‘A specter is haunting the financial markets – the specter of systemic risk’ (with apologies to Karl Marx)
It wasn’t long after the immediate, frenzied response to the financial crisis that governments and regulators began to turn their minds to the fault lines that had been exposed in the financial system as a whole and to ways in which these could and should be addressed. The phrase which has come to be used to describe these fault lines is ‘systemic risk’.
Systemic risk has been defined as “the threat that a material event (whether an unexpected crisis, the failure of proper risk management, or the result of public policies) would result in the failure of either financial markets or a significant number of financial firms and cause significant harm to the [U.S.] economy because of the interconnections between such markets and firms” (The Financial Services Round Table, Systemic Risk Implementation: Recommendations to the Financial Stability Oversight Council and the Office of Financial Research, September 10, 2010) or, more simply, “the risks that cumulate across institutions, markets and even countries to levels that could have serious effects on the real economy “(Paul Jenkins and Gordon Thiessen, Reducing the Potential for Future Financial Crises: A Framework for Macro-Prudential Policy in Canada, May 2012).
To date, financial sector reforms have primarily focused on the micro-prudential level (Jenkins & Thiessen), in other words, on specific, large systemically important institutions and the incentives they faced. As indicated by Daniel K. Tarullo, Governor of the Board of Governors of the Federal Reserve System in his prepared statement before the Committee on Banking, Housing and Urban Affairs of the U.S. Senate on June 6, 2012, “This effort reflects the prominence of both the Dodd Frank Act and international regulatory initiatives which were motivated largely by the failure or near failure of a number of major financial firms and the significant public policy problems created by the market perception that such firms are ‘too big to fail’.” Thus numerous measures, which perhaps can best be described as restraints, dampeners or governors on activities that could lead to the formation of asset or credit bubbles, are now winding their way towards implementation: higher capital ratios, enhanced liquidity standards, more intensive supervision, limits on trading activity, pre-designated resolution and recovery plans, enhanced disclosure requirements, measures intended to readjust incentives, predatory lending regulations, etc.
In April 2009, the G-20 leaders recommended that regulatory frameworks be reinforced with a macro–prudential overlay that promotes a system-wide approach to financial regulation and oversight, mitigates the build-up of systemic risk and thus reduces the occurrence of financial crises in the future. Behind this recommendation was the belief that a focus on structural problems caused by systemically important institutions may not be sufficient to address “inherent problems with any system of credit extension through fractional reserve banking, or inherent problems with liquid financial markets … [or] macroeconomic volatility induced by volatile credit support, first supplied too easily and at too low a price, then severely restricted”. (Adair Turner, Economics, Conventional Wisdom and Public Policy, Institute for Economic Thinking, Inaugural Conference, April 2010). In Turner’s view, the roots of credit volatility lie at a more fundamental level:
“The essence of the problem appears to lie in the specific character of credit demand and credit supply. Hyman Minsky – in his distinction of hedge finance, speculative finance and Ponzi finance – highlights that in the exuberant phase credit demand is significantly driven not by entrepreneurs seeking to finance new investment which they hope will generate profits enough to service the debt, nor by householders seeking to smooth consumption across their life cycle in a sustainable fashion, but by companies or households using credit in the anticipation of short to medium-term capital gain, in particular in real estate markets. And that demand is in turn met by banks, institutions which have evolved in a specific institutional form – with liquid resources very small relative to their short-term liabilities and with capital reserves very small relative to total assets. That combination – Minsky and others have argued – creates the potential for self-reinforcing cycles, which are not just one potential cause but the essential cause of macro volatility, both in the upswing and in the downswing: and which could arise as much in a system of multiple small banks as in one of large Too Big to Fail banks.”
His conclusion is that the policy response to systemic risk needs to be more radical than what we have so far seen: “discretionary through-the-cycle policy tools of a countercyclical nature to offset the risks of self-reinforcing credit and asset price cycles.” There must be:
“new economic thinking to ensure that in our response to the financial crisis we are adequately radical in addressing the fundamental drivers of instability, not just the symptoms … new tools to take away the punch-bowl before the party gets out of hand, and even perhaps to take it away from the already drunk but not from the still sober. All of which would take us far away from the dominant conventional wisdom of the last several decades, where optimal results are achieved provided financial regulators identify and correct specific market failures, while central banks use one instrument alone to pursue one unchanging inflation objective. But inevitably so given the large and inherent procyclicalities against which we need to lean”.
Such policy tools have come to be described as ‘macro-prudential’. The provenance of this concept has been described by Claudio Borio in his July 22, 2010 report to the Bank for International Settlements, entitled “Implementing a Macro-prudential Framework: Blending Boldness and Realism”:
“Paraphrasing Milton Friedman, “We are all macro-prudentialists now”. With breathtaking speed, in the wake of the crisis the concept has risen from virtual obscurity to currency in the policymaking world. The notion had been around for some time. It had been evolving quietly in the background from its first appearance in the late 1970s at BIS meetings. It was known only within a small, albeit growing, circle of cognoscenti. Once the crisis broke out, the concept helped policymakers frame their efforts to strengthen regulatory and supervisory frameworks.“
According to Borio, macro-prudential is
“an orientation or perspective of regulatory and supervisory arrangements. It means calibrating them from a system-wide or systemic perspective; rather than from that of the safety and soundness of individual institutions or a stand-alone basis. It means following a top-down approach, working out the desirable safety standard for the system as a whole and, from there, deriving that of the individual institutions within it.”
The critical feature of this concept which I wish here to highlight is that, by its very nature, it must be universal, applying to the financial system as a whole as opposed to its individual components (see Progress Report of the FSB, IMF, and BIS to the G20 of October 27, 2011, Macro-prudential Prudential Policy Tools and Frameworks). This impetus towards universality has manifested itself by seeking to erase boundaries between financial sectors, jurisdictions and even regulators.
Thus, “because of its system-wide perspective, macro-prudential policy requires an ability to capture the build-up of systemic risk also in the shadow banking system – defined broadly as the system of credit intermediation that involves entities and activities outside the regulated banking system.” The shadow banking system embraces money market funds, hedge funds, securitization and securities lending and repos (See the report by the IOSCO Technical Committee Task Force on Unregulated Financial Markets and Products, March 2011).
In “Emerging from the Shadows: Market-Based Financing in Canada”, a report to the Bank of Canada published in its Financial System Review of June 2011, Chapman, Lavoie and Schembri describe market-based financing (MBF, their term for shadow banking) as follows:
“MBF refers to credit-intermediation activities similar to those performed by banks. Like bank intermediation, these activities involve maturity or liquidity transformation, possibly with some degree of leverage, but they are conducted primarily via markets rather than within financial institutions (although) in many instances a bank is involved at some point in the intermediation chain). The MBF sector is often referred to as the “parallel,” “shadow” or “unregulated” banking sector, because MBF intermediation activities are subject to a different regulatory framework and typically are not prudentially regulated and supervised to the same extent as the traditional intermediation activities performed by banks.”
According to the FSB, “the shadow banking system can also be used to avoid financial regulation and lead to build-up of leverage and risks to the system. For example, securitization was unduly used by banks during the pre-crisis period to take on more tasks and facilitate the build-up of leverage in the system, while avoiding the regulatory capital requirements” (Strengthening the Oversight and Regulation of Shadow Banking, Progress Report to G20 Ministers and Governors, April 16, 2012). Indeed, FSA chairman Adair Turner has laid the bulk of the blame for the financial crisis on the shadow banking system, calling it
“inherently dangerous….Any macro-level counter factual analysis of the impact of the whole package of innovations which contributed to shadow banking would, I think, clearly illustrate that if we had to choose between having the whole package and none of it, we would have been better off with none of it – no [structured investment vehicles], no [collateralized debt obligations], no credit derivatives … Even if it could be proven, which is still unclear, that in some way this package did deliver the market completion and allocative efficiency benefits ascribed to it ahead of the crisis, there seems no possibility that the scale of that benefit – measured at the macro level as an increase in the obtainable level of income across the economy – could be more than a small fraction of the harm produced by the induced financial instability effect … it is difficult to think of any wave of innovations in any other sector of the economy about which we would be likely to reach such a negative judgment.” (As reported in mortgagestrategy by Gary Jackson on April 20, 2012.)
Several prudential regulators have noted that the tightening of regulations in respect of financial institutions may encourage the migration of activities to the shadow banking sector. According to Federal Reserve Governor Daniel Tarullo,
“A set of effective regulations in one area can produce arbitrage opportunities, which lead people to create new instruments or look for new channels to engage in similar kinds of activities that may produce similar kinds of risks. Indeed the possibility of such arbitrage [in the shadow banking system] has increased as the regulation of already regulated financial institutions has strengthened in the wake of the crisis” .
This has been reiterated by Mark Carney of the Financial Stability Board: “Particularly in boom periods, non-regulated institutions tend to take on an increasing share of intermediation and cross-border credit provision.” Such a state of affairs is obviously incompatible with a universal regulatory approach. “This is why enhanced supervision and regulation of shadow banking will be one of the top priorities for the Financial Stability Board in the coming months”.
Indeed, at the request of the G20 leaders, the FSB, in collaboration with standard setting bodies is developing regulatory recommendations (to be issued by the end of the year):
“(i) to mitigate the spill-over effect between the regular banking system and the shadow banking system; (ii) to reduce the susceptibility of money market funds to “runs”; (iii) to assess and mitigate systemic risks posed by other shadow tanking entities than money market funds; (iv) to assess and align the incentives associated with securitization to prevent a repeat of the creation of excessive leverage; and (v) to dampen risks and pro-cyclical incentives associated with securities lending and repos that may exacerbate funding strains at times of shocks to confidence” (Macro-prudential Policy Tools and Frameworks).
The danger of regulatory arbitrage is not restricted to financial sectors. In its Progress Report to the G20, the FSF, IMF and BIS made the following observation:
“Because of the close integration of global capital markets and the high risks of spillovers and regulatory arbitrage, it is important to consider the multilateral aspects of macro-prudential policymaking. Cooperation on macro-prudential policies requires (i) strong institutional mechanisms to promote a common understanding of threats to global financial stability and adequate policy actions; and (ii) steps to ensure that macro-prudential frameworks in individual countries are mutually consistent.”
This is echoed by Chapman et al:
“Thus, a coordinated global response is needed to establish clear principles for the monitoring, assessment and regulation of MBF that allows for differences in the MBF sector across countries and limits unintended consequences and opportunities for cross-country regulatory arbitrage.”
This fear of cross-jurisdictional regulatory arbitrage has been of primary concern for various international regulatory task forces (See, for example the Implementation Report of the IOSCO Technical Committee Task Force on Unregulated Financial Markets and Products, March 2011) and has been the primary motivating factor towards the convergence of several initiatives including for example, those related to enhanced disclosure, risk retention and OTC derivatives.
Finally, universality demands cross-regulatory co-ordination. Thus, as reported in the Globe and Mail on June 7, 2012 in an editorial piece by Jenkins and Thiessen:
“Other major countries have put in place formal macro-prudential arrangements. In the United States, a Financial Stability Oversight Council has been established. In the United Kingdom, the government has created a Financial Policy Committee in the Bank of England. And in Europe, they have set up the European Systemic Risk Board.”
In their view, in order to reduce the risk of future crises, Canada must also move in this direction:
“We believe that macro-prudential regulation is so important in reducing the risk of potential future crises that a formal legislated assignment of responsibility to a committee that would exist for this sole purpose is required … After examining a number of alternative governance arrangements for macro-prudential policy in Canada, our conclusion is that legislation should be enacted to assign formal responsibility for macro-prudential policy to a committee made up of the Governor of the Bank of Canada, the deputy minister of Finance Canada, the superintendent of Financial Institutions and, in the absence of a national securities commission, someone nominated by the federal government to deal with potential systemic risk in securities markets.”
The role of securities regulators in any such committee has been the subject of several reports and articles. In February 2011, the Technical Committee of IOSCO published a discussion paper entitled “Mitigating Systemic Risk; A Role for Securities Regulators”, in which they adopt the following principle: “The Regulator should have or contribute to a process to monitor, mitigate and manage systemic risk, appropriate to its mandate”.
“the role of securities and market conduct regulators in monitoring and addressing systemic risk in capital markets should also be recognized. Such regulators, through their traditional focus on transparency and disclosure, are well placed to work towards an appropriate flow of information to market participants, investors, and other regulators, and can also play a role via their direct authority over a wide cross-section of market participants (especially in terms of business conduct), financial market infrastructures, and trading venues via their market surveillance function.”
Indeed, according to Jenkins and Thiessen,
“the absence of attention to system-wide risks in securities markets (and their interconnections to other parts of the financial system) would represent a serious shortcoming in any framework for macro-prudential policy in Canada.”
Anita Avery of the Faculty of Law of the University of Toronto, in her February 23, 2010 paper entitled “Is Systemic Risk Relevant to Securities Regulation?”, recognized that currently Canadian securities regulators’ mandates do not expressly extend to the reduction of systemic risk, notwithstanding that the contrary argument could be made on the basis that systemic risk may undermine market confidence. In any case, she feels that, in “adopting a broad view of systemic risk, we would be short-sighted to maintain strict lines between our understanding of prudential regulation and securities regulations”. The reason for this is that (although she doesn’t use the term) the largely private shadow banking segment of the market has demonstrated a propensity to give rise to systemic risk and is outside the purview of provincial regulators. In essence this is an argument based on the universality principle noted above: if we are going to be serious about tackling systemic risk, our policies need to embrace the entire financial system and securities regulators are best placed to deal with certain aspects of it.
In a recent blog posting occasioned by the Supreme Court of Canada decision which found the federal government’s proposal for a national securities regulator to be unconstitutional, Anand noted that the Court specifically observed that the provinces would be incapable of enacting legislation to effectively address systemic risk and expressly stated “the need to prevent and respond to systematic risk may support federal legislation pertaining to the national problem raised by this phenomenon”. Taking her cue from that suggestion she wrote:
“With its more ambitious scheme deemed unconstitutional, the federal government should now move to enact a federal regime in areas that are clearly within federal jurisdiction. Taking the lead from the Supreme Court, the federal government should create a Financial Markets Regulatory Agency (FMRA) and mandate such a national regulator specifically with the oversight of systemic risks in securities markets, investing it with powers to intervene where particular products or activities threaten financial stability.”
Thus, in regulatory circles, the drive towards implementing macro-prudential policies to deal with systemic risk is well under way: and not only at the theoretical level, as revealed by the Technical Committee of IOSCO in their February 2011 paper which discusses in some detail the sources of systemic risk in the securities market place, approaches to identification of systemic risk and the development of systemic risk indicators. (It is particularly interesting to note that the working group which authored this report was co-chaired by the Autorité des marches financiers of Quebec and the Ontario Securities Commission.) In their summary of the issues for securities regulators, they “recognize that the pre-crisis practices that emphasized market discipline and transparency remain essential but need to be strengthened and complimented by stability focus on the challenges presented by systemic risk”.
“This focus will require changes in the approach to securities regulation and will require enhanced access to information for regulators (e.g. through trade repositories) and better surveillance systems that are able to cope with the greater integration of markets and technological developments. It will also require a significant increase in supervisory resources and enhancements in securities regulators’ capabilities for risk analysis. The resulting increase in costs for market participants and regulators will need to be balanced with the benefits of more intensive oversight. Lastly, it will also require regulators together with the responsible body (in some jurisdictions, the central bank or the systemic risk oversight body) to mitigate any emerging systemic risk before they can crystallize and threaten the financial system, as well as to reduce the impacts of any risks which, for whatever reason, happen to materialize”.
Thus, the “new direction implies not only monitoring the emergence of potential risks in the system, but also ensuring that financial markets are working efficiently and contributing positively to the real economy”. The issues that arise from this are many and complex. A key area of concern is the lack of data:
“closing all the gaps will take time and resources, and will require coordination at the international level and across disciplines, as well as strong high-level support. The legal framework for data collection might need to be strengthened in some economies. … there needs to be an internationally coordinated effort for data collection and sharing in order to better assess risks emanating from various regions of the world …”
How this information is to be assessed is also an issue which is acknowledged:
“There will be considerable trial and error in coming to an assessment, on an aggregate basis, of the extent of systemic risk prevailing in the financial system. This assessment of systemic risk is a new task for most securities regulators and those that have the capacity to undertake the tasks should share their expertise and outcomes with others”.
“Additionally, the lack of technical resources for systemic risk analysis is an obstacle in effectively monitoring and mitigating systemic risk and is encountered by securities regulators worldwide. Securities regulators have traditionally focused on market conduct and could lack some of the skilled professionals such as economists and statisticians as well as financial analysts with market experience that are needed to develop systemic risk analysis frameworks. Similarly, many regulators will need to build the IT infrastructure needed to store and analyse large volumes of data. These are important factors that influence the ability not only to develop new methods to measure systemic risk, but also to better use the existing data, information and expertise needed to monitor and mitigate systemic risk”.
It should be recalled here that the proposed IOSCO principle embraced not only the monitoring but also the mitigation and management of systemic risk:
“Under an expanded mandate, securities regulators may for example need to issue early warnings that alert financial market stakeholders to the build-up of systemic risk in certain types of securities transactions or hedge fund activities. Such assessments may require that securities regulators seek disclosure from market participants and private issuers. … securities regulators may need to prohibit certain types of securities transactions or permit them only with certain conditions.” (Anand)
“Transparency is crucial but is not always in and of itself sufficient to limit the development of risks. For example, transparency alone will not ensure that incentives are appropriately aligned. From the regulators’ perspective, access to information is not enough. Regulators must also use that information and act, as necessary … In some cases, regulators should be able, together with the systemic risk bodies in their respective jurisdictions, to restrict certain activities which might threaten the overall stability of the financial system” (IOSCO Technical Committee)
This has already been addressed in certain jurisdictions. The European Securities Markets Authority “may temporarily prohibit or restrict certain financial activities that threaten the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system in the Union (…) or if so required in the case of an emergency situation (…)”. In the United States, the Financial Stability Oversight Council’s response to “grave threats” includes the power to restrict the ability of companies to offer a financial product or products or to conduct one or more activities.
In Britain, Martin Wheatley of the Financial Services Authority, suggested product regulation would be a core focus of the new regulator. Regulation under the FCA will be about “following the money” to understand what lies behind firms’ profitability, he said. The FCA will look at whether firms have product development and approval processes that can “weed out harmful or inappropriately-marketed products”. Wheately said the approach will be to spot products where the risks are likely to outweigh the benefits the products will bring. He said the FCA would build on the work the FSA has already done on product regulation, adding that intervention could mean a product ban, but that “there are other things we can do behind the scenes with firms”. (IFAonline, May 4, 2012).
The financial crisis of 2007-2008 was a rather extreme example of the volatility to which modern financial markets are prone, occasioned by the confluence of multiple factors including a protracted low interest rate environment and the deliberate erosion of the regulatory safety net premised upon an axiomatic belief in the efficiency of free, unregulated markets and the benefits of increased liquidity and the increased financial speculation required to deliver it. These beliefs proved to be chimercial and could be and have been rather cynically viewed as simply justification for economic rent seeking and extraction on an industrial scale.
So now, as always, the pendulum has swung back and opposing forces (which were always present albeit temporarily cowed by the apparent ability of the other side to deliver the economic goods) have re-emerged with a vengeance sensing, in the words of Claudio Bario, that “the window of opportunity to put in place a fully-fledged macro-prudential framework should not be missed”. I had entitled an earlier piece “Regulatory High Tide” which now seems to have been somewhat premature. As reported by Reuters on April 29, 2012, according to Mark Carney,
“I would say we’re a little more than half way along this process of financial reform and this is really the tough bit because this is where, you know, momentum could flag.”
In various reports delivered a couple of weeks ago by the Financial Stability Bond to the G20 leaders on progress in the implementation of financial regulatory reforms and next steps, the FSB summarizes the reforms which are currently underway. The foregoing discussion is meant to give some notion of the main features of what a “fully-fledged macro-prudential framework” might look like, including:
- an unprecedented level of disclosure from virtually all market participants in order to provide a comprehensive picture of market risks. This would concentrate, and be especially onerous, on the largely private shadow market, the first indication of which we saw in the proposed securitized product regulations requiring disclosure in respect of private placements to even sophisticated investors, in contradiction of established principles distinguishing between public and private transactions;
- a tremendous growth of bureaucratic resources necessary to gather, collate and analyze such disclosure and identify systemic risks which may be present; and
- a significant degree of discretion necessarily granted to macro-prudential agencies in order to effectively address these risks, possibly (probably?) transforming them into gatekeepers of the financial system performing functions similar to those previously allocated to credit rating agencies.
That deregulation in the last years of the prior century and the first years of this century was a contributing factor to the financial crisis is undeniable. That increased regulation may hamper growth is also undoubtedly true as one of its primary purposes is, on one hand, to slow the growth of potential bubbles and, on the other hand, to provide some weight, in the words of Adair Turner, to “lean against the inherent procyclicalities” characteristic thereof. Nevertheless, we should resist calls to abandon or dramatically scale back the regulations currently under discussion (see, for example, the article in the National Post of June 21, 2012 by Steve H. Hanke who argues that to scale back the regulations would “alleviate financial repression, allowing the banking system to increase the privately produced portion of the broad money supply”). Rather, we should give the proposed regulations time to work and revisit them in a few years to see what adjustments need to be made in order to get the balance right. It is, or at least should be, a matter of trial and error. I do not believe that such an incrementalist approach exhibits a lack of vision but rather a fundamental belief that public policy should be constrained by an acknowledgement and acceptance of the limitations on our ability to predict or shape the future as well as an acceptance of the observation that financial markets are by their nature volatile and must always be so if they are to properly function as expressions and conduits of creative economic energy. This, it seems to me, is squarely within the tradition of the common law and is nothing about which to be embarrassed. That is not to say that certain macro-prudential policies that are designed to “dampen the magnitude and duration of excessive swings in key asset markets” would not be useful. As argued by Frydman and Goldberg in “Beyond Mechanical Markets”, “as long as interventionalist measures are aimed at dampening excess in market fluctuations, rather than at pricking the bubble early, the state can help markets function better without presuming that it knows more than they do.”
Whether or not the proponents of a “fully-fledged macro-prudential framework” intend it, their approach contains within it the possibility of a degree of intervention in market decisions which could drift intentionally or unintentionally into credit allocation policies and the substitution of the judgment of regulators for that of market participants; in other words, towards some degree of central planning. This possibility alone is enough to condemn it. Or as expressed by Adair Turner, “if new economic thinking rejects the idea that the market will naturally deliver perfect equilibrium, it should equally be wary of believing that public policy can achieve it”.