Monday, January 27, 2014

The Ascent of Money – “Behind each great historical phenomenon there lies a financial secret.”

In 2008, Niall Ferguson, has written a great about the history of finance. In “The Ascent of Money” the author explains the evolution of financial instruments and traces the history of important bubbles in financial history. Niall wants us to better understand the complexities of today's modern financial institutions and terminology by digging into the origins of finance.

The book is fantastic; reading “The Ascent of Money” should be mandatory for everyone working in the industry.

In the second part of his book, Niall Ferguson discusses stock markets, risk management, insurance, and real estate markets.

Stock Markets

“It is the company that enables thousands of individuals to pool their resources for risky, long-term projects that require the investment of vast sums of capital before profits can be realized.”

After the invention of banks and bonds, the next major step in financial history was the joint stock and limited liability corporation. New features were the following:
  • The capital of the company was jointly owned by multiple investors.
  • The corporation is a legal person separate from its investors.
  • Investors' liability is limited to their initial investment.

The first stock market was created in the early 17th century in Netherlands. It was more created by accident than by systematic planning: The United Dutch Chartered East India Company which operated the Dutch trade with the east was originally meant to the liquidated to grant investors a return. As such liquidation turned out impossible, trading its shares was the only alternative left for shareholders to cash in on their investment. To that extend, a stock market was required.

When you talk about stock markets, you must inevitably talk about bubbles and their burst. Niall first outlines the main stages of stock market bubbles:
  • Change in economic circumstances creates new and profitable opportunities for certain companies.
  • Rising expected profits lead to rapid growth in share prices of those companies.
  • First time investors and swindlers are attracted.
  • Insiders discern that expected profits cannot possibly justify the now exorbitant price of the shares and begin to take profits by selling.
  • As share prices fall, the outsiders all stampede for the exits, causing the bubble to burst altogether.

One great example of financial crisis that Niall Ferguson describes in his book is linked to the career of John Law.

Born in 1671 in Edinburgh, Law went to London in 1692 and lost a lot of money in business ventures and gambling escapades. In 1694, he killed his neighbor in a duel and was sentenced to death. He fled to Amsterdam which was, at that time, the world capital of financial innovation. In the early 18th century, he developed the idea that central banks should issue interest bearing notes instead of hard currency. After Scotland and Italy rejected his idea in 1705 and 1715 respectively, he brought it to France. Plagued by fiscal problems, France accepted Law's proposal and nominated Law in May 1716 to govern the private Banque Générale. In December 1718, the Banque Générale became Banque Royale, the first French central bank. France's transition from coinage to paper money had begun.

“Confidence alone was the basis for public credit; with confidence, banknotes would serve just as well as coins.”

In the following years, Law expanded money supply in France heavily and, thereby, created inflation and a huge asset bubble. Share prices increased more and more, justified only by expectations of future profit.

“The whole nation would become a body of traders, who have for cash the royal bank, in which by consequence all commerce, money, and merchandise re-unite.”

“It was as if one man [John Law] was simultaneously running all five hundred of the top US corporations, the US Treasury and the Federal Reserve System.”

When Law tried, on 21 May 1720, to pass a deflationary decree reducing official share prices and the number and value of banknotes to ½, people's confidence in the financial system was gone. The Government revoked the monetary policy measures and dismissed and incarcerated Law on 29 May 1720. Later on, he fled the country.

“Law's bubble and bust fatally set back France's financial development, putting Frenchmen off paper money and stock markets for generations.”

Other famous financial crisis that Niall describes in his book are
  • the great depression in the U.S. in 1929,
  • the fall of the DJIA by 23 % on 19 October 1987 (“Black Monday”), and
  • the Enron fraud leading to the company's bankruptcy on 2 December 2001.

He emphasizes the role central banks play in financial crisis, writing that “a crucial role, however, is nearly always played by central bankers, who are supposed to be the cowboys in control of the herd.”

A final note on stock market movements: Niall explains book that they actually don't follow a normal distribution: “If it were a normal distribution, an annual drop of the DJIA of 10 % or more would only occur once every 500 years which is not the case. In reality, there are many more “fat tail” events.”

Risk management and insurance

How do we deal with the risks and uncertainties of the future? Insurance by the individual? Voluntary charity? Count on the state through compulsory contributions?

“The history of risk management is one long struggle between our vain desire to be financially secure and the hard reality that there really is no such thing as the 'future'.”

Once we realize that the future is uncertain, we still don't know exactly today how we should deal with risk.

The earliest forms of insurance simply meant to set resources aside to guarantee tribe members a decent interment.

“Saving in advance of probable future adversity remains the fundamental principle of insurance, whether it is against death, the effects of old age, sickness or accident. The trick is knowing how much to save and what to do with these savings.”

In the 1350s, true insurance contracts occurred, with premiums ranging from 15 to 20 % of the sum insured, falling below 10 % by the fifteenth century. At that time, insurers were not specialists but rather merchants who also engaged in trade on their own account.

In the late 17th century, an insurance market developed in London, namely in the life and maritime insurance sector. It was at that time that the six major insurance basics were introduced:

  • The French mathematician Blaise Pascal proposed the concept of probability in 1660.
  • John Graunt estimated life expectancy on statistical grounds.
  • In 1705, Jacob Bernully in 1705 suggested the concept of certainty, i.e. the idea that the occurrence (or non-occurrence) of an event in the future will follow the same pattern as was observed in the past.
  • Abraham de Moivre introduced normal distribution by showing that outcomes of any kind of iterated process could be distributed around the mean or standard deviation.
  • Daniel Bernoulli wrote, in 1738, about utility, stating that the value of an item should not be based on its price but on the utility that it yields.
  • Thomas Bayes did research about inference: The probability of any event is the ratio between the value at which an expectation depending on the happening of the event ought to be computed, and the chance of the thing expected upon its happening.

In 1744, the Church of Scotland set up the first life insurance fund. It was the first insurance vehicle based on correct actuarial and financial principles, rather than mercantile gambling. It was also the first insurance fund that collected premiums to indemnify the insured through profitable investment of the premiums rather than the premiums themselves. To pay widows and orphans, the fund made accurate projections of how many beneficiaries there would be in the future and how much money could be generated to report them.

Today, insurance companies and pension funds are among the biggest institutional investors in the global financial markets. Their huge size is inherent in an insurance's business model:

“Size matters in insurance because the more people who pay into a fund the easier it becomes, by the law of averages, to predict what will have to be paid out each year. The individual date of death is difficult to determine but the average life expectation is possible to calculate.”

“Insurance, in other words, is where the risks and uncertainties of daily life meet the risks and uncertainties of finance.”

In his book, Niall Ferguson also discusses the two major alternatives to the insurance model, i.e. the welfare state (which was first introduced in Germany in 1880 by Otto von Bismarck) and hedging (which had its origins in agriculture in the late 19th century and, today, takes the form of traded and OTC derivatives).

“A man who has a pension for his old age is much easier to deal with than a man without that prospect.”

“When Hurricane Katrina struck New Orleans, it laid bare some realities about the American system that many people had been doing their best to ignore. Yes, America had a welfare state. No, it didn't work.”

Real estate

“The real estate market is unique. Every adult, no matter how economically literate, has a view on its future prospects.”

To point out the importance that real estate enjoys today as an asset class, Niall Ferguson tells to the story of the Monopoly game. Invented in 1903 by Elizabeth Phillips in the U.S., its original purpose was to show the iniquity of a social system in which a small minority of landlords profited from the rents they collected from tenants. Today, the game is not only in itself a huge commercial success worldwide; in addition, its message has turned upside down: Even the youngest player learns very fast that the more real estate you own, the more rents you earn and the more chances you have to win the game.

Looking at the history of real estate booms and bust, from the first modern property crash in the United Kingdom, involving the Duke of Buckingham's Stowe house in 1848 to the recent sub-prime mortgage crisis in the U.S. in 2007/08, we know today that this is actually not true.

Particularly interesting in the book is Niall's description of how U.S. real estate policy to some extent triggered the sub-prime mortgage crisis. The major steps were the following:
  • In 1913, interest payments on mortgages become tax deductible.
  • New deal reform by the Franklin D. Roosevelt administration between 1933 and 1938 with a strong focus on the development of housing and the idea of a property owner democracy
  • Creation of the Federal Home Loan Bank Board and the Home Owner's Loan Corporation in 1932
  • To reassure depositors and facilitate the use of deposits for mortgage lending, Roosevelt introduced the federal deposit insurance in 1933, which accelerated mortgage lending significantly: “The idea was that putting money in mortgages would be even safer than houses, because if borrowers defaulted, the government would simply compensate the savers.”
  • In the mid 20th century, the Federal Housing Administration (FHA) standardizes long-term mortgages and creates a national system of official inspection and valuation.
  • 1938 sees the birth of the Federal National Mortgage Association (nicknamed Fannie Mae). The organization is authorized to issue bonds and use the proceeds to buy mortgages.
  • In 1968, Fannie Mae is divided into two separate entities: The Government National Mortgage Association (Ginnie Mae) has the mission to lend to poor real estate borrowers such as military veterans. A rechartered Fannie Mae becomes a privately owned government sponsored enterprise (GSE), able to buy conventional as well as government-guaranteed mortgages.
  • In 1970, the Federal Home Loan Mortgage Corporation (Fannie Mac) is set up to stimulate competition in the secondary mortgage market. The overall idea was to stimulate the mortgage market, bring down interest rates, and fight against racial discrimination in mortgage lending.
  • Since 1983, mortgages are regularly converted into bonds through securitization. Until 2007, the mortgage-backed securities market grew from 20 million USD to 4 trillion USD.

“Significantly, a disproportionate number of sub-prime borrowers belonged to ethnic minorities. Indeed, I found myself wondering as I drove around Detroit if sub-prime was in fact a new financial euphemism for black.”

“As a business model sub-prime lending worked beautifully – as long as interest rates stayed low, as long as people kept their jobs, and as long as real estate prices continued to rise.”

“At the time, the sellers of these 'structured products' boasted that securitization was having the effect of allocating risk 'to those best able to bear it'. Only later did it turn out that risk was being allocated to those least able to understand it.”

On the merits, what are the pros and cons of investing in real estate?
  • Pro: Real estate serves as valuable collateral for lending purposes. It is far less volatile than stocks.
  • Contra: Real estate needs regular investment to be maintained. It is less liquid than stocks.

“But the real home bias is the tendency to invest nearly all our wealth in our own homes. The key to financial security should be a properly diversified portfolio of assets.”

Towards the end of his book, Niall describes some additional events and tendencies in international finance such as
  • Hyperinflation in France and Germany in 1923
  • Set-up of the Bretton Woods treaty, providing for fixed exchange rates between 1944 and 1971
  • Rise and fall of the hedge fund Long-Term Capital Management (LTCM) between 1994 and 1998.
  • Recent Chinese / American self-enforcing import-export relationship (The author refers to “Chimerica”).

At the end of his journey through financial history, Niall Ferguson reaches an interesting conclusion:

“Yet money's ascent has not been, and can never be, a smooth one. On the contrary, financial history is a roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes.”

I would like to add: There is no reason that this would change in the future, let's prepare for the next crisis!


Niall Ferguson – The Ascent of Money

Monday, January 20, 2014

The leverage ratio under Basel III – Why all kids like spinach!

Imagine you have a sore throat. You ask your doctor to have a look. He prescribes you a standard medicine and sends you back home. A week later, it’s not only your throat that hurts. You also suffer from earache and fever. How is that possible? You simply haven’t told your doctor that you were in bad physical shape and felt ill since a long time. If he had examined your whole body, he would had perhaps have detected your additional health problems and prescribed additional medicine...

The leverage ratio does exactly that: It doesn’t stop at measuring risk-based capital ratios but checks a bank’s balance sheet entirely.

For the Basel Committee, a major problem of the 2008 / 2009 financial crisis was the “build-up of excessive on- and off-balance sheet leverage while apparently maintaining strong risk-based capital ratios”. This is why the leverage ratio is now introduced as a complementary capital requirement. It is meant to be simple, transparent, and non-risk based.

The Basel III leverage is not intuitive. As you can easily grasp from the above, leverage is something bad that we should avoid if we want to benefit from a safe financial system. Why is it then that the Basel Committee prescribes a minimum leverage ratio of 3 %? The answer lies in the definition of the ratio:

Leverage ratio = Capital measure / Exposure measure

This definition is comparable to defining spinach as pasta and then saying that all kids like spinach!

The capital measure has not changed in BIS' recent publication. It corresponds to Tier 1 capital which is the sum of

  • the bank’s shares (including additional paid-in capital),
  • retained earnings, and
  • additional capital which is subordinated to general creditors and depositors, unsecured, perpetual or only exceptionally redeemable, and whose remuneration is at the bank’s discretion.

A simplistic leverage ratio would create a perverse disincentive for banks to hold risk-free or very low risk assets such as cash or government securities.”
Timothy Adams – Institute of International Finance – 11 October 2013

New is only the definition of the exposure measure. It now captures

  • on-balance sheet exposures,
  • derivative exposures,
  • securities financing transaction (SFT) exposures, and
  • off-balance sheet (OBS) items.

In general, the exposure value corresponds to the pure accounting value.

On-balance sheet exposures

On-balance sheet exposures are all balance sheet assets, including on-balance sheet collateral and collateral for SFT. Except for derivatives, they are measured net of specific provisions and accounting valuation adjustments. However, a netting of loans and deposits is not allowed and assets shall not be diminished by collateral or other forms of guarantees provided to the bank.

Unfortunately, as good as simplicity is as a goal, we need both leverage and risk-weighting as compensating factors.”
Rodgin Cohen – Sullivan Cromwell – 12 October 2013

Derivative exposures

Derivatives exposures comprise the replacement cost (RC) for current exposure plus an add-on for potential future exposure (PFE). Banks should calculate RC by marking the derivative contract to market; RC cannot be negative. PFE is the product of the notional principal of the derivative and an add-on factor. The latter depends on the underlying of the derivative and its maturity.

Generally speaking, collateral that the bank provides or receives shall not affect the institution’s exposure under the derivative. Only if collateral has been received in the form of cash, it might reduce a bank’s derivatives exposure, subject to five cumulative conditions:

  • The trade is cleared through a qualifying central counter-party.
  • The parties mark the derivative to market at least daily.
  • Collateral and clearing currency are the same.
  • The cash amount covers the entire mark-to-market, subject to threshold and minimum transfer amounts.
  • A single master netting agreement covers both derivatives and collateral.

National regulators can tweak the above calculation if the parties trade the derivative under an eligible bilateral netting contract.

Securities Financing Transaction (SFT) exposures

SFT exposures are assets recognized on the balance sheet as securities financing transactions (namely secured lending and borrowing and repurchase agreements). However, banks can deduct two types of assets:

  • Securities received under the SFT where the bank has recognized the securities as an asset on its balance sheet.
  • Cash payables and cash receivables in SFTs with the same counter-party if the transactions have the same settlement date, the bank has a right to set-off, and the transactions are settled on a net basis.

SFT assets are adjusted for counter-party credit risk. The adjustment depends on the type of master netting agreement in place and the fair value of securities received.

The current debate is not whether there should be a leverage ratio but rather - Should it be the binding constraint?.”
Timothy Adams – Institute of International Finance – 11 October 2013

Off-balance sheet (OBS) items

Off-balance sheet items include

  • commitments (including liquidity facilities), whether or not subject to unconditional cancellation,
  • direct credit substitutes,
  • acceptances,
  • standby letters of credit, and
  • trade letters of credit.

They are converted into credit exposure equivalents by multiplying the notional amount with a credit conversion factor (CCF) as detailed in the Basel III leverage ratio framework.

The Basel III leverage ratio will have to be disclosed by 1 January 2015.


Wednesday, January 15, 2014

The Ascent of Money – “Planet finance is beginning to dwarf planet earth.”

In 2008, Niall Ferguson, has written a great about the history of finance. In “The Ascent of Money” the author explains the evolution of financial instruments and traces the history of important bubbles in financial history. Niall wants us to better understand the complexities of today's modern financial institutions and terminology by digging into the origins of finance.

The book is fantastic; reading “The Ascent of Money” should be mandatory for everyone working in the industry.

In the first part of his book, Niall Ferguson discusses the reputation of finance, money, banks, credit, and bonds.

The reputation of finance

Why has finance bad reputation? Niall gives three reasons:

  • Debtors tend to outnumber creditors.
  • Financial crisis and scandals occur frequently.
  • For centuries, financial services have been disproportionately provided by members of ethnic and religious minorities.

In Niall's view, finance doesn't deserve a bad reputation:

“People are poor because of the absence of banks and reliable financial institutions, not because of their presence.”

“A world without money would be worse, much worse, than our present world. It is wrong to think of all lenders of money as mere leeches, sucking the life's blood out of unfortunate debtors.”


Can you imagine a world without money? Until about 600 BC, the world did not know coins. They were first introduced, at that time, in the temple of Artemis at Ephesus (near today's Izmir in Turkey).

Why is money important? Because

  • , as a medium of exchange, it eliminates the inefficiencies of barter;
  • , as a unit of account, it facilitates valuation and calculation;
  • , as a store of value, it allows to conduct economic transactions over long periods as well as geographical distances.

To fulfill these functions, money must be available, affordable, durable, fungible, portable, and reliable.

In ancient Rome, coins were made out of three metals: aureus (gold), denarius (silver), and sestertius (bronze). Its value was a function of the commodities' increasing scarcity, from bronze, to silver, to gold. As a consequence, the value of money was directly linked to the commodity it was made of. The author describes the development of the Spanish currency to the state of a world currency. As a matter of fact, the Spanish colonialist Diego Gualpa discovered the South American Silver mine in Potosi in 1545. The depletion of this Potosi mine until 1783 allowed Spain to create smaller units of accounts of its currency (compared to the more valuable gold), raising it to the status of a world currency.

In the same vein, Niall Ferguson says that the idea of crusades was not only religious but also had the purpose to overcome Europe's monetary shortage.

The next step in the evolution of money is its gradual detachment from the value of its underlying commodity.

“Money is worth only what someone else is willing to give you for it.”

Banknotes, whose intrinsic value is close to zero, first occurred in China in the seventeenth century.

“Money is a matter of belief, even faith: belief in the person issuing the money he uses or the institution that honors his cheques or transfers. Money is not metal. It is trust inscribed.”

Banks and credit

A central evolution in the world of finance is obviously granting of credit. The term is derived from the latin term credo (= I believe). Banks play a central role here.

In his book, Niall Ferguson traces the development of major banking institutions:

From 1385 on, the Medici bank developed, in a multi-currency environment, namely through currency trading and issuing bills of exchange (cambium per literas). Both were closely intertwined at that time, because currency transfers were, due to their physical expression in base metals, complicated to put in place. A systematic use of balance sheets, its partnership structure, and risk diversification were other success factors for the Medici bank.

“It was decentralization that helped make the Medici bank so profitable.”

“In finance, small is seldom beautiful. By making their bank bigger and more diversified than any previous financial institution, they found a way of spreading their risks.”

The Amsterdam Exchange Bank (Wisselbank), created in 1609, developed trade payment systems substantially: The bank allowed merchants to set up accounts denominated in a standardized currency, to deposit cheques, and to make direct debits and transfers. This meant that commercial transactions could take place without materializing actual coins. A merchant could pay another merchant simply by debiting his account and crediting the other merchant's account.

After its foundation in Stockholm in 1656, the Swedish Riksbank introduced another fundamental precept of modern finance. The bank lend amounts in excess of its metallic reserves and, thereby, allowed the creation of additional credit. Today, this system is known as fractional reserve banking.

1694 saw the creation of the Bank of England. It was the first bank that kept, from 1742 on, a monopoly on the issue of banknotes and, thus, the first central bank. Even though its primary purpose was to convert government debt into bank equity to finance wars, it also played a central role in the development of cashless intra-bank and inter-bank payments. The bank also developed the concept of the “lender of last resort” for banks.

Other central banks followed the path of the Bank of England: The Banque de France from 1800 on, the German Reichsbank from 1875 on, the Bank of Japan from 1882 on, the Swiss National Bank from 1907 on, and the U.S. Federal Reserve System from 1913 on.


For governments and large corporations, issuing bonds is a way of borrowing money from a broader range of people and institutions than just banks. Bond markets were developed 800 years ago in the city-states of northern Italy. As Niall explains in his book, bonds were essentially invented to finance wars.

“War, declared the ancient Greek philosopher Heraclitus, is the father of all things. It was certainly the father of the bond market.”

It was the Rothschild bank that played a particularly important role in the development of bond markets. The author delivers a very detailed description of the history of this institution, from its foundation by Nathan Rothschild (“the Bonaparte of Finance”) to their development in the United Stated since 1830.

The Rothschild family was at the heart of several important contributions to the development of bonds:

  • The bank used price differences in European bond markets to do arbitrage.
  • After 1830, the bank put up a system of issue/distribution of bonds: It bought tranches of new bonds outright and charged a commission (in form of a spread between the subscription and the distribution price) for distributing the bonds to their network of brokers and investors throughout Europe.
  • Bondholders were allowed to collect interest on the bonds in different locations of the Rothschild network.

Bonds provided also the platform for the invention of another major financial innovation – Collateral. In May 1863, two years into the American civil war, the South, through the French firm Emile Erlanger and Co., issued cotton-backed bonds in London and Amsterdam.

The bonds were convertible into cotton at the pre-war price of 6 pence a pound. Investors, however, quickly realized that the issuer could himself influence the value of the collateral by restricting or raising the supply of cotton. In addition, as the Union finally blocked the ports, creditors could no more obtain their collateral, making it ultimately worthless.

“Collateral is, after all, only good if a creditor can get his hands on it.”

Investors loosing faith in the South's cotton-backed bonds was the turning point in the American civil war and lead to the fall of New Orleans and its port in 1862.

Niall Ferguson also discusses some famous sovereign bond debt defaults of the financial history:

Germany's default and hyperinflation after the first world war can be traced back to the following sequence of events: Germany raised money through bond issues to finance the war. During the war time, however, the country had no access to international capital markets. As a consequence, the country had to turn to central bank funding much earlier than other war participants. Short-term central bank funding essentially turned German Government debt into cash, thereby creating inflation. Insufficient taxation, excessive spending, and enormous budget deficits in 1919 and 1920 finally triggered hyperinflation.

“Inflation is a monetary phenomenon. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country's political economy.”

In 1913, Argentina was, due to its huge natural resources, one of the ten richest countries in the world. But, after the second world war, the country consistently underperformed its neighbors and most of the rest of the world. In addition, it mismanaged high inflation periods between 1945 and 1952, 1956 and 1968, 1970 and 1974, and 1975 and 1990. When international lenders disappeared, the country's currency devaluated and Argentina turned to central bank funding, leading to inflation. Recurrent debt defaults in 1982, 1989, 2002, and 2004 were the consequence.

“To put it simply, there was no significant group with an interest in price stability [in Argentina].”

To be continued in the next post.

Thursday, January 9, 2014

Strengthening oversight and regulation of shadow banking – Is the regulator always one step behind?

My own view of the world is: The regulator is always one step behind.”
Alan D. Schwartz – Guggenheim Partners / 12 October 2013

When Alan said this at the Institute of International Finance, the Financial Stability Board (FSB) had already published its recommendations on the shadow banking system, dated 29 August 2013. The FSB is an association that federates national financial regulators. Is it really one step behind?

A shadow is an area where direct light from a light source cannot reach due to obstruction by an object.

In finance, regulators shed light on banks. Financial regulation is then like the rising sun that wakes us up in the morning. Keep that in mind when you read, next time, Basel III or any other nice banking legislation! But behind these banks, where you enter the parking and the garbage leaves the building, lies a dark and cold place. No financial regulation enlightens people here. Financiers do what they want and aren't responsible to anyone!

More seriously, shadow banking is financing done by non-banks. The FSB writes about “credit intermediation involving entities (fully or partially) outside the regular banking system”.

Obviously, strictly regulating banks doesn't really help if the financing activity that regulators intend to protect simply shifts to non-banks. And this is why we need shadow banking regulation, do we?

 Last summer, the FSB has published a series of three documents:
  • Overview of policy recommendations
  • Policy framework for addressing shadow banking risks in securities lending and repos
  • Policy framework for strengthening oversight and regulation of shadow banking entities

A. Overview of policy recommendations

Tackling the shadow banking issue is a two step process. It involves

  • tracking financial sector developments outside the banking system and
  • strengthening oversight and regulation of the shadow banking system.

Nothing revolutionary so far: Before regulating, you have to understand what it is that you want to regulate.

Next, the FSB describes more specifically which areas of the non-bank system it intends to tackle:

  • Counter heavy reliance on short-term wholesale funding by reducing the susceptibility of money market funds to “runs”
  • Assess and align the incentives associated with securitization
  • Introduce data collection standards, transparency, minimum collateral valuation, reinvestment, and management standards, and structural elements such as central clearing in securities financing transactions such as repos and securities lending

Beyond, the FSB wants to mitigate the spill-over effect between the regular banking system and the shadow banking system and assess the systemic risk of shadow banking entities. As a matter of fact, these areas of intervention are not part of the shadow banking as such but concern more the intersection between the banking and shadow banking system.

Given the interconnectedness of markets and the strong adaptive capacity of the shadow banking system, the FSB believes that policies in this area necessarily have to be comprehensive.“

Finally, shadow banking should “focus on economic functions and activities rather than on legal forms of entities conducting them”.

B. Policy framework for addressing shadow banking risks in securities lending and repos

Securities lending and repo markets are good for the economy because they support price discovery, secondary market liquidity, and market making.

However, they also represent risks:

  • The sellers' obligations to buy back securities create money-like liabilities, boost credit growth, and facilitate maturity/liquidity transformation outside the banking system.
  • Securities lending is a pro-cyclical activity and, as such, enhances system leverage.
  • Collateral is susceptible to fire sales if the solvency of the underlying firm declines.
  • Collateral reutilization and revaluation amplify the above risks.

To take up the risks in the securities lending and repo space, the FSB recommends the following:

  • Improve transparency: Transparency means better data (counterparty concentration, maturity breakdown, and composition of received collateral). It requires more granular and timely information on securities lending and repo exposure. Transparency needs data on both trade level (flow data) and aggregate market. Transparency implies standardization for data collection and treatment.
  • Limit cash collateral reinvestment: Haircuts should ensure that only a reasonable portion of collateral is reinvested. Reasonable means that haircuts should cover the maximum expected decline in the market price of the collateral asset, calculated at a minimum 95th confidence interval; they can range from 0.5 % to 7.5 %.
  • Impose contingency plans for the failure of important counterparties, including in times of market stress.
  • Inflict daily mark to market and daily collection of variation margin.
  • Favor a wider use of central counterparties (CCP).

C. Policy framework for strengthening oversight and regulation of shadow banking entities

The FSB outlines the economic functions of shadow banking entities, the risks involved, and how to counter these risks.

I. Risk analysis

1. Management of collective investment vehicles (CIV) with features that make them susceptible to runs

CIV are particularly prone to runs as investors oftentimes redeem funds within short periods of time, thus obliging the CIV to roll over its positions in stressed market environments. This risk is amplified because

  • CIV are repeatedly leveraged;
  • CIV investors show low tolerance to absorb losses;
  • CIV investments are oftentimes complex and, therefore, illiquid;
  • CIV investments can be concentrated in market segments or counterparties.

2. Loan provision that is dependent on short-term funding

Shadow banking entities can provide credit to both retail and corporate customers. This activity can be funded by short-term liabilities and be concentrated in specific sectors in which the entity is experienced. Apart from the problem of matching maturities, this activity is especially precarious if it is carried out in cyclical sectors such as real estate, construction, shipping, automobiles, and retail consumers.

3. Intermediation of market activities that is dependent on short-term funding or on secured funding of client assets

This intermediation may consist of securities broking services (i.e. buying and selling of securities and derivatives on and off exchanges including in a market making role) or prime brokerage services to hedge funds. If non-bank entities doing such intermediation are dependent on short-term funding or on secured funding of client assets, they may be vulnerable to runs.

4. Facilitation of credit creation

Facilitating credit creation through credit insurance, guarantees, or credit default swaps may create imperfect credit risk transfer or lead to improper credit risk pricing. The consequence can be excessive leverage in the financial system.

5. Securitization-based credit intermediation and funding of financial entities

Securitization may facilitate or aid in the creation of excessive maturity / liquidity transformation, leverage or regulatory arbitrage in the financial system.

II. Policy toolkits to deal with risks

The FSB first introduces “general principles” and “overarching principles”. You can read about “focus, proportionality, forward-looking measures, effectiveness, and regular adjustment”. I must admit that I didn’t feel much better informed after reading all these honorable principles.

More concrete suggestions from the FSB include:

  • Collect and disclose information
  • Limit and suspend redemption from collective investment undertakings (“redemption gates”)
  • Impose redemption fees on collective investment undertakings
  • Create side pockets of investment portfolios that serve as a safety cushion in case of a run
  • Impose quantitative limits for investments in illiquid assets
  • Put (quantitative) limits on asset concentration
  • Limit leverage of shadow banking entities
  • Restrict the maturity of collective investment portfolios, measured through duration or weighted average maturity
  • Set long-term and countercyclical capital requirements for non-bank entities that provide loans
  • Limit large exposures’ concentration of shadow banking entities
  • Impose minimum capital requirements
  • Restrict the use of client assets (Client monies and unencumbered assets should not be used to finance the entities’ own account activities.)
  • Restrict the scale and scope of shadow banking entities’ businesses
  • Enhance risk management practices such as loss modeling and stress testing to capture tail events
  • Impose quality restrictions on eligible collateral to avoid that a collateral deterioration leads to margin calls and, thus, contagion in the financial system

Now again: Are shadow banking regulators one step behind? I don’t think so, the FSB recommendations show that risks have been identified precisely. Whether such recommendations will be put in practice is another question that does not depend exclusively on regulators.