Belmont Club

Eve of Destruction 2

How much of the risk to the financial system came from well-regulated Europe? Not intentionally, but lurking within the hidden parts of the system, from interactions that nobody understood. Brad Setser from the Council of Foreign Relations describes a shadow financial system domiciled in London, a shadow system which posed hidden risks which are only now fully coming to light.

Gordon Brown wants to shine a bit more light on the shadow financial system (hat tip IPEZone). One plank of his G-20 action plan is:

“reform of international regulation to close regulatory gaps so shadow banking systems have nowhere to hide”

It isn’t exactly clear though why Brown needs the cooperation of the other members of the G-20 to do increase transparency here: an awful lot of the shadow financial system is based in the UK. If the UK collected the kind of detailed data that the US collects in the TIC, a large part of the shadow financial system would either emerge from the shadows or a lot of banks – and bankers – would need to migrate. And given how much trouble has emerged from the shadows, a bit more transparency about what goes on in the UK might have helped the world’s regulators (and the IMF) do a better job of providing a bit more “early warning” of budding problems.

Think of the various less-than-transparent actors that have set up shop in London

– Many sovereign wealth funds.
– A lot of the SIVs set up by US (and European) banks were legally domiciled in the UK
– Some credit hedge funds
– And most importantly, a host of European banks with large dollar books (think of them as badly regulated credit hedge funds) ran a large part of the dollar exposure through London.

There was a reason, after all, why residents in the UK were the largest purchaser of US corporate debt over the past few years. Corporate debt – in the US balance of payments data – includes asset-backed securities. Foreign purchases of such debt soared – especially from 2004 to 2007 – before falling off a cliff during the crisis.

Three recent papers – one from the Bank of Spain and two in the latest BIS quarterly – have shed a bit of light on the true nature of the all the flows through the UK over the past few years. Had there been an international “early warning” system that was on the ball – and had the UK been willing to collect the data on flows through the UK in the face of inevitable complaints that such efforts would drive business abroad – it might well have picked up on some of these flows as a sign of brewing trouble in global financial market

The absence of easily accessible information concealed the scale of two things. The first was the extent to which US credit originated from abroad. Second, the degree to which overseas financial institutions were dependent on access to US dollars. To some extent one was simply the dual of the other. Setser writes:

It is notable, at least to me, that the regulators focused on the risk Lehman’s failure posed to the CDS market but not – at least from what has been reported – on the risk that Lehman’s failure posed to the money markets, and thus to all the institutions that relied on the money markets for financing. This suggests to me that the regulators didn’t fully understand the role European banks were playing in US credit markets – or how exactly they funded their positions – until the crisis made their funding needs acute. I suspect that it took the crisis for the researchers at the BIS to be able to figure out how to use the BIS data to estimate European banks need for wholesale dollar funding.

It might be argued that if more information had been available then markets might have spotted the problem sooner. I’m not sure that more bureaucracy will necessary put greater amounts of it in view. After all, the Europeans didn’t see it coming either so making the US like Europe may be a good idea, but on a case-to-case basis, not on general principles. The proposals have to stand on their merit. Information is different from data. The market is the biggest self-regulator of all, if it has the information to hand. The investors have a self-interest in not losing their shirts. If they see danger coming they will be the first to avoid it. If they see it. Because there’s all kinds of information out there that is unreachable they don’t always see it. Consider an analogous information structure: the Deep Web. It is the case that most of the information that is theoretically available is in practice, out of reach. The bulk of the information that is potentially available over networks is either dynamically generated, behind security walls or is unindexed. Google only scrapes the surface. Indeed, much information is beyond the reach of indexing spiders. There are vast streams of information out there which we don’t even know we have. We possess more data than we can grasp and as a result, there are surprises beneath the dark current of bits. The financial systems reached the limits of its information span last year by walking off a cliff they didn’t see. And the trick is to see the next cliff. What steps will create more information out of the data instead of more walls, more partitions, more black boxes?

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