It’s time to revisit the dangerous loopholes in the financial system

The author is chairman of the Systemic Risk Council and author of “Unelected power”

The West cannot afford another financial crisis. It would be a disaster in any way it could nationally, and a geopolitical giveaway to strategic competitors in Beijing and elsewhere.

In March and April, the fabric of our financial system was stretched almost beyond endurance. Only the intervention of the central banks of the North Atlantic seems to have avoided a sort of catastrophe triggered by the markets seizing that the pandemic was serious.

We can more than quibble about the gigantic scale of bond purchases by central banks and their vague explanations, but monetary policy issues should not distract from the imperative of ensuring that the system is more resistant to the future.

Many describe the US Treasury market as the most liquid capital market in the world. It would be more accurate to say that for the dollar to be secure as the world’s primary reserve currency, the treasury bill trade must remain reasonably liquid in all weathers. The same goes for the government bond markets on the European side of the Atlantic.

Three things are needed to tackle this part of the unfinished or neglected business backlog in order to preserve stability. First, central banks need to dust off plans made a decade ago to act as market makers of last resort – buying and selling securities, subject to an insurance premium – when trade liquidity sinks. ‘evaporates.

It is not necessary to buy an entire market to support its liquidity, as Mario Draghi demonstrated in 2012 when he said that the European Central Bank “will do whatever it takes” to prevent the rush into the sovereign debt markets. Acting as the market maker of last resort is not the same as using quantitative easing to stimulate spending in the economy or buying bonds to match debt servicing costs. It is about restoring liquidity by acting as a buy and sell backstop, without targeting a particular price.

Second, the plumbing and design of major government bond and bond loan markets need repairs, if not overhaul, if they are to cope with the occasional extraordinary spikes in sales activity today. . Maybe, as Stanford economist Darrell Duffie said offers, all government bond transactions must be processed through central clearing houses.

But since many clearinghouses are now super-systemic, authorities should only consider this solution if, at last, they understand how to resolve a struggling CCP without taxpayer bailouts. This is a painful reform that we badly need.

Third, and most importantly, the specter of excessive leverage and liquidity mismatches between certain types of funds and other investment vehicles must now be resolved.

The historical fragility of the bank is reproduced outside the industry, and without constraints or backstops. Generally speaking, this was expected: banking re-regulation after the 2008-09 collapse would obviously encourage activity to migrate elsewhere.

It was intended to develop policies for these shadow banking services, distinguishing them from vanilla capital market activity which does not pose a threat to the resilient provision of essential credit, insurance and payment services. But plans stalled, and when the shadow banking label was ditched for much more positive sounding “market finance”, the issue was, in fact, whitewashed.

Last October, the Systemic Risk Council, a group of former senior central bankers and regulators, academics and others, published proposals reforms to ensure a stable financial system. The 2008 market collapse triggered by the dramatic failure of investment bank Lehman Brothers gripped the public, fueling demands for reform. But the near miss of March 2020 overtook most people.

Under the leadership of new US Treasury Secretary Janet Yellen, authorities, including lawmakers, must get on with it. The system is less resistant than it is claimed, and many know it. Lawmakers should use the upcoming confirmation and review hearings on both sides of the Atlantic to demand that inbound and outbound officials and regulators commit to addressing these dangerous loopholes.

So, Democratic leaders, please do what only you can do: inject public energy into this. More prosaically, to demand that substantial progress be reported at the next G20 summit. And central bankers, market regulators and prudential supervisors are acting decisively whether elected power awakens or not. A near miss was a special kind of blessing – don’t let it go to waste.


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Don F. Davis