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Most of the time, innovations can be good. Other times, they have unintended side effects. This is especially true of financial innovations. Paul Volcker famously said that the banking's greatest innovation was the ATM.

I've never been an investment banker, but I was a research analyst once upon a time. (Yes, Virginia - Chinese walls do exist.) I do know enough about investment banking to know that it can be a very creative job. You spend a lot of time thinking of creative and innovative ways to get around regulations in order to get the deal done. That's how financial innovations get engineered.

Disintermediation in China

Here are a couple of examples of financial innovations that are not likely to end well. The Chinese authorities have been taking active steps to rein in bank lending by raising reserve ratios and interest rates. Recently, we have seen examples of disintermediation in China as a way of getting around restrictions on banking regulation. Patrick Chovanec explains:

According to Caixin, Chinese banks — limited in their ability to lend by China’s efforts to rein in inflation — have introduced a dizzying array of “private wealth management” (PWM) products aimed at higher-income investors.

These products are a way of getting around banking regulation by matching lenders with borrowers:

Why are Chinese banks suddenly so active in selling these products? One possibility is that they are simply an end-run around high reserve requirements. Instead of struggling to gather deposits (at less and less attractive interest rates) and then setting aside 21.5% as cash reserves before lending the rest out, banks can promise high interest rates and channel the whole amount directly into lending, collecting a fee instead of a spread.

The other possibility is that PWM funds provide a way for banks to shift growing lending risks onto customers. Rather than underwriting loans, they’re playing matchmaker. In some cases, critics fear, banks may have a conflict of interest, and may actually be shifting not just risk but known losses onto naive investors. For instance, if bank helps a local government sell bonds in order to repay its troubled bank debt, it can offload its problem debts onto its clients.

Tracy Alloway at FT Alphaville wrote that Chinese companies are also getting into the act. She quotes a Standard Chartered research report:

In City X, something slightly different is happening, which we suspect is being repeated in cities across the country. We found that a couple of large local state-owned firms whose main business was not finance are now expanding into operating guarantee companies, pawnshops, trusts, etc. We surmise that they are doing so with the support of large surplus cash earned by the group’s (often monopoly) activities, or with funds easily borrowed by the parent group from friendly banks. It appeared that at least some of their business was based on their ability to borrow funds at 7-8%, and then on-lend at rates of 20-30%, arbitraging the dual-interest rate environment. They would also in theory be free to funnel funds borrowed for one purpose into, say, real estate.

We find this disturbing for a number of reasons:

  • The state already dominates much of the financial sector, but areas like GCs and small loan companies open a window to private-sector activity. Local SOEs now look set to dominate these new parts of the financial sector too.
  • Such platforms combine industrial and financial functions within the same group. This introduces new risks, since it facilitates fund flows that fall outside of regulators’ monitoring. It also adds a new transmission mechanism for bad credit problems to spread through the economy.
  • These platforms also broaden the scope for corruption at firms with low levels of government oversight.

There are times when government regulation inhibits economic activity. At other times, they are meant to minimize systemic risk by avoiding the moral hazard problem. This is one of the instances of the latter. Chovanec commented that disintermediation can makes the system more opaque. If this unravels, then how do you unscramble an omelette?

The most alarming part of the story, however, is how banks have been rolling over and pooling short-term, high-return funds in a way that makes it very difficult to trace how, exactly, investors are being paid off.

If this blows up, some people are going to get bullets in the backs of their heads.

The collateral swap

Another example of financial innovation is the collateral swap. Izabella Kaminska of FT Alphaville explains the mechanics [emphasis added]:

A collateral swap is essentially a form of secured lending whereby one counterparty transfers relatively liquid assets to another in exchange for a pledge of less liquid collateral. In a typical collateral swap, a bank holding a portfolio of ABS or other securitizations will transfer these assets to a pension fund or insurance company which, in exchange for a periodic fee, will deliver a portfolio of more liquid collateral such as high-grade government or corporate bonds.

The pension fund or insurer thereby receives a higher yield on its (ostensibly) safe investments, while the bank obtains access to a portfolio of liquid assets which it can then re-pledge to obtain funding from central banks and other sources which, in the wake of the GFC, have been less willing to accept ABS and other securitizations as eligible collateral. The development of collateral swaps is thus, in effect, an innovative response to both the post-crisis funding constraints on banks and the need to satisfy new liquidity requirements soon to be imposed under Basel III.

The immediate benefit to the investor (pension fund, insurer, etc.) is a higher yield on its investments. It's fully collateralized, right??? The bank gets higher quality paper to satisfy Basel III requirements and, in the event of a liquidity squeeze, to pledge to a central bank such as the ECB or BoE.

Everybody wins! Right?

The Ray DeVoe quip still applies today, "More money has been lost reaching for yield than at the point of a gun." Here are the risks:

Collateral swaps contribute to the complexity of modern financial markets in at least three ways. First, the collateral swap market is extremely opaque. Nobody knows with any certainty, for example, how big this market is, who the major players are, or the size of the aggregate exposures. As a result, it is exceedingly difficult to ascertain the nature and extent of the attendant risks. Second, given the identity of the counterparties, collateral swaps seem destined to strengthen the interconnections between (1) banking markets and (2) insurance and pension markets. Finally, as described above, collateral swaps are a reflexive response to changes in the post-crisis market and regulatory environment.

An accident waiting to happen

Given the heightened level of systemic risk in the financial system, these developments can only be viewed as disturbing. In my first example of disintermediation in China, it suggests that a shadow banking system is forming in China and control of the banking system is slipping away from the Chinese authorities.

In the second case, it suggests that a number of institutions could get hurt should a banking crisis erupt in Europe. They will have to read the legal language of those swap agreements very, very carefully in order to limit their exposure.

Something tells me that this isn't going to end well. This is one of those times when the markets really needs some adult supervision and we can't all walk around with the attitude that risk management is for pu**ies.

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Source: Some Financial Innovations That Aren't Going To End Well