Reply #22: The cost of a lifeline: Humbled financial groups brace for more regulation [View All]

[Demeter]

http://www.ft.com/cms/s/0/a7a843ba-115d-11dd-a93b-0000779fd2ac.html

By Gillian Tett and Krishna Guha



A decade ago, Paul Calello of Credit Suisse was grappling with the horrors at Long Term Capital Management, the hedge fund that was destined for collapse. Mr Calello, now head of investment banking at Credit Suisse, was his bank’s main representative back then in a consortium that took over the fund. But this job became horrendous because LTCM was at the heart of a complex web of trades with other entities that were fiendishly hard to unravel...These days, Mr Calello says, Wall Street is confronting “the same set of issues” – but on a potentially far more deadly scale. “After LTCM it took us almost 10 years to sort out what happened there in relation to trades,” says Mr Callelo.“But we don’t have another 10 years to fix our problems ... The time for action is now.”

But while (it) has calmed the markets for now, the Fed’s action (bailout of Bear Stearns) has raised much bigger, longer-term questions about the future direction of the financial world. LTCM posed a threat because of the sheer size of its trades in the government bond market and the bank credit lines that funded it. But this time Bear was entwined in tens of thousands of positions across the whole spectrum of financial markets... what the Bear saga shows with brutal clarity is that modern financial markets are even more tightly interwoven than before – leaving regulated, lightly regulated and unregulated institutions increasingly exposed to each other’s risks. Thus the crucial question now is whether regulators and bankers can find ways to offset the dangers posed by this ultra-interconnected world.

Above all, policymakers are anxious to avoid the “moral hazard” problems that occur when a lightly monitored institution takes big bets knowing that it is so systemically important that it cannot be allowed to fail. Not least, that is because such recklessness could cause the next financial crisis.
“We have to think about the bigger policy implications of this,” says Nouriel Roubini, a prominent American economist, who maintains that the rescue of Bear Stearns has in effect extended the Fed safety net to a swath of other institutions. As Mr Calello puts it: “This new phenomenon of ‘too interconnected to fail’ is now a permanent part of the financial system ... and there needs to be a wider debate about the consequences of this.

...The past eight months have blown apart any cosy assumptions that it is possible to draw a simple dividing line between institutions that need to be regulated and those that do not. It has become painfully clear to regulators that loosely regulated entities such as SIVs have remained so tightly entwined with their originating banks that their problems tend to migrate back to those regulated banks...It has also become clear that these so-called “shadow banks” cannot be viewed merely as a minor appendage of the mainstream financial world. JPMorgan, for example, recently calculated that activity in so-called parallel – or unregulated – US banking was worth $5,900bn last year, compared with $9,400bn for regulated banking...Most pernicious of all, the explosion of derivatives and other complex financial arrangements has left institutions so closely intermeshed in their market dealings that it is increasingly difficult to ring-fence regulated entities from problems emanating from less regulated institutions. Take Bear Stearns. A couple of decades ago, regulators would probably have presumed that this broker was not in the category of “too big to fail”, since it did not serve retail clients on a large scale and was not a commercial bank. The Fed last month tacitly recognised, however, that Bear was now in effect “too interconnected to fail”. That is partly because Bear was a crucial participant in the $62,200bn credit derivatives market...Bear was also a central participant in the so-called tri-party repo market, the sector where banks and brokers lend securities to each other overnight in exchange for cash. This sector is crucial to banks’ funding. Contracts in this little-watched corner of finance also tend to be tightly entwined. When Bear started to face problems funding itself through repurchase transactions, Fed officials feared this would cause the broker to default on its related contracts, sparking a daisy chain of defaults across the banking sector. “It was the repo thing that really scared people – there was the potential for a huge panic,” says one senior American financial official.

A second view is that the regulatory net needs to be cast much wider. Sheila Bair, head of the US Federal Deposit Insurance Corporation, is among those in Washington who argue that if brokers are to receive public support in a crisis, there needs to be a level playing field with commercial banks – an argument that implies brokers should face capital requirements...Don Kohn, vice-chairman of the Fed, last week suggested that supervisors should require investment banks to use less in the way of cheap overnight funding and more, relatively expensive, long-term funding – reducing the incentive to gear up...Some go further and argue that the division between regulated and unregulated institutions should be much stronger – and that entities outside the regulated sphere should not be able to engage in activities that could cause wide harm. Gary Stern, president of the Minneapolis Fed, has suggested that supervisors should be given the authority to stop institutions outside the safety net from building up positions that create systemic risk...Privately, some senior officials at the International Monetary Fund also suggest authorities should limit the ability of unregulated institutions to sell credit default swaps to regulated banks and brokers.

But a third view is that regulators should abandon the attempt to divide financial institutions into different categories – and regulate them all. Prof Roubini says financial history suggests that whenever regulators try to devise clear boundaries, bankers find ways to bypass these controls – implying that any attempt to stop unregulated institutions from generating systemic risk is doomed to fail. Instead, he argues that higher standards should be imposed across the markets, including for SIVs, investment banks and hedge funds that operate as shadow banks....There are now five federal banking regulators, including the Federal Reserve. There is one federal regulator for the securities market, along with state supervision, and a separate regulator for futures. Fifty regulators oversee insurance, which is supervised almost entirely at the state level...There is growing recognition that such a Balkanised system – parts of which date back to the Civil War – is untenable in a world where the boundaries between financial products and institutions have blurred. An increasingly interconnected marketplace, in other words, should have a more joined-up regulatory structure...