Dec 26, 2013

Next Trojan horse

1. Cash pools in money markets

Specifically, in the markets of repurchase agreements (repos), reverse repos, securities lending and borrowing, and securities margin lending.

As described in the article on the "equally safe" phenomenon (VLTCM, 2013), cash pools will again play a central role in the next financial crisis, as their withdrawal turns troubled and illiquid institutions into insolvent ones virtually overnight. Cash pools possess the most vivid Trojan horse characteristic, as they evaporate without any prior indication, unexpectedly to everyone.

2. Maturity transformation

Maturity transformation is a process of borrowing in short-term markets to finance long-term assets, such as structured products or corporate bonds. In this process, a firm holds assets on its balance sheet that mature later than when its liabilities are due. For example, a 3-day repurchase agreement - the firm’s liability - matures much earlier than a 3-year corporate bond - the firm’s acquired asset. To finance long-term assets, financial firms have to continuously roll-over short-term liabilities, that is, continuously borrow in short-term markets. The greater the degree of the maturity mismatch, the greater the risk of a liquidity shortfall and an immediate default.

Excessive maturity transformation, fueled by the tendency of cash pools to dry up in a very short-time period, will again turn up as a deadly Trojan horse that ruins big financial institutions and leaves the financial sector without liquidity.

3. Systemically important financial institutions (SIFIs)

It might appear as if the too-big-to-fail issue has been successfully addressed by recent regulatory reforms, including the formation of higher capital levels for systemically important institutions, the imposition of more rigorous stress tests, the creation of the orderly liquidation authority, which makes shareholders, not taxpayers, liable for corporate losses, and the introduction of no taxpayer bailouts that induces firms to be more prudent in risk-taking.

However, nobody truly knows whether these measures are enough to contain a failure of a systemically important institution. Just like Lehman Brothers, that was overly exposed to the subprime real estate sector, a systemically important entity might be knocked down by a shock to an asset class in which it is excessively invested. After all, stress tests do not tell an institution where to invest.

Given that SIFIs have become larger than they were prior to the 2008 financial crisis, a failure of one such firm poses sizeable threats to the financial system, especially considering the speed with which a modern financial contagion spreads.

4. Complexity

To better understand the complexity of a modern financial system, it is quite appropriate to first look at the complexity present on the eve of the stock market crash in October, 1929. In those days, the banking system was already highly developed and complicated. To give just one example, upon its failure in 1930, the Bank of the United States owned 59 separate affiliate companies (U.S. Senate, 1931) that underwrote new securities, invested in the stock market for speculative purposes, took over doubtful assets from the parent bank, and engaged in convoluted financial arrangements, such as owning other affiliates, that in turn acquired yet further affiliates, thus moving deeper and deeper into the unregulated waters.

The current financial system is considerably more complicated than the financial arrangements of the 1920s. For instance, prior to the 2008 financial crisis, very few market participants even knew of the existence of the now-extinct structured investment vehicles - financial vehicles that were at the epicenter of securitization. Add to that the fact that financial regulation is always retrospective in nature - policy makers only react to what has already happened and almost never create laws that are anticipatory, and it becomes evident that the next Trojan horse will come in the form of complexity growing in less-regulated parts of the system.


Sources

U.S. Senate, Committee on Banking and Currency (1931). Operation of the National and Federal Reserve Systems: Hearings on S.R. 71, Appendix, Part VII (p.1068). Hearings before a Subcommittee of the Committee on Banking and Currency, 71 Congress, 3rd session. Washington, DC: Government Printing Office.

VLTCM (2013). The "equally safe" phenomenon.

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