Sowing the Seeds of the Next Crisis

Regulations Help Transform Capitalism into a Marxian Caricature

by  Pater Tenebrarum

The regulations introduced by Frank-Dodd and other laws elsewhere that are designed to mitigate the risks of the last crash, are increasingly producing new types of risks that will become manifest in the next crash. Naturally, it is completely absurd to believe that one can have five years of massive monetary inflation and at the same time 'reduce financial risks' by means of regulations. As long as fractional reserve banking exists and the banking cartel comprised of the central banks and commercial banks is able to create money and credit  ex nihilo in unlimited amounts, no amount of regulation will be able to forestall the next crisis.

In fact, there are always new regulations introduced in the wake of crises, and they tend to be focused on the features of the crisis that has just passed, a kind of 'closing the barn door after the horse has escaped' approach. Naturally, the shape of the next crisis will be completely different, so that most of these regulations are either useless or actually apt to become one of the causes of, and/or exacerbate the next crisis. For instance, Sarbanes-Oxley was supposed to forestall market crises after the Nasdaq crash by making corporate disclosure more reliable. It sure added a huge layer of bureaucracy to listed corporations and imposed huge costs on the economy, but the stock market crashed again anyway.

It is also in the nature of these regulatory monstrosities that they become ever more complex and costly to implement. Keep in mind that big corporations rarely complain about this sort of thing, because they know it mainly kills off their smaller competition which cannot afford the compliance costs.

Can you even imagine trying to open a new bank today? The very idea seems utterly absurd. And so the nominally capitalist system begins to ever more resemble the caricature of capitalism envisaged by Karl Marx, with economic power ever more concentrated in fewer and fewer hands, as upstarts with little capital are drowned by regulations and the associated compliance costs and find it ever more difficult to compete.

The added complexity moreover does not make the system 'safer' – it does the exact opposite. We have previously mentioned Dylan Grice's thoughts on the topic. Mr. Grice pointed to the example of the only 'accident-free' cities in Europe: the handful of towns in Germany and the Netherlands where all traffic signs were removed and all traffic regulations rescinded to be replaced with just three rules as an experiment. Accidents in these towns declined by 98%. Hayek's 'spontaneous order' proved to be vastly superior to the ever more complex traffic regulations accumulated over more than a century. It is the same with financial regulations: increasing complexity makes the system inherently less safe.

One of the things that is increasingly cited as posing a major potential risk to the market is the huge decline in liquidity in the repo market, the size of which has almost halved since 2008. Along similar lines, banks have vastly decreased their bond market trading operations as a result of new regulations.

From a recent article in the FT: 

“Across Wall Street, bond-trading desks have been shrinking. So has the amount of company money they are allowed to use in their daily business of buying and selling corporate bonds.

“I know one trader who used to have $2bn of balance sheet. He now has $20m of balance sheet,” says Mr McDonald, now a strategist at Newedge, the broker.

Buffeted by new regulations and scarred from their near-death experience during the financial crisis, big banks have quietly retreated from the business of dealing in corporate bonds. This has reduced the amount of bond risk lurking on the banks’ balance sheets. But some in the industry are worried that this shift in the structure of the $9.2tn market for companies’ debt could help sow the seeds of a new financial shock.

Since September 2008, investors have poured $524bn into investment-grade corporate bond funds alone, hoping to find better yields at a time when interest rates are at record lows. The lure of higher returns has attracted big investors such as pension funds and insurers and led to the creation of new types of funds to replicate fixed-income assets.

At the same time, the amount of corporate bonds held on the balance sheets of the dealer banks, which include Wall Street stalwarts such as Goldman Sachs and JPMorgan Chase, has dropped sharply. Dealers’ inventories of corporate debt and other non-US Treasury bonds have fallen 78 per cent since their 2007 peak of $235bn, according to Federal Reserve data. “There’s been a structural change in liquidity in the fixed-income markets,” says Dan Fuss, vice-chairman of Loomis Sayles. “The major dealers do have a tighter ‘risk budget’ now. They really do.”

Liquidity is the lifeblood of any well-functioning market. It lets investors dart quickly and easily into and out of positions without significantly moving the price of the securities they are buying or selling. A dearth of liquidity contributed to the global financial crisis as banks were unable to offload billions of dollars’ worth of complex assets tainted with the stench of failing subprime mortgages. Unable to sell the securities or raise financing against them in the “repo market”, banks were eventually forced to take big writedowns on the positions.

The risk embedded in corporate bonds has now been shifted from the banks to investors. From a regulator’s standpoint, this means banks are less likely to require a bailout. Instead of pain being inflicted on taxpayers, investors will feel it.

But with interest rates able to move in only one direction – up – many bankers and asset managers are warning that investors who have built up corporate debt positions worth billions of dollars may find the exit crowded when the great 30-year bull run in bonds finally comes to an end. “When the big funds come in and sell there’s just nobody there,” says Mr McDonald.

Ask a banker what the problem is and they will direct you to a host of industry developments that have sucked liquidity out of the fixed-income world. Chief among these is the introduction of rules by international and US bank regulators aimed at preventing a rerun of the kind of mayhem experienced five years ago.” 

(emphasis added)

In short, the regulations aimed at “preventing a rerun of the kind of mayhem experienced five years ago” are likely to produce a different kind of mayhem at some indeterminate point in the future. As an aside, it does not really matter where in the system the risk is concentrated: the banks are going to  get into trouble anyway when push comes to shove.

The interdependence of the various cogs in the system is such that once trouble starts in one end of the markets, it quickly moves even to normally completely uncorrelated sectors of the markets. Furthermore, if e.g. banks no longer hold  bonds on their own books, but lend money to bond investors employing leverage, they are just as much, if not more exposed to the associated risks. With bonds on their own books they do not have to mark to market anymore and can pretend that everything is fine even if it isn't. In the event of debtors becoming unable to pay this trick isn't going to work, so a cascade of margin calls can be expected. The bond markets could easily seize up then, leading to the forced selling of whatever assets are still deemed liquid.