Is The Financial System Any Safer Or Sounder 5 Years Later?

Includes: IYF, PFI, RWW, VFH, XLF
by: John M. Mason

There have been many articles written over the past two weeks examining the bankruptcy filing of Lehman Brothers, the financial collapse, and the Great Recession…all of which began, we are told, roughly five years ago.

The mood, I would say, is captured by the piece by Gretchen Morgenson in the Sunday New York Times, "Five Years Later, The Plumbing is Still Broken."

Notice that this is not a question… it is a declarative statement.

And, the key to Ms. Morgenson's concern is centered on one market… the repo market.

She writes that "for all the new regulations governing derivatives, mortgages and bank holding companies, a crucial vulnerability remains. It's found in our vast and opaque securities financing system, know as the repurchase obligation or repo markets. Now $4.6 trillion in size, it is where almost every financial crisis since the 1980s has begun. Little has been done, however, to reduce its risks."

The problem is that lending in this market can dry up almost immediately and it is highly interconnected and so can impact a large number of firms almost immediately.

But there are no deposits involved, so this market is not subject to the rules and regulation that apply to deposit-holding financial institutions.

Furthermore, this market, at its most fundamental level, is all electronic. In other words, Ms. Morgenson writes, "this is a $4.6 trillion arena operating on trust, which can disappear in an instant."

Right now, the main effort to impose some safety into this market is to raise capital requirements. Up till now, no regulatory body has required banks to set aside capital against the assets that they finance in the repo market. JPMorgan Chase (NYSE:JPM) has issued a report that "under the Basel proposal, the eight largest domestic banks would have to raise $28 billion to $34 billion in capital" to satisfy new requirements.

The alternative to raising the capital is to shrink the market. Ms. Morgenson responds: "the liquidity in this titanic market is essential for the government's financing of its debt. As the JPMorgan report noted, trading volumes in the United States government bond market are closely linked to the amount of repos outstanding. So any contraction in the arena may reduce liquidity in the Treasury market."

Even though the clearing of transactions in is dominated by prominent two "banking" organizations, Bank of New York Mellon and, "to a lesser degree" JPMorgan Chase, "the biggest participants that provide funding in this market are the money market mutual funds…."

Oh, no, we are back in the shadows of the "alternative financial institutions. Can't we ever get away from these "shadow" banks?

The answer to this is NO WE CAN'T get away from these "shadow" banks. Shadow banking is going to continue to grow… not shrink. And this is going to make it harder and harder for governments and regulators to regulate and control what is going on in all of the institutions that are gong to inhabit the financial world.

Banking and banking regulation has been based on the premise that financial institutions will offer deposits.

But what is a deposit? Suppose your money is in a money market fund. You write a check against your demand deposit that has no funds in it. Yet when your financial institution receives the check, it instantaneously transfers funds from your money market fund to your checking account, that had a zero balance in it, to cover the check the financial institution had just received.

Your checking account receives a electronic deposit and within a very short time the funds in the checking account are transferred to your money market fund.

How much money is accounted for in the checking account? Theoretically, the funds that are in these transaction accounts could be there only for… seconds!

Well, right now, people that keep their money in these accounts tend to be wealthier individuals. But as we have seen over and over, in area after area, the individuals included in these more advanced electronic venues grow in number. And this is not going to stop.

Think about how much more sophisticated larger businesses and financial organizations are. The repo markets are showing that many of these larger institutions do not need to keep much money in "deposits" at all. And the need to keep funds in deposits in the future is just going to continue to diminish.

So, conceptually, picture a world where there are no deposits in the financial system. Do we still have "liquidity" risk and "systemic" risk? The answer is yes. The reason is the one given above, lending in these "non-deposit" markets can dry up almost immediately… and the market is highly interconnected so a lot of companies can be impacted almost immediately.

Does this mean that the plumbing is "still broken?" Can this "liquidity" risk and "systemic" risk ever be reduced… or eliminated?

My answer to these two questions is no and no. This is a part of the risk of the financial system and given the computer technology that exists today, these risks can never be eliminated and will just be transferred elsewhere if the capital requirements or the regulatory requirements become too onerous.

A crucial requirement going forward is to increase the transparency and openness of what is being done. For one, you don't chase business into the hedge funds and non-bank financial institutions like what is happening in the case of many derivatives. (See my post "More Derivatives Trading Now in the Shadows.")

But governments also need to understand that when they create an environment of credit inflation that it forces financial institutions… and others… to increase their financial leverage, to increase their risk taking, to increase financing long-term assets with short-term liabilities, and to create more financial innovation.

Ms. Morgenson writes about "the firms had financed their holdings of illiquid and long-term assets-like mortgage securities and real estate-in the overnight repo markets. Not only was the repo borrowing low-cost, it also allowed them to leverage their operations." Furthermore, little capital was needed against the trades.

Credit inflation, especially if it has been carried on over a 40- or 50-year period, forces financial institutions to compete on the basis of risk-taking, not sound risk management. In this respect, we still have the government over-taxing the "plumbing system." More on this in coming weeks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.