by Don Alexander, MBA
Associate, RSD Solutions Inc.
(Mr. Alexander is also a lecturer at NYU and SunySB)
It is been four years since Lehman went under. There have been important initiatives on the regulatory front to minimize taxpayer bailouts to the financial sector (aimed at the banking sector). The payouts (i.e., taxpayer bailouts) in various forms were provided by governments to a variety of financial institutions and markets that were outside the regulatory perimeter—the ―shadow‖ banking system, although, a few recent regulatory proposals attempt to reduce these ― imputed puts.
These issues are examined in a recent IMF working party called “Puts” in the Shadows by Manmohan Singh (Sept. 2012). This study provides examples from non-banking activities within a bank, money market funds, Triparty repo, OTC derivatives market, collateral with central banks, and issuance of floating rate notes etc., that these risks remain. The results suggest that a regulatory environment where puts are not ambiguous will likely lower the cost of bail-outs after a crisis.
There are a plethora of views on reducing systemic risks at banks, including reverting to the Glass Steagall Act that separates commercial banking (i.e., depository type of business) with the non-depository business. Intermediate solutions like the Vickers and Volcker Rule that insulate (or provide buffers) to the depository part of the banks, or push out riskier activities outside the BHC (Bank Holding Companies) have gained momentum in various key jurisdictions. However, proposed regulation (via Basel III, Dodd Frank Act etc.), is unlikely to remove all the puts within the BHC, as it is one legal entity. The recent FSB (Financial Stability Board) list of SIFIs (Systemically Important Financial Institutions) acknowledges that the overall BHC is systemic.
The nonbank/bank nexus is an important part of financial system. However, nonbanks are separate legal entities outside a bank and thus the puts do not legally pass from the bank to the nonbank (and they shouldn‘t). There is sound economics behind the existence of nonbanks and these entities should not be driven only by regulatory arbitrage due to the puts. On non-bank resolution, no country has a comprehensive regime for addressing non-bank SIFIs, mostly because until recently nonbanks were rarely considered systemic. Thus, resolution of non-banks has become an increasing priority aside from the push for ―living wills. Regulators are starting to address this and the U.K.‘s Treasury and EC intend to publish consultation papers on this issue.
A less ambiguous regulatory environment will lower moral hazard; this will likely reduce cost to taxpayer if/when bailing out the shadow banking system. However, by intent, or political/policy choice, or by limited foresight, if ―puts are not removed ex-ante a crisis, there will always be room for bailouts. An example of an intended (but implicit) put is the creation of CCPs (Central Counter Party)―despite earnest efforts to reduce the size of SIFIs, the creation of new SIFIs (i.e. CCPs) is not clear. Another example is the political/policy choice not to explicitly remove the put from the MMFs industry in the U.S―it continues to offer par NAV (net asset value) with no capital supporting the business. Similarly, an example of limited foresight is bailing out money-like collateral at subsidized haircuts―recall Fed‘s PDCF (Primary Dealer Credit Facility), and the ECB‘s LTROs (Longer-Term Refinancing Operations) and the respective Eurozone national bank‘s ELA (Emergency Liquidity Assistance) efforts.
There will always remain some (unintended) puts ex-post a crisis. However, the puts that can be removed ex-ante should be addressed; otherwise "shadow banking" will continue to be a pejorative term and the issue of systemic risk is not fully addressed in reform proposals.
For more on this follow the link: www.imf.org/external/pubs/ft/wp/2012/wp12229.pdf
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