The following is an excellent excerpt from the book “THE ONLY GAME IN TOWN: Central Banks, Instability, and Avoiding the Next Collapse” by Mohamed A. El-Erian from Part III: “From the What to the So What” from Chapter 15: “The Migration and Morphing of Financial Risks” on page 108 and I quote:
“Quantitative easing has been a bold and innovative experiment. Its outcomes were always uncertain, and some may have been unfortunate. But central banks have been right to do what they did.” –FINANCIAL TIMES
“Issue 7: With systemic risks migrating from banks to nonbanks, and morphing in the process, regulators are again challenged to get ahead of future problems.
Undoubtedly, the banking system in advanced economies is now safer–a lot safer. The de-risking has been led by the United States, where in 2009 the government moved forcefully in implementing a rigorous stress testing of banks. The United Kingdom followed soon after. After some false starts, it was the turn of the Eurozone when in October 2014, under the auspices of a more powerful and empowered ECB, banks were finally subjected to a credible stress test of their balance sheets (or “AQRs,” for asset quality reviews) under a range of stressful scenarios.
Forced not just by regulatory actions but also by market pressures, banks have built considerable capital cushions to offset the impact of possible and future mistakes and adverse exogenous shocks; these cushions will be further enhanced in the years ahead as additional capital requirements (“surcharges”) kick in for what are now known as the “GSIBs,” or the “global systemically important banks”–including those banks that are still viewed as too big to manage and/or too big to fail.
At the same time, considerable efforts have been devoted to cleaning up balance sheets, be it through the disposal of shady assets or better pricing and risk assessments. There have even been efforts to better align internal incentives and try to reduce classic principal/agent problems that result in excessive short-termism and irresponsible risk taking. And all this has been supplemented by a revised legislative framework, including Dodd-Frank in the United States, the details of which are still under implementation (and some have already been diluted by bank lobbying).
The net outcome is–undoubtedly- greater banking system soundness. To the extent that there are efficiency losses, and there are, they are viewed as an acceptable cost for pulling banks away from a culture of excessive risk taking and pushing them toward greater safety, both for them individually and for the system as a whole.
Stronger regulation is being accompanied by more intrusive supervision of banks. Supervisors spend a lot more time on bank premises these days, and, especially after leaks out of the New York Fed regarding some pockets of pressure for lenient treatment, they are subject to much greater scrutiny to guard against regulatory capture. All this is being undertaken with full recognition that there is virtually no appetite in society, and certainly not in the political system, for another round of bank bailouts.
Whichever way you look at it, the banking system is on a multi-year journey toward a “utility model.” It will be consistently de-risked and scaled down. Indeed as Jamie Dimon, the intelligent and outspoken CEO of JPMorgan Chase, put it on his company’s earnings call in January 2015, the “banks are under assault” from multiple regulators.
Banks, already slimmed down, will see their list of “allowable” activities shrink further. Bankers’ compensation will remain under review, with constant pressures for a larger variable equity share in the total payout. Vesting periods, which determine when bankers actually get their hands of part of their equity compensation, will be emphasized. There will be attempts to expand the use of clawbacks under which bankers must return part of their compensation should results falter over time. And there will be the occasional calls for outright dollar caps on bankers’ pay.
The sector as a whole will be made less volatile and, yes, more “boring.” In the process, market valuations will evolve to reflect this new banking landscape, including the relative pricing of bonds and stocks. It is a world that involves lower returns on capital, reduced and relatively less volatile stock valuations, and higher bond credit-worthiness.
Yet this is not to say that systemic risks–that is, the threat of financial accidents contaminating the real economy and thus destroying jobs and livelihoods–will be eliminated or overwhelmingly reduced. After all, the risks are morphing as they migrate out of banks and to other sectors of the financial system.
Institutional vacuums that are perceived to be profitable tend to be filled quickly in financial markets. As such, both existing and new nonbank institutions are looking to exploit the business gaps left behind by retreating banks. Thus the institutional evolution of some hedge funds and private equity firms, as well as specialized, large asset managers and new entrants.
Greg Ip, formerly of The Economist and now with The Wall Street Journal, has a good metaphor to describe what is happening. He notes that “squeezing risk out of the economy can be like pressing down on a water bed: The risk often re-emerges elsewhere. So it goes with efforts to make the financial system safer since the financial crisis.”
This development is accentuating a growing imbalance between the shrinking intermediaries in the marketplace (the broker-dealers) and the growing number of end users (asset managers of both the traditional and nontraditional ilk, as well as sovereign wealth funds, pension managers, insurance companies, etc.). It is a durable structural change that, in addition to the liquidity implications discussed in the next chapter, will make market volatility more common, together with prolonged price overshoots, price contagion, and then sudden and sharp reversals.
There are already quite a few reasons that contribute to the repeated emergence of asset bubbles. The impact of information failures and market imperfections is accentuated by behavioral patterns that result in recurrent errors as well as principal-agent misalignments. Asset managers’ approach to business risk has also been shown to be a “strong motivator for institutional herding and rational bubble riding.” The Minsky financial instability hypothesis is also relevant here, reminding us that long periods of stability tend to encourage behaviors that then fuel instability.
All these shifts have been turbocharged by the low interest rate environment. As Jaime Caruana, the general manager of the BIS, put it in a December 2014 speech in Abu Dhabi when commenting on the migration of risks to the nonbank sector: “It is likely, though not undisputed, that the search for yield in a low interest rate environment can contribute to the build-up of financial imbalances. This so-called risk-taking channel of monetary policy could be particularly relevant when economic agents anticipate that the low rate environment will persist or that monetary policy will be eased in the case of market turmoil–a kind of central banker’s put, if you will.”
Together, these factors add an important element of pro-cyclicality to financial market behaviors, one that will likely fuel overshoots in both directions. They point to the need to seriously expand the emphasis on financial stability outside the strict confines of the banking system, which requires more than the current macro-prudential approaches.
Of course, this is not the first time that close observers of financial developments have worried about the morphing of risk and its migration from one sector to another. I, for one, experienced a similar concern back in 2007.
Having observed how new structured products were used, I noted at that time that complex derivative products were acting as a “credit risk transfer technology” that was enabling in a big way the migration of risk “to a new set of investors inexperienced in this arena and posing exposure problems for the international financial system.”
This time around, the assessment of risk and return is accentuated by an intriguing new type of entrant into financial markets. Similar to what has happened in the accommodation space with Airbnb, the transport sector with Uber, fashion with Rent the Runway, and retail with Amazon–just to name a few–the financial service industry is seeing interest from disruptors from “another world.” These nontraditional players disrupt traditional industries through the smart application of technological innovations and insights from behavioral science. In the financial world, as a New York Times article put it, “they are focused on transforming the economics of underwriting and the experience of consumer borrowing–and hope to make more loans available at lower cost for millions of Americans.
Together with the expansion of P2P (peer-to-peer) interactions and crowdfunding, these approaches offer the possibility of improving the provision of financial services (especially to badly served segments of the population), lowering barriers to entry, reducing old-style overheads, and broadening sources and uses of loanable funds. But it is also an area where regulation is lagging and modes of operation are yet to be properly tested in a general economic downturn; it is also an approach whose collective rigor has yet to be subjected to a full market cycle.
Recognizing the ongoing shifts, regulators and supervisors are now playing catch-up, and they are looking to step up their efforts lest they end up fighting the last war. In the process, they will need to pay particularly attention to the extent to which liquidity risk has been terribly underpriced, and thus to the more limited ability of the financial system to reposition should key elements of the underlying market paradigm change. Indeed, in my opinion this is such a big issue that it deserves to be looked at on a stand-alone basis (see next chapter).
In adjusting to these new realities, regulators are slowly discovering that they cannot simply apply to nonbanks the approaches developed with great care for banks. The institutional structures are different, and so are important components of risks, behaviors, culture, and balance sheet management. As such, there is a lot that regulators still need to do at the national, regional, and international levels.
As Jaime Caruana notes, “There is relatively little knowledge as to what policy measures could be taken to address the build-up of financial excesses that originate from outside the banking system. A relevant consideration here is the way in which credit intermediation is moving away from the banking sector to the debt securities market.” I would add that it is moving well beyond even that.”
(THE FOLLOWING IS PRAISE FOR THIS BOOK BY ANNE-MARIE SLAUGHTER AND I QUOTE:
“The Only Game in Town may well be the only book you need to read on how the global financial system works, the serious trouble we may be in, and what to do about it. El-Erian’s gift for clarity and his use of compelling examples make important economic issues accessible.” –ANNE-MARIE SLAUGHTER, president and CEO, New America
MY COMMENTS: THE ISSUE OF THE BIG, UNREGULATED, INVESTMENT BANKS HAVE BEEN TALKED ABOUT IN MANY BOOKS LIKE THIS ONE, AS WELL AS BY SENATOR BERNIE SANDERS, WHO ALMOST BEAT HILLARY CLINTON FOR THE DEMOCRATIC PRESIDENTIAL NOMINATION ON THIS ONE ISSUE. THE ISSUE OF THE UNREGULATED HEDGE FUND DEALERS WAS TALKED ABOUT IN THE 2008 DEMOCRATIC PRESIDENTIAL PRIMARY BETWEEN BARACK OBAMA AND HILLARY CLINTON. BOTH SAID THEY WOULD TAX THEM AND THIS WOULD HELP THE HEDGE FUND DEALERS AND THE GROWING, TOXIC DERIVATIVES MARKET. THAT’S WHY THIS BOOK AND OTHERS HAS MADE A GREAT CONTRIBUTION TO HELP SOLVE THIS VERY IMPORTANT PROBLEM WITH WALL STREET, THE BIG INVESTMENT BANKS, HEDGE FUNDS AND THE GROWING, UNREGULATED, TOXIC DERIVATIVES THAT WILL AFFECT THIS COUNTRY, AS WELL AS THE WHOLE WORLD AND PARTICULARLY ENGLAND SINCE THEY GOT OUT OF THE EUROPEAN UNION. THE BIG, UNREGULATED, INVESTMENT BANKS ARE RUNNING THEIR INDUSTRY LIKE A BUNCH OF CORRUPT PAYDAY LENDERS.
LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran
isely 