Backdraft in the banking system

Basle III and other bank regulations are intended to help prevent a future financial crisis. But with credit risks on the rise and obscured by derivatives, a crisis is becoming more likely, not less.

Yesterday I wrote about the European Central Bank’s most recent Financial Stability Report, in particular their analysis of why the gold price has been rising so much and how this might result in one or more financial instutitions incurring large losses. But the report is far more extensive and also takes a look at, among other things, credit risks in the banking system.

In subsection 3.2 titled, “Asset quality deterioration has remained contained, but credit risk and provisioning needs are likely to increase,” they make the following intriguing observation:

[A] benign asset quality picture overall masks diverging trends at the country level, as banks located in some euro area countries where NPL ratios used to be low saw an increase in their NPL stocks in 2024 (Chart 3.5, panel c). By contrast, countries which had experienced a significant increase in NPL ratios during the sovereign debt crisis saw further declines in NPL stocks in 2024, driven by the continued disposal of long-dated NPLs.

NPLs are non-performing loans. As banks are primarily in the business of taking deposits are making loans, and earning a margin between the two, deterioration in NPL ratios is a potential problem in certain member countries.

However, the report also observes that, across countries, there has been a general deterioration in CRE loans, that is, commercial real estate, and SME loans, or small and medium-sized businesses.

Given the weakness of the euro-area economy is recent years, perhaps that shouldn’t be much of a surprise. Then there is also the structural factor that the CRE market has never properly recovered from the “work and shop from home” legacy of the Covid years.

The report then points out that all of this is taking place prior to the potentially negative shocks to world trade of rising tariffs and how the above credit trends could well worsen as a result. As it happens, BBB corporate credit spreads have already risen somewhat over the past year.

Now, I have no robust way of estimating just how bad things could get and whether a euro or global banking crisis of some sort might ensue. But what I do know is that the credit risks in the banking system today have become far harder to measure and model due to the extensive growth of credit derivatives since the global financial crisis of 2008-9.

The new Basle III capital and liquidity regulations are meant to address the evolving credit risk dynamics of the modern international banking system. But even a skilled firefighter is in danger from that which he cannot see: backdraft, a fire hiding in and moving between the walls, unseen, only to emerge suddenly, possibly where you least expect it. Credit risk can move around in much the same way.

Derivatives: financial weapons of mass destruction

Back in 2002, Warren Buffet famously proclaimed that derivatives were “financial weapons of mass destruction” (FWMDs). Time has proven this view to be correct. It is difficult to imagine that the US housing and general global credit bubble of 2004-07 could have formed without the widespread use of collateralized debt obligations (CDOs) and various other products of early 21st century financial engineering.

But to paraphrase those who oppose gun control, “FWMDs don’t cause crises, people do.” But then who, exactly, does? And why? And can so-called “liquidity regulation” prevent the next crisis? To answer these questions, let’s take a look at modern central bank liquidity regulation as a response to the growing use of “collateral transformation”: the latest, greatest FWMD in the arsenal.

Behind the curve, as usual

Back in 2006, as the debate was raging whether or not the US had a mortgage credit and housing bubble, I had an ongoing, related exchange with the Chief US Economist of a large US investment bank. It had to do with what is now commonly referred to as the “shadow banking system”.

While the debate was somewhat arcane in its specifics, it boiled down to whether the additional financial market liquidity created through the use of securities repo and other forms of collateralized lending were destabilizing the financial system.

The Chief US Economist had argued that, because US monetary aggregates were not growing at a historically elevated rate, the Fed was not adding liquidity fuel to the house price inflation fire and that monetary policy was, therefore, appropriate. (Indeed, he denied that the rapid house price inflation at the time was cause for serious concern in the first place.) I countered by arguing that these other forms of liquidity (eg securities repo) should be included and that, if they were, then in fact the growth of broad liquidity was dangerously high and almost certainly was contributing to the credit+housing bubble.

We never resolved the debate. My parting shot was something along the lines of, “If the financial markets treat something as a money substitute—that is, if the incremental credit spread for the collateral providing the marginal liquidity approaches zero—then we should treat it as a form of de facto money.”

He dismissed this argument although I’m not sure he really understood it; at least not until there was a run on money-market funds in the wake of the Lehman Brothers bankruptcy in November 2008. It was at that point that economic officials at the Fed and elsewhere finally came to realise how the shadow banking system had grown so large that it was impossible to contain the incipient run on money-market funds and, by extension, the financial system generally without providing explicit government guarantees, which the authorities subsequently did.

This particular Chief US Economist had previously worked at the Fed. This was and remains true, in fact, of a majority of senior US bank economists. Indeed, in addition to a PhD from one of the premiere US economics departments, a tour of duty at the Fed, as it were, has traditionally been the most important qualification for this role.

Trained as most of them are in the same economics departments and at the same institution, the Fed, it should perhaps be no surprise that neither the Fed, nor senior economists at the bulge-bracket banks, nor the US economic academic and policy mainstream generally predicted the global financial crisis. As the discussion above illuminates, this is because they failed to recognize the importance of the shadow banking system. But how could they? As neo-Keynesian economists, they didn’t—and still don’t—have a coherent theory of money and credit.[1]

From blissful ignorance to paranoia

Time marches on and with lessons learned harshly comes a fresh resolve to somehow get ahead of whatever might cause the next financial crisis. For all the complacent talk about how the “recovery is on track” and “there has been much economic deleveraging” and “the banks are again well-capitalised,” the truth behind the scenes is that central bankers and other economic officials the world over remain, in a word, terrified. Of what, you ask? Of the shadow banking system that, I believe, they still fail to properly understand.

Two examples are provided by a 2013 speech given by former Fed Governor Jeremy Stein and a report produced by the Bank of International Settlements (BIS), the “central bank of central banks” that plays an important role in determining and harmonizing bank regulatory practices internationally.

The BIS report, “Asset encumbrance, financial reform and the demand for collateral assets,” was prepared by a “Working Group established by the Committee on the Global Financial System,” which happens to be chaired by none other than NYFed President William Dudley, former Chief US Economist for Goldman Sachs. (No, he is not the Chief US Economist referred to earlier in this report, although as explained above these guys are largely substitutes for one another in any case.)[2]

In the preface, Mr Dudley presents the report’s key findings, in particular “evidence of increased reliance by banks on collateralized funding markets,” and that we should expect “[t]emporary supply-demand imbalances,” which is central banker code for liquidity crises requiring action by central banks.

He also makes specific reference to “collateral transformation”: when banks swap collateral with one another. This practice, he notes, “will mitigate collateral scarcity.” But it will also “likely come at the cost of increased interconnectedness, procyclicality and financial system opacity as well as higher operational, funding and rollover risks.”

Why should this be so? Well, if interbank lending is increasingly collateralized by banks’ highest quality assets, then unsecured creditors, including depositors, are being de facto subordinated in the capital structure and are highly likely to ‘run’ at the first signs of trouble. And if banks are holding similar types of collateral that suddenly fall in value, then they can all become subject to a run at the same time, for the same reason.

Collateral transformation is thus a potentially powerful FWMD. But don’t worry, central banks, the BIS and other regulators are on the case and doing the worrying. As a belated response to the financial crisis that they all failed to foresee, the latest, greatest trend in financial system oversight is “liquidity regulation”. Former Fed Governor Jeremy Stein explained the need for it thus:

[A]s the financial crisis made painfully clear, the business of liquidity provision inevitably exposes financial intermediaries to various forms of run risk. That is, in response to adverse events, their fragile funding structures, together with the binding liquidity commitments they have made, can result in rapid outflows that, absent central bank intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether. And fire sales and bank failures--and the accompanying contractions in credit availability--can have spillover effects to other financial institutions and to the economy as a whole. Thus, while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because, although they bear all the costs of this buffer stocking, they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure. It is this externality that creates a role for policy.[3]

A ubiquitous, iniquitous enigma

Ah yes, wouldn’t you know it, that ubiquitous, iniquitous enigma: market failure. Regulators have never found a market that doesn’t fail in some way, hence the crucial need for regulators to prevent the next failure or, at a minimum, to sort out the subsequent mess.

In the present instance, so the thinking behind liquidity regulation goes, prior to 2008 the regulators were overly focused on capital adequacy rather than liquidity and, therefore, missed the vastly expanded role played by securitized collateral in the international shadow banking system. In other words, the regulators now realise, as I was arguing back in the mid-2000s, that the vast growth in shadow banking liquidity placed the stability of the financial system at risk in the event that there was a drop in securitized collateral values.

In 2007, house prices began to decline, taking collateral values with them and sucking much of the additional, collateral-based liquidity right back out of the financial system, unleashing a de facto wave of monetary+credit deflation, resulting in the subsequent financial crisis. But none of this was caused by “market failure”, as Governor Stein contends. Rather, there is another, simpler explanation for why banks were insufficiently provisioned against the risk of declining collateral values, yet it is not one that the regulators much like to hear, namely, that their own policies were at fault.

Notwithstanding the prominent pattern in recent decades of market-distorting interest-rate manipulation, guarantees, subsidies and occasional bailouts, fostering the growth of reckless lending and other forms of moral hazard, the regulators continue their self-serving search for the “silver bullet” to defend against the next “market failure” which, if diagnosed correctly as I do so above is, in fact, regulatory failure.

Were there no moral hazard of guarantees, explicit or implicit, in the system all these years, the shadow banking system could never have grown into the regulatory nightmare it has now become and liquidity regulation would be a non-issue. Poorly capitalized banks would have failed from time to time but, absent the massive systemic linkages that such guarantees have enabled—encouraged even—these failures would have been contained within a more dispersed and better capitalized system.

As it stands, however, the regulators’ modus operandi remains unchanged. They continue to deal with the unintended consequences of “misregulation” with ever more misregulation, thereby ensuring that yet more unintended consequences lurk in the future.

Might collateral transformation be the crux of the next crisis?

In his speech quoted above, former Fed Governor Stein also briefly mentions collateral transformation, when poor quality collateral is asset-swapped for high quality collateral. Naturally this is not done 1:1 but rather the low quality collateral must be valued commensurately higher.

In certain respects these transactions are similar to traditional asset swaps that trade fixed for floating coupons and allow financial and non-financial businesses alike to manage interest rate and credit risk with greater flexibility. But in the case of collateral transformation, what is being swapped is the credit principal and the credit rating it represents, and one purpose of these swaps is to meet financial regulatory requirements for capital and, under Basle III rules, also liquidity.

An obvious consequence of such collateral transformation is that it increases rather than decreases the linkages in the financial system and thus in effect replaces firm-specific, idiosyncratic risk with systemic risk, exactly the opposite of what the regulators claim they are trying to do by increasing bank regulatory capital ratios. Liquidity regulation is an attempt to address this accelerating trend and the growing systemic risks it implies.

Those financial institutions engaging in the practice probably don’t see things this way. From the perspective of any one institution swapping collateral in order to meet changing regulatory requirements, they see it as necessary and prudent risk management. But within a closed system, if most actors are behaving in the same way, then the net risk is not, in fact, reduced. The perception that it is, however, can be dangerous and can also contribute to banks unwittingly underprovisioning liquidity and undercapitalising against risk.

Viewed system-wide, therefore, collateral transformation really just represents a form of financial alchemy. It does not make the overall system more robust to credit risks, including that posed by rising NPL ratios. It might even detract from such value by rending opaque risks that would otherwise be more immediately apparent. So I do understand the regulators’ concerns with the practice. I don’t, however, subscribe to their proposed self-serving remedies for what they perceive as just another form of market failure.

Plagiarized copies of an old playbook

Already plagued by the “Too Big to Fail” (TBTF) problem back in 2008, the regulators have now succeeded in creating a new, even more dangerous situation I characterize as MAFID, or “Mutual Assured FInancial Destruction.” Because all banks are swapping and therefore holding essentially the same collateral, there is now zero diversification or dispersion of financial system risk.

It is as if there is one massive global bank with thousands of branches around the world, with one capital base, one liquidity ratio and one risk-management department. If any one branch of this bank fails, the resulting margin call will cascade via collateral transformation through the other branches and into the holding company at the center, taking down the entire global financial system.

Am I exaggerating here? Well, if central bankers and other regulators at the Fed, the ECB, at the BIS and around the world are to be believed, we shouldn’t really worry because, while capital regulation didn’t prevent 2008, liquidity regulation will prevent the scenario described above. All that needs to happen is for the regulators to get Basle III implemented and set the liquidity requirements at the right level and, voila, financial crises will be a thing of the past: Never mind that setting interest rates and setting capital requirements in the past didn’t work out so well. Introducing liquidity requirements is the silver bullet that will do the trick.

Sarcasm aside, it should be clear that all that is happening here is that the regulators are expanding their role yet again, thereby further shrinking the role that the markets can play in allocating savings, capital and liquidity from where they are relatively inefficiently utilized to where they are relatively more so.

This concept of free market allocation of capital is a key characteristic of a theoretical economic system known as “capitalism”. But capitalism cannot function properly where capital flows are severely distorted by regulators and where capital is diverted from productive to unproductive economic sectors through bailouts. Resources will be chronically misallocated, resulting in a low or possibly even negative potential rate of economic growth.

The regulators don’t see it that way of course. Everywhere they look they see market failure. And because they take this market failure as a given, rather than seeking to understand properly how past regulatory actions have severely distorted perceptions of risk and encouraged moral hazard, they are naturally drawn to regulatory “solutions” that are really just plagiarized copies of an old playbook. What was Einstein’s definition of insanity again, about doing the same thing over and over but expecting different results?

Resources

[1] Neo-Keynesians will deny this, claiming that their models take money and credit into account. But they do so only to a very limited extent, with financial crises relegated to mere aberrations in the data. The Austrian economic school of Menger, Mises, Hayek, etc, by contrast, has a comprehensive and consistent theory of money and credit that can explain and even predict financial crises.

[2] The entire paper can be found at the link here.

[3] This entire speech can be found at the link here.