Big Bubbles, No Troubles?
When I was a child, a popular chewing gum had a rather sticky commercial. Hubba Bubba used the slogan ‘Big bubbles, no troubles’. The financial market legislators are, with good intentions, trying to avoid the next crisis, but financial bubbles will eventually form and then burst. The slogan for the financial sector should read: the bigger the bubbles, the bigger the troubles…
Ten years on from Lehman Brothers’ bankruptcy acting as a catalyst to international financial collapse, we should ask ourselves if our financial system is more robust now. To reflect on this we need to think about what makes a financial system robust and what makes it fragile. Unfortunately, there are no clear answers; a financial system evolves over time as both individuals and companies adapt their behaviour to new situations. New behaviour as a response to new legislation has the potential to cause unintended consequences.
Robustness and adaptivity in a system means that if one component breaks, its function is re-routed elsewhere via other components in the system. One component shouldn’t be so central to the system that its failure results in a systemic breakdown.
Ideally, a robust financial system is decentralised and consists of lots of heterogeneous independent players. If one of these companies defaults due to bad managerial decisions (for example), it will not threaten the stability of the whole financial system. This was the intention of the Glass-Steagall Act (1933), which prohibited securities firm from acting as savings banks.
In a fundamentally robust system, occasional bankruptcies are part of its natural evolution and adaptiveness. The knock-on effects of Lehman Brothers’ collapse showed with painful clarity that financial markets had become fragile. The increasing complexity of financial institutions and consolidation in the sector resulted in a few huge players becoming so interconnected that it was impossible to foresee possible chain reactions propagating through the system. Fear took control of the sector and brought it to a systemwide freeze until it was bailed out by taxpayers.
To prevent this from ever happening again, legislators acted forcefully and introduced a massive blanket of regulation. In other words, they decided to regulate complex instruments and complex institutions with complex legislation. Everything was done with honest and admirable intent, but, as always, there were unintended consequences of the new regulation.
The massive rise in regulation after the 2008 crisis increased overhead burdens for smaller banks, driving further consolidation. An unintended consequence was that it created a more concentrated financial network.
Leverage, lack of transparency and interconnection between banks were central elements in the 2008 crisis. “Too big to fail” was replaced by “too interconnected to fail”. The regulatory remedy was to create central clearing mechanisms for all financial derivatives. A poorly regulated network of interconnected banks was replaced by an extremely centralised network with a few, but highly system critical nodes. History shows us that everything that can fail eventually will and if a centralised system fails, the consequences are much more serious. Things will look safer on the surface but underlying systemic risks will increase.
Central to post-2008 legislation is the regulatory price of financial risk that does not necessarily reflect actual economic risk. Commercial banks and insurance companies maximise their profits within a risk budget where the regulatory price of risk becomes the binding constraint. This will lead to herding behaviour where most financial institutions will end up holding similar portfolios, thus reducing the robustness of the system as a whole. Homogeneity has similarities with centralisation: it might look safe for a while but when it collapses, a system wide collapse would be inevitable.
To make banks more robust, the regulation heavily punishes market-making activities. Before the crisis, market-makers used to hold an inventory of assets and traded themselves in the market. But under the new legislation market-making has been reduced to match buyers and sellers directly which has dramatically reduced liquidity in the market. Banks have become safer, but the system itself has less liquidity and is, therefore, more fragile. More safety on a micro level may imply more risk on a macro level.
A false sense of security
Regulating financial risk is a ‘whack-a-mole’ game. Once you’ve hit the mole in one hole, a new one pops up somewhere else. The legislators have just whacked one risk using a massive legislative package and financial risks are about to reappear somewhere else in the system.
Bankers and investors are intelligent and adaptive. To generate excess returns, new financial instruments and strategies will be developed to maximise the real economic risk while keeping the regulatory price of risk low. It certainly makes sense to maximise profit at the expense of robustness if you are too interconnected to fail. We can’t solely blame bankers, they are only playing the game by the rules laid out by regulation, with the aim to maximise the return for their shareholders.
So where in the system will we see systemic risk building up that could lead to a crisis? Your guess is as good as mine, but I would keep an eye on liquidity. The catalyst could be something as innocent as an ETF being forced putting down the gate to redeeming investors…
The more decentralised a system is, the more robust it will be. The less interconnected a system is, the more robust it will be. The more heterogenous the nodes in the system are, the more robust it will be.
Perhaps the answer is to be found in having less regulation and a simpler system; a modern Glass-Stegall Act combined with deregulation. To be realistic, moving to a more robust system is extremely unlikely given the legislators’ illusion of controlling the system and the national pride of having large multi-national financial institutions. We will probably experience more well-intended legislation until the next time systemic risk pops up.
Legislators and regulators just have to keep in mind that the bigger the bubbles, the bigger the troubles…