Streetwise Professor warns that clearing and collateral mandates create a ‘sort of liquidity death star’ because collateral-based funding (through repo markets) creates systemic liqudity vulnerabilities: margining leads to spikes in demand for liquidity, that in turn forces sales in illiquid markets, with further price volatility and margining. The mechanics of fire-sales and liquidity illusions are well known to regulators since Lehman (read Tarullo here), though the solution – clearing houses – doesn’t do away with the problem since it increase reliance on collateral sourced through repo markets.

Two further points.

1. Central banks cannot fight the liquidity death star until they get off it. For a central bank to fight the liquidity death star, the Professor argues, it will need to ease collateral constraints by expanding the definition of ‘good’ collateral. This, of course, was the first measure that central banks across the world took after Lehman. But accepting ‘bad’ collateral won’t solve liquidity problems as long as central banks’ extraordinary lending relies on the same collateral practices that created (funding and market) liquidity problems in the first place.

Since the late 1980s, central banks have increasingly used repos to implement monetary policy, lending against collateral    instead of outright purchases of government bonds (the traditional form of open market operations). The turn to repos in monetary policy implementation prompted central banks to adopt the collateral risk management practices used by repo markets – the graph below shows that as the ECB took over from national central banks, it marked the beginning of a new regime for lender of last resort, where ECB marks collateral to market, and calls margin on a daily basis*.

Consider this scenario. When liquidity demand spikes and collateral constraints tighten, financial institutions turn to central banks. As good lenders of last resort seeing the death star approaching, central banks lend against ‘bad’ collateral.  But at the same time,  to protect themselves against credit risk, central banks mark-to-market and call margin if that ‘bad’ collateral falls in market price. Central bank margining means that a financial institution borrowing from the central bank against bad collateral faces the same funding pressures that it would experience in private funding markets.  This is exactly what happened to European banks during the sovereign debt crisis – with ECB making large margin calls at the height of the crisis in 2012.  The traditional crisis intervention – providing banks with funding liquidity – becomes pro-cyclical.

The money view – developed by Perry Mehrling and others – provides important insights. A crisis of market-based finance needs central banks to be much more than lender of last resort. As  dealers, or market-makers of last resort, central banks need to support the monetary quality of collateral-based liabilities, that is, to support (collateral) market liquidity. This is what OMTs did in Europe. A much messier world of central banking, as Mario Draghi well knows.

2. The repo ‘paradox’ – the growing post crisis collateral-based regulatory regime has not been matched by significant regulation of repo markets. At global level, the FSB has watered down plans to impose minimum (through the cycle) haircuts on all collateral – including government bonds. Latest plans leave out repos between banks and repos with government collateral. There is little left after that. In Europe, the Commission and Parliament have finally agreed on transparency requirements for repo markets, without any structural regulations. With the Capital Markets Union plans in full swing, transparency is as far as Europe will go.

Daniela Gabor

*for more on the ECB and the European repo market, read Gabor, D. and C. Ban (2015) Banking on bonds, Journal of Common Market Studies

Today, I attended a CMU event organised by Bruegel and HM Treasury at Westminster. The keynote address from the City Minister Harriet Baldwin was followed by a panel with market participants (the buy side – asset managers and insurers – and a credit rating agency), a Commission official and a Treasury official. The view from the government: UK a staunch supporter, celebrating the CMU as an excellent initiative of the type that Brussels and the EU should be generating more often. Having a UK Commissioner in charge of CMU clearly helps. Beyond the consensus ‘CMU is a good idea’ and between the lines, I noticed three issues.

1. ‘It is our strong belief that institutional change is not required to achieve the objectives of the CMU. Single supervision would not add anything’

This is one of the sensitive points in CMU, and a lot of energy spent in documents and meetings to pretends that’s not the case. Although the Commission and several member states (see the 5 presidents report) would prefer to create a supranational regulator for integrated capital markets, UK opposes it strongly. According to this view, ESMA – the candidate for a pan-European regulator – is best placed to ensure that national regulators implement supervision effectively. In the context of the Brexit referendum, ‘the last thing we need is institutional change’ captures well the British politics of the CMU.

Is there a danger that European states repeat the pre-crisis mistakes with cross-border banking? The banking crisis demonstrated that the prevailing regulatory nationalism  was ill suited to deal with the coordination issues between home and host regulators. Ask any Eastern European banking supervisor.

The pessimistic British response to this question points to the foot dragging on the institutional architecture of the Banking Union. The hesitations and compromises there are steadily eroding (market) confidence in the ability of European politicians to create strong pan-European regulatory bodies. The optimistic view is that supervisory convergence that harmonizes rules would be enough to put the CMU on strong foundations.

One of the panelists questioned the premise of the optimistic view that for a single market it is enough to have common rules (and I would add, a rather fuzzy notion of ‘convergence’). In accounting, the application of rules (international standards) is not uniform – the fragmented enforcement of rules effectively entrenches the type of cross-border barriers that CMU aims to remove. The Commission recognises the validity of this point but is prepared to put the question aside because it wishes to avoid politically divisive topics.

So instead of calibrating the regulatory architecture to integrated markets, CMU envisages as next step a comprehensive review of post-crisis regulation. Given the complaints from the industry on the post Lehman ‘regulatory tsunami’ (loud and clear at this event too), expect this ‘proportionate regulation’ agenda to accelerate the process of watering down regulation that is already unfolding.

Recall this argument when your UK pension fund with exposure to German SME securitisation takes a massive hit due to large defaults in a market illiquid during crisis. And pray that ECB has normalised ABS purchases.

2. ‘CMU will not harmonize borrowing costs for SMEs until there is a mechanism for rebalancing sovereign risks in Europe’

Market participants typically focus their CMU interventions either on deploring ‘regulatory tsunamis’ or identifying CMU areas that would improve synergies of their business model. In an unusual departure from the script, one panelist sought to make constructive criticisms. And it picked the elephant in the CMU room: government bond markets.

It is surely a measure of the creative genius of European regulatory politics that a project on furthering the integration of debt markets manages to say nothing about the largest debt markets in Europe (in Eurozone, EUR 6.8 trillion out of EUR 14 trillion outstanding in August 2015). Before Lehman and the sovereign debt crisis, the European agendas for financial integration used to stress the critical role that government bond markets play in financial markets, as proxy for risk-free interest rates, benchmark and hedging instrument for positions in other fixed income markets, and reserve ‘safe’ asset. The ECB made the integration of sovereign bond markets a priority, and used its lending collateral framework to accelerate it (by treating all Euro sovereigns as identical in terms of credit risk). The 2002 Collateral Directive was designed with the same ambition in mind – to allow private financial institutions to raise funding cross-border regardless of what sovereign collateral they use.

So can we have integrated capital markets with fragmented government bond markets? One of the panelists argued that  securitisation performance across countries reflects credit differences between sovereigns (the graph below, in a rather bad photo, mea culpa). So much for reviving the European securitisation market.

Yet the CMU authorities have tended to fudge this question because answers are as politically divisive as the issue of supranational regulator. If CMU was to make government bond markets a priority, what would concrete policy measures look like? Put differently, if CMU is about persuading German savers to give money to Portugese corporations without a bank in between*, what would it take to persuade that German saver to give money to the Portugese government? Or even more complicated, how much would a Portuguese SME need to pay a German saver to borrow when that saver is reluctant to lend to the Portuguese government?

Here the CMU official supporters answer the usual European way – not a priority to think about it.

3. ‘ As public policy makers we have to deal with competing objectives, and balance them carefully. The FTT / CMU is a good example’

Private finance agreed that the FTT plans are at odds with CMU. Putting the FTT genie back in the bottle has been a priority, particularly for the European banking lobby**.

Yet the FTT genie has proven more resilient than many expected. Recent statements suggest a new impetus to finish negotiations, as France independently decided to extend its own FTT to intraday trades. This raises interesting questions of coordination between DG FISMA, that is designing CMU, and DG Taxud, that designed and (still) defends the FTT in the working groups of the 11 member states. The best that the former can do is to follow negotiations closely and ensure that member states are aware that the tax should minimize impact on market liquidity and NEVER EVER include the repo market.

The repo market has always enjoyed a privileged position in the minds of European regulators – particularly the ECB***. The Green Paper on CMU made some oblique references to it, stressing the importance of collateral fluidity to ensure that securitization activities can be funded in cross-border repo markets. ‘Fluid’ collateral appeals to the pre-crisis image of the repo market as an engine for financial integration that led European regulators to endorse the creation of a market architecture governed entirely by private rules. Since the crisis, we know that private architectures creates systemic vulnerabilities – this is why the FSB has identified repo markets as markets systemic to shadow banking. Yet so far the only reform European regulators are prepared to contemplate has been increased transparency of repo transactions, despite warnings from the ECB that ‘The interaction between CMU and shadow banking reform needs to be addressed. This interaction is not addressed in the Commission’s Green Paper, but it is relevant.’

The priority remains funding for SMEs. Repo, shadow banking, government bonds, and supranational regulation, are not a priority of CMU. The art of political compromise in Europe rests precisely on that ability to postpone critical questions. If we try very hard to ignore these questions they may go away.

* best translation I’ve heard of the CMU ambitions.

** the EBF response to the CMU Action Plan stresses that ‘ If European lawmakers are indeed serious about CMU, they also need to recognise the importance of liquidity in financial markets. Proposals such as the Financial Transaction Tax (FTT) and Bank Structural Reform (BSR) are at odds with the objectives of CMU. Dropping these proposals will greatly enhance the chances of success for CMU’.

*** for those interested in the FTT on repo markets, you can read more here: A step too far? The European FTT on shadow banking. Journal of European Public Policy 

Daniela Gabor

Last week, the European Commission launched its Action Plan for a European Capital Markets Union (CMU). By European standards, this ‘most significant EU proposal for the last 10 years’ has proceeded at rapid pace under the leadership of the British Commissioner Lord Hill. For those attuned to the complexities of European politics, the CMU is a peace offering from Brussels (Berlin/Frankfurt) designed to showcase the strategic benefits that UK (and its City) enjoys from EU membership. Its (referendum) politics aside, the CMU’s ambitions are great: SME financing and job creation, growth via capital markets. Yet, we argue, if the CMU is to make a substantial and lasting contribution to investment and job creation in Europe, it must be accompanied by reforms that address systemic risk in securities-based financial systems and enhance pan-European supervision of securitization and repo markets.

The crisis of European banking after the collapse of Lehman was a crisis of market-based banking. European banks engaged in structured finance and other off-balance sheet activities were threatened by insolvency in 2008, leading to significant bail-out costs for European sovereigns. According to IMF research, 18 out of the 25 TBTF European banks vulnerable due to their trading activities required bailouts after 2008.  Since, as the IMF put it, ‘the vast majority of global finance is intermediated by a handful of large, complex financial institutions’,  initial regulatory efforts focused on reforming banks that had migrated to leveraged, interconnected, market-based activities. This also involved – through the FSB – global initiatives to curtail banks’ involvement in shadow banking, particularly in securitization and repo markets.

In this context, it is remarkable to see the growing consensus that growth in Europe requires more market-based finance. The European Commission makes the following case:  banks are still repairing balance sheets, new regulatory regimes increase their costs, making lending – to SMEs and other businesses – expensive. Allowing banks to engage more in capital market lending via securitisation, and to fund it in short-term money markets, would improve lending conditions in Europe, restarting growth. Those familiar with Perry Mehrling and Zoltan Pozsar’s work will recognise this ‘money market funding of capital market lending‘ as shadow banking.

Ironically, all evidence suggests that a Capital Markets Union is unlikely to improve SME financing. It’s unclear how much European SMEs are constrained not by limited access to finance, but by shortage of customers (i.e, demand). Stefanie Schulte, from RWGV, a German cooperative banks association, argues that even in the United States, the country upheld by the Commission as the model country in terms of capital markets, SME loan securitization is small and supported by public guarantees.  Here in Europe, when Germany recently tried to help SMEs issue bonds, the result was a wave of defaults and insolvencies. That experience suggests that the policy goal should not be to to reduce SME’s reliance on bank lending, but to nurture competitive and viable relationship banking. The argument of an over banked Europe compared to US is also bogus, Schulte argues:

   U.S. Federal Deposit Insurance Corporation (FDIC) counts more than 6400 credit institutions, among them thousands of small, privately owned, regionally active community banks. Community banks provide almost half of all small business loans in the U.S. In addition to this, there are more than 6000 credit unions. Per 1 million citizens, there are more than 40 banks and credit unions in the U.S. Now compare this to Europe: Here, Germany is one of the few countries with a relatively high density of banks. There are nearly 23 banks, credit cooperatives and savings banks per 1 million [German] citizens.

Four issues are essential to address for a sustainable CMU:

First, it is of paramount importance that key principles of “good securitisation” are not watered-down through pressure from large, international banks. Insisting that banks have a “skin in the game” is meant to avoid the perverse incentives that led to the global financial crisis. At the levels discussed now, however, risk retention requirements are too small to matter. Similarly, ongoing industry pressure to include synthetic forms of securitization in the CMU framework completely undermines the key notion of “simple” securitisation. The current ambiguity on whether to allow tranching in the forms of securitisation that are to be deemed ‘high quality’ also severely undermines the notion of simple and transparent securitization – since tranching by its very nature renders securitized products complex and opaque. A sustainable CMU must stand firm on the core principles – allowing only truly simple securitization in the framework, and insisting on substantial risk retention on the part of issuers. If it does not, it risks undermining rather than enhancing prosperity and growth in Europe.

Second, the CMU is likely to further increase the systemic importance of large banks in capital markets. Until recently, regulators in Europe were contemplating banking separation reforms to address the problem of too-big-to-fail banks. With the CMU, TBTF banks are likely to become larger still, as they will play key roles in reviving securitisation as issuers and market-makers. For their market-making activities, banks rely on collateralized funding markets, where borrowing against collateral makes leverage cheapest. So when the CMU speaks of the importance of “collateral fluidity”, it is essentially saying that we should ensure that collateral based funding for large banks remains unregulated although there is compelling evidence since the global financial crisis that banks run on each other in wholesale funding markets. Two implications result from this: (1) the sustainable CMU must abandon the notion of “freely flowing” collateral, instead adopting the (already watered down) minimum haircut requirements framework developed by the FSB and (2) serious banking separation reform must be pursued in parallel.

Third, regulators should take note that national supervisory regimes for capital markets are neither converging nor consistent. A pan-European agency that regulates European capital markets directly will be necessary to mitigate the cross-border nature of systemic risk in integrated capital markets, just as the Banking Union proved indispensable to adequately supervise large, cross-border European banks. Integrated capital markets are still vulnerable to sudden shifts in market liquidity, as the global financial crisis demonstrated that even very large markets can see liquidity evaporating rapidly. Without a pan-European regulator that can take countercyclical measures, it is difficult to see how systemic risks arising from European capital markets could be effectively addressed. An institutions-based regulatory regime – the one we have been building since 2008 – is ill suited to address (capital) market fragilities. A sustainable CMU must recognize that integrated capital markets cannot have segmented regulation.

Fourth, the action plan unveiled last week promotes a private Capital Markets Union. While the Commission has been reluctant to spell out the implications for government bond markets, it is important to recognize that the cornerstone of financial systems, government bond markets, have been (further) segmented by first the banking and then the sovereign debt crisis. Recent improvements are mainly due to the ECB’s quantitative easing (QE) and OMT commitments. Yet such unconventional monetary policies are designed to be temporary, while Europe has seen growing pressures for revisiting the preferential regulatory treatment of government bonds. Alberto Giovannini, one of the early architects of the European financial architecture, reminds us that ‘a very large proportion of the securities-based financial system requires means of transactions, and riskless government securities are best candidates’. How can capital markets function without risk-free sovereigns? Credit ratings and market liquidity will matter even more, thus sharpening the existing asymmetries between ‘periphery’ and ‘core’ (read Germany) governments.  Since the latter are more inclined to run budget surpluses, the second answer is exactly what brought us the 2008 crisis of shadow banking: private sector takes over the provision of ‘safe assets’.  A sustainable CMU should aim to eradicate existing asymmetries in market liquidity so that integrated government bond markets support the convergence in the costs of market funding for businesses across Europe.

Daniela Gabor and Jakob Vestergaard

The essay is based on ongoing joint work. We are grateful for comments from Vincenzo Bavoso and Frédéric Hache.