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The Essential Guide (Now with a Revised Introduction)

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Advanced Search Find a Library. Refine Your Search Year. Your list has reached the maximum number of items. Please create a new list with a new name; move some items to a new or existing list; or delete some items. Global Financial Regulation. Global financial regulation : the essential guide. Fast-moving risks are unpredictable, and they intensify so quickly that they inflict damage before regulators can require managers to take effective countermeasures.

We will discuss these strategies in detail in a later section. During the era before financial deregulation, when interest rates were commonly regulated by the state, banks primarily took on credit risk as their main value-creating risk. After interest rates were deregulated, banks also added interest rate risk to their list of value-creating risks, but as we argued above, this is also a slow-moving risk.

Other financial institutions such as broker-dealers investment banks and finance companies focused on fast-moving risks such as market risk and liquidity risk. First, because banks engage in maturity transformation, it is true that they have also faced significant funding liquidity risk in the past. This risk has largely been removed from banks through two types of government intervention, however.

THE FUTURE OF GLOBAL FINANCIAL REGULATION

Second, and perhaps more effective on a day-to-day basis, has been the introduction of government-administered deposit insurance in most banking systems. In particular, it is always possible for banks to go on lending binges between supervisory examinations and in fact banks may have the incentive to do so when their financial condition is already deteriorating. This strategy, which is called a gamble for resurrection, is well known in the banking literature.

Thus, while this strategy generally increases the losses once a bank defaults or is seized by regulators, it does not create fast moving risk per se. Disintermediation led to innovation, both in terms of new products and new practices. In the face of fast-paced and large-scale innovations, regulators often had little choice but to accept the innovations, particularly when the innovations moved certain financial activities beyond their jurisdiction.

Both in order to prevent further innovation of this nature, as well as because of changes in regulatory philosophy in favor of free competition, regulators began to deregulate financial markets more quickly and intentionally. But this also led to further disintermediation, which placed additional revenue pressure on banks and also gave other financial institutions new opportunities to expand.

Banks sought new income streams to replace decreased lending revenues as large corporations decreased their reliance on banks and instead funded an increasing share of their debt in the money market, by issuing commercial paper. When deregulation allowed it, many money-center banks turned to market-making and trading as new sources of revenue. In addition, banks of all sizes increasingly took advantage of new types of securities for funding their activities, such as medium-term notes.

For example, the creation of the money-market mutual fund established a new path through which household savings could reach companies in search of funding. Money-market funds were the natural purchasers of commercial paper issued by finance companies, who in turn used this funding to expand their lending portfolios. Later, creation of asset-backed securities enabled structured investment vehicles SIVs to issue asset-backed commercial paper and invest the proceeds in tranches of collateralized debt obligations CDOs. Although these products are frequently used for hedging purposes, slow-moving but market-traded risks can also be converted to fast-moving risks through the application of leverage.

Because leverage multiplies the payoff to a risk exposure, it can transform the typically small payoff from a change in a slow-moving risk into a large payoff to the holder of a leveraged exposure to the risk. For example, a small price change on an interest-rate future or credit default swap can become a source of large profits if the position is highly leveraged.

This situation corresponds to the definition of fast-moving risk given above. In other words, they develop gradually over several discrete periods and give some advanced warning of increased future losses, like the underlying risks that cause them. This in turn implies that regulators should have enough time to intervene to mitigate banking crises. In other words, this suggests that the story of the one-step-behind regulator is not an accurate description of banking crises. This does not imply, of course, that banking crises will necessarily be infrequent or mild, only that they are not well described by the one-step-behind story.

In the next section, we discuss the historical experience of financial crises and examine whether this analysis is valid. The narrative of the one-step-behind regulator suggests that new financial products get out of control and cause crises before regulators are either aware of the danger or have sufficient time to extend appropriate regulation to the product. This makes for a compelling story, but is it an accurate representation of most financial crises? In other words, financial crises seem more often to have been caused by slow-moving risks than by fast-moving risks.

Of course, fast-moving risks doubtlessly play an important role in many crises along with slow-moving risks. But when we look for the main, underlying causes of historical crises, we find that slow-moving risks are more prevalent than fast-moving risks. Banking crises in the United States, the Nordic countries, and Japan that took place in the s and s have received the most attention internationally, but nearly every country with a banking system experienced at least one banking crisis during the period. Many major international financial crises of the past half century, such as the Chilean crisis of , the East Asian crisis of the late s, the Turkish crisis of , and the Icelandic crisis of are fundamentally banking crises.

First, the instruments that cause these crises are not new products but rather one of the oldest financial products, the bank loan. Second, the risks of excessive lending manifest themselves so slowly that even a regulator who is one step behind should have sufficient time to perceive the rising risk and then act in ways to prevent or at least mitigate a developing banking crisis. But as the literature has shown, these lags were created by intentional temporizing and forbearance on the part of regulators. Choosing a course of inaction is fundamentally different from lacking sufficient time to understand or deal with the danger.

Thus, in these crises, giving the regulators more time would not have solved the problem, but only allowed the problem to grow or intensify. The experience of Japan is instructive in this regard. Like banking crises, sovereign debt crises involve instruments that have existed for hundreds of years. In addition, these are also slow-moving crises. Debt-to-GDP levels in countries like Greece and Italy, for example, were known to be excessively high for years before the crisis emerged. And finally, sovereign debt crises almost inevitably involve banks, who purchase large quantities of this debt because of its attractive yields.

The Russian default of , for example, damaged domestic Russian banks that held large quantities of government securities and caused problems in the financial markets through its knock-on effects.

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Global Financial Regulation

Had LTCM been forced to liquidate its positions quickly, this could have caused a financial panic. This coordination, moreover, took place over a weekend. That is, the hedge fund LTCM effectively transformed fast-moving market risk into slow-moving credit risk, so that the banks were not directly exposed to fast-moving market risks.

Banks, and their regulators, did not have to deal with fast-moving risks. Although market risk caused by the Russian default led to the collapse of a prominent hedge fund, it did not cause widespread financial panic. In this case, the segregation of risks provided enough of a time lag to enable regulatory mitigation of the risk before it precipitated a full-blown crisis. In this case, market risk was amplified by financial innovation. This fall in prices put market makers and other broker-dealers into potential financial distress.

But these losses did not affect banks, due to the segregation of risks between banks and nonbank intermediaries. In fact, an announcement by the Fed late on Black Monday that the Fed stood ready to provide needed liquidity to the broker-dealer system—intermediated through the banks—was instrumental in calming the markets and averting wider or lasting damage from the stock market crash.

Financial regulation essential

The Black Monday crash was one of the most clear examples of financial innovation leading to problems, but it failed to precipitate a financial crisis, at least in part because of the segregation of risks in the system. This happened as banks began to take on direct exposures to fast-moving risks in the early s.

In some cases, banks took on exposure to fast-moving market risk by engaging in proprietary trading. But it was actually liquidity risk—not from deposits, but market-based, wholesale funding sources such as commercial paper and repurchase agreements repo —that ended up doing significant damage to banks. During the early s, banks increasingly turned to capital markets and away from deposits for their funding.

For example, the British bank Northern Rock turned to capital markets to fund its massive expansion into mortgage lending during this period.


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Capital markets can provide huge amounts of wholesale funding, and can do so quickly, but this funding can leave just as quickly, which is a source of liquidity risk that moves faster than classic deposit runs. The sudden departure of capital-market-sourced liquidity is actually what placed banks in jeopardy faster than regulators could react. The bank could not replace this wholesale funding quickly, which caused it to go into distress. But regulators were unprepared for the sudden loss of funding and did nothing to ameliorate the situation.

Indeed, Mervyn King, the head of the Bank of England, responded to this development by drawing a line in the sand, declaring that there would be no bailouts. Four months after this statement, however, the bank had been nationalized. Regulators who were a step behind the industry found themselves forced to do the one thing they explicitly said they would not do, because the risks moved faster than they were prepared to deal with.

As in the case of Northern Rock, banks chose to expose themselves directly to capital-market-based liquidity risk rather than fund this lending via deposits.


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