26 February 2017

John Nugée: The Bank of England, financial stability and the next crisis

[...] The main thrust of regulators’ work since the financial crisis has been to make this plumbing more resilient, and the chosen solution goes by the name of Central Counterparties (CCPs), institutions that stand between market participants and take one side of every deal.  By doing so, they turn the standard “cat’s cradle” of a market, in which everyone deals with everyone, into a “hub and spoke” system in which everyone deals with the centre.  This is seen as the solution to the problem of a financial system whose linkages had become too complex and interwoven, and where as a result no-one had a full oversight of all the risks in the system and failures in one company had unpredictable consequences for others.

To go with the creation of CCPs, regulators have added the model of centralised regulation and risk buffers.  Each market will have one central clearer under one regulator, with one set of risk controls and creating one common defence against financial instability.  This, Sir Jon claimed, makes the system proof against almost all conceivable risks and defaults by participants – thus achieving one of the regulatory holy grails, a system which is strong enough to survive the default of individual constituent companies.

While accepting that financial infrastructure is a utility service that lends itself naturally to monopolistic providers, critics of this approach have focused on the considerable centralisation of risk that it implies.

Indeed, there are actually two centralisations inherent in the chosen structure of CCPs:  the concentration of risk in the CCP itself, and the concentration of the regulatory response.  Any given function of the market infrastructure has just one central clearing agent and one set of regulations.  As long as the CCP stays operative, this is both effective and efficient, but for many in the market it recalls the phrase “all eggs in one basket”.  And the response to this – in effect “Yes, but it is an extremely strong basket” – raises the issue of how regulators can be sure of this when faced with the unknown, and indeed unknowable, crises that will certainly occur in the future.

Beyond this, and potentially more seriously, there is the nagging fear that making CCPs ever stronger may not in the end be the most important thing the global financial system needs to worry about.  For there is a growing concern among regulators and market participants alike that the next crisis may appear in a completely different part of the financial eco‑system, that of the asset management community.

[...] while asset managers do not have capital buffers, they do in their own way offer clients a shock absorber through their intellect and trading ability.  Asset managers traditionally manage client assets on a discretionary basis;  that is, they know what their client is trying to achieve and have discretion on how best, given the state of the market, to achieve it.  This discretion was in the past every bit as valuable a shock absorber as a bank’s capital – if an asset manager thought a particular market was fragile or unable to execute a trade, he would find a different way to meet the client’s needs.

The challenge for the asset management industry is that increasingly today, this discretion is being removed.  The rise of passive investing (where, as the name implies, the asset manager has no choice over what they invest in but passively “buys the market”) and especially of vehicles like Exchange Traded Funds (ETFs) leaves the decision-making ever more firmly with the investor, both on what to buy and, more importantly, when – if an investor redeems a holding in an ETF, the ETF manager has no discretion at all, and has almost instantaneously to sell the underlying assets.  Whatever the state of the market at the time.

It is this that worries many in the regulatory space.  Asset managers who have no discretion about when they trade their clients’ funds can no longer provide the shock absorber of intelligent discretionary trading and sensitive market timing, and may make fragile and volatile markets worse.

To be fair to regulators, they have not been inactive.  They have been urgently creating a new rulebook for asset managers, replete with acronyms (FMIR, MIFID, RADAR) and theoretical controls aplenty.  But it remains controversial – asset managers are still resisting parts of the framework – and largely untried in the heat of battle.

So, two forward-looking statements by the Bank last week.  On the regulatory and financial stability side, Sir Jon Cunliffe exuded confidence that the financial infrastructure of markets can withstand anything the next crisis could throw at it.  For the economists though, Gertjan Vlieghe seemed keener to lower expectations that the Bank can predict either when that crisis will hit or what it will entail.    We will all have to hope that when Vlieghe’s “unknown unknowns” occur, Sir Jon’s confidence is shown to be well-placed, and not just, like the Maginot line, defences against the battles of the last crisis while the next one blows up elsewhere.

Full piece on Laburnum Consulting website

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