Regulating specific risky activities in the financial sector is more useful than trying to identify systemic non-bank, non-insurance institutions.
Many of you may know Lewis Carroll’s poem The Hunting of the Snark, written nearly 150 years ago, at about the same time as people began managing assets in funds. The point of the poem is that there is no snark. The hunt was a waste of time.
The Financial Stability Board (FSB) has just set out on what may turn out to be a similar voyage to look for non-bank non-insurer global systemically important financial institutions (NBNI GSIFIs). They have their gaze fixed on asset management. Unfortunately, because the hunt is led by bank supervisors who have little understanding of asset management, they are hunting for the wrong thing in the wrong place.
Fruitless search
Throughout its recent consultation, the FSB has stressed that it is looking for those “entities” that could cause danger. It has to be doubted whether any will be found. The FSB is also looking for “entities whose distress or disorderly failure” could cause disruption. But funds do not suffer “distress or disorderly failure”. The prices of their underlying assets may fall and that will be reflected in the buying or selling price. The investor may be discomfited, but it is not failure.
The FSB is closer to the mark when it asks about inter-connectedness. Many of the transactions that funds carry out are with banks, so asset price changes could flow through to the banking system. This is particularly true if leverage is involved; the leverage will almost certainly have come from a bank in one way or another.
Moreover, funds may invest in securities issued by banks or governments. That can be troubling. In 2009, $300bn flowed out of US money market funds. With one exception, those flows were handled without stress or disorderly failure by the funds involved. Handling such flows has been part and parcel of fund management for more than 150 years. The problem was that the underlying drivers behind those flows were reflected in subsequent sales of bank and government debt, particularly when the bank or state was thought to be of poor credit quality. Of course, it was precisely those concerns that led to the withdrawals from the funds in the first place. The funds, as 'entities', were not in distress. Any distress was in bank or government funding, or in politicians’ egos, not in the funds themselves.
Shine a light on shadows
But, oddly, the bank supervisors appear not to have noticed that the major players in these transactions are the banks they supervise. So it turns out that 'shadow' banking was only in the shadows because the bank supervisors had their eyes firmly shut or they were looking in the wrong direction.
The FSB also complains about the lack of data. But this also is partly because, until recently, bank supervisors were only interested in balance sheets and asset quality, and they would refer sniffily to the conduct of business regulators. Recently, however, they have begun to notice that some of the largest losses that have arisen in banks, the fines due to money laundering, and the redress required for misselling and benchmark misbehaviour, have all resulted from poor conduct not poor assets. Bank supervisors need to pay much more attention to banks’ conduct of business, in markets in particular.
The lack of data does make examination of the case difficult. David Wright, the secretary-general of the International Organisation of Securities Commissions, has written: “Good policy-making requires sound, consistent and preferably real-time data. We would not dare run a nuclear power station, a high-speed train or a Dreamliner without full knowledge of every working part and how they interconnect. So why do we accept third-best knowledge for financial markets?”
The FSB needs a completely different framework for its important work, which recognises that the further sources of danger in the financial system may not be found in individual entities, but in complex interactions between entities that are difficult to map and even more difficult to measure. It would be most unwise to try to designate entities as NBNI GSIFIs until this mapping and measuring has been done. It would be even more unwise for bank regulators to reach for the only club in their bag, prudential capital, which is likely to be irrelevant to any dangers in the system and merely act as a tax on savers.
Above all, the FSB work, although ill-directed, makes it clear that financial stability requires safe banks, which is already in the remit of the bank supervisors. Unless there is radical change in the FSB mindset, its search for NBNI GSIFIs may face the same fate as the hunters of the snark.
Philip Warland is head of public policy at Fidelity Worldwide Investment. He previously worked at the Bank of England for more than 20 years. The views expressed here are entirely his own.
