Attempts at preventing ‘another Lehman’ will have limited upside for taxpayers
John Dizard
Rules aimed at preventing ‘another Lehman’ threaten to freeze up capital flows and create an unintended systemic disaster © John Stillwell/PA Wire
Only a few days into the decade and finance people are being forced to confront another year of regulatory deadlines that will be impossible to achieve, in particular those imposed by Brexit, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions.
How about finding a way of not doing this to ourselves?
On Brexit, we can only hope that each side is exhausted enough to abandon fantasies of a wealthy pirate ship or the bureaucratic destruction of London. Europeans need each other too much to indulge in revenge and domination.
The Basel regulation mess should be easier to deal with than Brexit, as there seems to be less cultural and geopolitical noise intruding. But the post-financial crisis regulation has created a swamp of self-serving professionals masked as honest brokers, “fintech start-ups” and in-house profit centres. They do not want a solution for financial instability. They want career success for themselves. These are not the same thing.
There is a point in bureaucratic negotiations, as in war, where participants should realise that their maximalist demands and victory fantasies are pointless and destructive. For the Basel process, that would be now.
For the first years after the financial crisis, the global regulatory process was able to make real progress on reducing risk in banking and securities dealing. The rulemaking concentrated on major banks and dealers, as well as key pieces of financial market infrastructure. This made sense: those are the institutions that the public would be forced to bail out to save its own interest come the next crisis.
Also, the big banks, along with infrastructure bits such as the clearing houses, have the compliance bureaucracy and quasi-monopoly status that comes with their licensing. Top management of big banks can be reasonably expected to spend much of its time going to Basel, or mini-Basel, meetings on how banks should be regulated.
But as the Basel regulatory process reached into asset management and operating companies, it has become self-defeating. By trying to turn every participant in the capital markets into a bank, Basel risks freezing up capital flows and creating an unintended systemic disaster.
I am thinking in particular of the uncleared margin rules (UMR) for derivatives transactions that are set to be imposed by next year on several thousand capital markets participants, most of them non-bank asset managers. The idea, easy to sell to the world’s politicians, is that we can avoid “another Lehman” by requiring a large number of investors to put up high quality liquid assets against their exposure to financial derivatives.
Sounds good. Until you look at the details. Lehman was one of about a dozen key New York dealers, a bad apple at the centre of the dollar system. The Lehmans of the world are already covered by the Basel requirements intended to avoid another systemic disaster in derivatives markets.
According to the International Swaps and Derivatives Association (ISDA), the major institutions covered by the first phases of the UMR had already posted $170bn in two-way regulatory margin by the end of 2018. That margin comes in the form of high quality liquid assets that are segregated and unavailable for other purposes.
But the planned extension of the UMR will cover not just top banks with taxpayer guarantees and a lot of staff, but many of their customers. BNY Mellon, the custodial bank, estimates the remaining phases of the Basel margin requirements will cover at least 640 institutions with more than 9,000 interconnecting relationships in the market. Based on my discussions with asset managers, there could be thousands of asset managers and companies that will be shocked to find out how many government bonds they have to put up as sterilised capital if they are to comply with the rules.
Regulators already know this, as the UMR were originally intended to be in place by this September. Last July they were postponed until September of 2021. But that does not offer much relief, as counterparty banks and dealers will insist that a compliance process must be in place at least a year in advance.
The Basel compliance process favours banks and large dealers over asset managers and investors. For example, the mathematical model that ISDA endorses to calculate initial margin runs to 29 pages of equations. One of the effects of the “simplified” model, by the way, is to make it easier for banks to reduce the initial margin requirements that might otherwise burden their illiquid assets.
In other words, the Basel regulatory process has been partly captured by those it was intended to regulate. Asset managers and capital markets, which have taken away some of the banks’ capital allocation function, will now be burdened by higher technology and staff costs, and prospectively required to buy trillions of dollars in government debt.
This is not going to happen. Stop postponing initial margin rules — rethink the process in a realistic manner for non-banks.
The benefits are going to consultants, lawyers and therapists, not the tax paying public.
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