The trigger for the next financial crisis

We know that financial crisis are recurring. The last one was in 2008, almost 8 years ago, so it is not difficult to forecast that a new one is in the making.

The trouble for investors is that it is almost impossible to forecast when a new crisis will arrive. It may be next month, next year or in five years. Who knows?

Another annoying feature of financial crisis is that it is equally difficult to foresee which drop will spill the glass, that is, what will be blamed as its trigger.

Paul Krugman just listed two possible candidates – China and oil – in his NYT op-ed “The 8 A. M. Call”.

So, let me add another candidate – IRRBB Interest rate risk in the banking book – caused by the excessive reliance of banks on the derivatives market.

This choice may sound odd, given that the Basle Committee has been working hard on new standards for this risk which will be implemented in 2018, aimed at preventing IRRBB to materialize when interest rates normalise from historically low levels. Indeed, the notional value OTC derivatives which at end-2014 was 6.5 times larger than all outstanding debt securities has been reduced by 70 trillion USD in the first half of 2015.

It really does not matter if the crisis is triggered in these markets, or any other place like the M&A or the currency markets. The “fire” can be started anywhere, as long as the “wood” is close enough to spread it by contagion.

What matters is to know whether the “firemen” are capable of containing it.

In this regard the perspectives are frightening, given the resistance to apply the so-called Volcker rule to ring-fence commercial banking from investment banking, the exhaustion of ammunition by central banks to deal with a liquidity trap and the balance of public finances in some major economies.

Is the Volcker rule enough to revamp the financial regulatory system?

Well-regulated financial markets are an essential part of market capitalism. Contrary to what people often think, efficient regulation means light regulation and not tight regulation. If proof were needed, we can look at the failure of Fannie Mae and Freddie Mac, despite being regulated by a dedicated team of more than 100 regulators which saw nothing coming. This clearly shows that heavy and complex regulation only adds bureaucracy - not efficiency. So, simple rules as the Volcker rule aimed at separating proprietary trading from commercial banking are most welcome.

However, as Volcker himself recognizes the rule is just one piece of a broader set of legal rules needed. So how far do we need to go? The answer to this question depends on how many of these problems we wish to tackle: 1) the moral hazard associated with the too big to fail issue, 2) the risks associated with the growth of the shadow banking system (made up of investment banks, private equity and hedge funds), and 3) the rise of casino-like financial markets. We have not included the bankers’ rock star-like compensation packages. This problem is part of a broader issue on compensation practices in corporate America that is undermining American capitalism and needs a separate treatment.

If we only want to tackle the first problem, then the Volcker rule together with similarly simple-minded competition and anti-trust rules aimed at breaking mammoth conglomerates such as Citigroup will be enough. For instance, such rules should limit deposit taking institutions from owning some types of businesses (in particular those belonging to the shadow banking system). Tighter limits on the use of leverage (well above the current BIS ratio) and restrictions on securitization should also be imposed so that banks return to their basic role in credit screening.

In relation to the shadow banking system, a first step could be the separation of investment banking from asset management so that investment banks can go back to their traditional business of underwriting and advisory work. That is, we should go beyond the old Glass-Steagall Act and separate commercial banking, investment banking and asset management. As a rule, it also seems to us that the potential for systemic risks originating in primary brokerage activities, private equity or hedge funds is better done through limits on leverage than through an increased level of disclosure about their portfolios.

Finally, the casino-like markets can be regulated in the same spirit we use to regulate conventional gambling casinos. We need rules to make sure that people do not bet money they cannot afford to lose. For instance, company treasurers willing to bet on exotic derivatives and structured products could be required to demonstrate that they have enough solvability and liquidity rather than knowledge about such complex products.

Overall, we only need a few basic rules to enforce an effective regulatory system.