examine more carefully than busy bankers can the nature of different securities; and who, by attending only to one class, come to be particularly well acquainted with that class. And as these specially qualified dealers can for the most part lend much more than their own capital, they will always be ready to borrow largely from bankers and others, and to deposit the securities which they know to be good as a pledge for the loan.
- Walter Bagehot, Lombard Street, 1873
Much like the physical goods supply chain, the financial supply chain economizes on scarce resources — in this case: scarce equity capital. Contrary to how it’s often characterized, the financial system does not exist simply to match up equity supply with equity demand; an app could do that today. It’s also about manufacturing balance sheet.
Leverage is not a byproduct of the financial system; it’s its primary output, satisfying the most basic financial needs (think: deposit liabilities). But, you need some amount of capital to keep the whole system running. And capital can’t be manufactured the way leverage can; it represents risk tolerances and specialized knowledge—and is thus in scarce supply.
Also much like physical supply chains, a blowup in part of the financial supply chain can disrupt the whole system. As global central banks have rapidly tightened monetary conditions, however, we’ve seen continued financial stability; the core of the financial supply chain—the banking system—has demonstrated continued balance sheet resiliency. Yet, we’ve also seen an absolute parade of market instability episodes.
Here’s Laura Noonan in the FT last week summarizing the highest profile recent examples of blowups that have emanated from the shadows:
The first seeds for regulators’ NBFI [nonbank financial institutions] awakening were sown in March 2020 when hedge funds were sucked into a dash for cash by Covid-panicked markets. Two years later, the London Metal Exchange had to temporarily close its nickel market because a squeeze threatened its clearing house. Before 2022 was out, European governments rescued energy companies caught out by soaring energy prices, and the BoE had to intervene to arrest a collapse in UK government bond markets that was triggered by poorly appreciated risks in obscure investment strategies run by pension funds whose operations straddled the UK, Ireland and Luxembourg.
South Korea, China, Cryptopia, etc. are also facing material instability emanating from outside the banking system.
Noonan goes on:
The crises collectively shone a light on the risks that largely migrated, whack-a-mole style, elsewhere in the financial system after watchdogs tightened regulations on banks following Lehman Brothers’ collapse in 2008.
Here, she hits on a growing concern: Have stronger bank regulations simply pushed the very same risks into the shadows? This an increasingly common refrain. This also leads to a terrible false choice for regulators about how to prevent financial crises. Either:
1) Chase down the risks indefinitely wherever they may go. This leaves bank regulators perpetually behind and with an ever-expanding mandate. Here’s last month’s annual NBFI report from the Financial Stability Board:
The NBFI sector grew by 8.9% in 2021, higher than its five-year average growth of 6.6%, reaching $239.3 trillion. […] The total NBFI sector increased its relative share of total global financial assets from 48.6% to 49.2% in 2021.
Good luck chasing a 100% increase in assets under your supervision… and hoping the risk doesn’t move (or blow up) before you get there.
2) Let the banks run roughshod and bring all the risks back into the supervisory “light.” Regulate banks’ risk management processes, etc. — but otherwise let them bear whatever risks they want. This was effectively the pre-crisis status quo; i.e., it didn't work great.1
Risks as they are in the shadows now, there’s still a net financial stability gain to be had by the banks being the resilient ones. That is, pushing risks out of the regulated banking system and failing to catch up to wherever they run is still a net positive if the aim is to avoid a financial crisis.
Strong Bank Balance Sheets Mean the Price Just Has to Be Right
Bank capital these days is regulation-constrained, not market-constrained. In the absence of Dodd-Frank, none of the large banks would run as capital-heavy as they do now; the market would allow them to run more debt-heavy, and they would.
Practically, that means they have room to lever up, via two routes. One, regulators can offer capital relief. We saw this with the supplementary leverage ratio during covid, for instance.
Two, the banks can use their capital “buffers.” This has proved challenging to encourage, likely due to stigma issues and because dipping into these buffers comes with regulatory restrictions for the banks (buyback restrictions, etc.) despite the bank still being considered adequately capitalized. However, this buffer usage still would happen if either the draws on the bank’s balance sheet were automatic (aka, pre-committed credit lines) or if the bank arranges new credit simply because the price is right (aka, markets are blown up enough).
Why it’s more important that it’s banks that are resilient in this scenario than anyone else along the finance supply chain is that banks can do this funding without going to the market. Whereas, even the bankiest of nonbanks would have to do something like issue a repo, a bank need not; it can manufacture the deposit via keystroke. Indeed, banks performed this market support function to the extent possible in the early stages of the GFC, but ultimately faced their own balance sheet issues — a fate that could in theory be avoided thanks to the higher capital levels.
“Nonbanks” Are Not the Investment Banks of Yestercrisis
Too, we no longer have massive investment banks functioning as serious bank competitors—and thus functioning while starved for sufficient pre-placed access to that backup banking liquidity.
Take instead, for instance, a subprime mortgage lender in the pre-GFC world. It might fund itself in the repo market (in addition to warehouse credit), but would also have standing credit access from its banker(s). (In a particularly salient example, recall Countrywide facing the threat of BNY not unwinding its repo book and being told by the Fed to kick rocks given its access to bank credit—and thus drawing down its $11.5 billion line.)
This wasn’t materially the case for the likes of Bear Stearns and Lehman Brothers. And by the time the price would’ve looked good enough for the big banks to offer a new facility to one of the standalone investment banks, their own balance sheets were too strained. (Lehman was almost allocated across the whole Street before ultimately just going down, and JPM picked up Bear only when the Fed shouldered a slug of the risk.) Today’s capital requirements mean it would take an even bigger discount before banks were willing take to this risk on balance sheet. But it also means the banks will be more able to take on the risk at some reasonable price.
i.e., their more-regulated-but-stronger balance sheets means it’s more likely the deal will at least still be sensitive to price, instead of just being an ignored phone call while other balance sheet fires get put out.
Strong Banks Can Function As Reserve Banks
It’s also worth noting that banks have the cleanest access to central bank balance sheet of any market participants. This edge in access is perhaps the smallest it’s ever been given how central banks have expanded their emergency pipes, but even much of that uses banks as operational intermediaries. AND, banks’ access typically requires less emergency declaration by policymakers. That is, keeping resilient banks may allow liquidity to get to the right place after a market blowup without needing to call it an emergency—which could face legal hurdles or other drawbacks in the market. (Central bank programs are also another entry point for policymakers to implement regulatory relief.)
All Told: We Call Them Nonbanks for a Reason
As long as the balance sheets of banks are healthy, they will be elastic to available returns. It’s when those balance sheets are likewise broken that the system can break irrespective of available returns—despite banks’ advantage of not needing to go to market to provide liquidity.
For instance, supplementary leverage ratio be damned, I’m confident banks would take on every one of their clients’ Treasuries if yields hit, say, 10% (once the necessary capital reallocation happened internally). However, the reservation price needed for banks to do this intervention need not be above where policymakers’ would put the reservation price from a public interest perspective. Hence why we’re talking about sovereign interventions in a world of strong banks.
See this excellent FRBNY autopsy: Systemic Risk and Bank Supervision (draft released by the FCIC)