"Hitherto underappreciated mismatches"

I read Ms. Gillian Tett’s article in FT titled, ‘Toilet rolls and Treasury bonds tell the same panicked story’. What follows is a slightly expanded and modified version of the comments I had posted on the article. My comment is being moderated and has not yet appeared on the FT site.

The all-important lines in her article are these:

First, the sheer violence of the price moves suggests that asset managers have amassed leverage and maturity mismatches that are much bigger than hitherto appreciated. Current watchdogs should hang their heads in shame, given the lessons of 2008, as the Systemic Risk Council, made up of former regulators, notes.

Time and again, this is going to come up. In 2008, policymakers had no idea of the extent of sub-prime mortgages issued and of their securitisation. Now, they have contented themselves and patted themselves on their backs that banks are stronger and recapitalised (apparently!). Again, that is bolting the door after the horse had fled. It is a response to the last crisis. Banks are stronger again because, this time, they have transferred the risk to non-financial corporate borrowers who have leveraged themselves substantially since 2008. They are to be found both in advanced and in emerging economies.

Second, they have provided leverage to asset managers who have amassed mismatches as Ms. Tett notes.

It is one thing to blame the so-called regulatory (or, macroprudential) watchdogs. It is another thing to identify and call out the root cause of the problem AND that is the monetary policy of central banks of advanced nations, principally, ECB, BoJ, BoE, SNB, PBoC and FRB. Not in any particular order. All are egregiously guilty of ‘too easy for too long’ policy. That is what has almost near-totally blunted their effectiveness now and yet, they are going to double-down with MMT and with much more adventerous measures, unprecedented in nature and with un-anticipate-able consequences. See her words, ‘hitherto unappreciated’. That will repeat itself again.

Debt is not accumulated until it is made too cheap to do so. Period. Regulatory or macroprudential policies will not help in the face of policies that.

She had provided a link to the statement released by the ‘Systemic Risk Council’ (SRC). Apparently, the CFA Institute is now fully supporting this body of former global policymakers and academics. I do not see any name from emerging economies. In any case, that is not a priority now.

The Systemic Risk Council (SRC) has released a lengthy statement on 19th March 2020. You can find it here. In the current context, it is hard to fault SRC’s statement. Now that there is a deluge, it is not the time to be talking about what caused it but it is time to fix it.

The good thing is that comunication talks about what to do after the immediate crisis dissipates:

For all their interventions, governments and central banks should incorporate into their design incentives for smooth exit when conditions permit. That is as important for forbearance in banking supervision as it is for central banks’ market support measures, and government subsidies and guarantees.

That is good. But, no mention of what is principally behind all the massive dislocation that is happening in financial markets which distract the authorities from focusing on the real economy – small and medium businesses and households. 

Jeremy Stein who joined the SRC in January 2020 had said the following in a speech in Feb. 2013:

In spite of the caveats I just described, I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability. Let me offer three observations in support of this perspective.

First, despite much recent progress, supervisory and regulatory tools  remain imperfect in their ability to promptly address many sorts of financial stability concerns. If the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behavior. This, of course, is not to say that we should not try to do our best with these tools–we absolutely should. But we should also be realistic about their limitations. These limitations arise because of the inherent fallibility of the tools in a world of regulatory arbitrage; because the scope of our regulatory authority does not extend equally to all parts of the financial system; and because risk-taking  naturally tends to be structured in a nontransparent way that can make it  hard to recognize. In some cases, regulatory tools may also be difficult to  adjust on a timely basis–if, for example, doing so requires extended interagency negotiation.

Second, while monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation– namely that it gets in all of the cracks. The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose ABCP vehicle have in common is that they all face the same set of market interest rates. To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot. [Link]

This is the point that SRC misses in its opening paragraphs of its communication. It had expressed concern over “steps taken to reduce equity and liquidity requirements in banking” and urged “greater vigilance over leverage and liquidity mismatches in shadow banking and trading markets.

That is all fine and dandy. But, what is the root cause of these two issues that the SRC is concerned about? It is to be found in Jeremy Stein’s remarks pasted above. That is misisng from SRC’s concerns. That should be on top of their list.

Equally, that is why it is rather disappointing that Ms. Tett’s solutions are precisely those that would aggravate the issue and not end them. Paul Tucker’s suggestion that the central banks buy ‘toilet rolls’ too or lend against them will build up leverage again. These asset managers with ‘leverage and maturity mismatches’ will be emboldened to do more of the same because the central banks have their backs with even more unconventional measures.  Classic and humongous moral hazard. Paul Tucker’s solution which Ms. Tett channelises will achieve exactly that!!

Second and more importantly, Ms. Tett is guilty of not identifying and calling out this principal source of the problem – monetary policies of the post-2008 era and, more generally, the monetary policy framework in place since Mr. Greenspan became the Governor of the Federal Reserve Board in 1987.

By all indications, they are going to be at it (rinse, lather and repeat) until they truly bust the world. It is unfortunate that even some perceptive and erudite observers and commentators like Ms. Tett become willing or unwitting accomplices to this massive and reckless policy experiment. A century or even half a century from now, some historians would consider if the ‘too easy for too long’ policies were ‘crimes against humanity’.

2 thoughts on “"Hitherto underappreciated mismatches"

  1. The points are now centred around what the package is, and what it proposed to do for the people, companies, economy,etc. The measures are unprecedented and a step towards a Japanese style underwriting of risks to Banks and other balance sheets.
    Once the Fed is seen as an institution that can be bullied, and with such precedents and their inability to actually dial down extraordinary measures, what does it leave use with.
    We are seeing monetary debasement? As a long term investor, where do we then hide?


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