Committees, Central Banks & Clouds

In the wake of the '08 global crisis, the role of financial stability committees (FSCs) became more important than ever.  The majority of regulatory solutions-based dialogue today tends to revolve around central banks, and macroprudential policies.  The Brookings Institution is one such FSC entity that convenes to implement these tools offered by the macroprudential toolkit.  But what exactly are these macroprudential tools?

Basically in a nutshell, it's nothing extremely new or novel.  It first came about in the 1970s, but under a different name.  By focusing on things like removing unnecessary restraints to credit growth, boosting credit supply, and building up buffers to protect the financial cycle from banks (and vice versa,) it looks at macro-economic policy measures to keep the whole financial system stable, rather than individual institutions or specific capital ratio requirements for types of institutions (as the '08 crisis proved these could be loop-holed around.  As a "school of thought," this perspective on reducing risk by keeping stability has been endorsed and embraced by the IMF, World Bank, key central banks, and powerful think-tanks.

However, there's a growing number of critics who say that these macroprudential tools are insufficient to ensure financial stability in the global market.

Indeed, the World Bank has confirmed its adjusted global economic forecast indicates growth slowing down to 2.9%, citing weaker investment and trade.  The IMF's forecast is 3.5%, so slightly higher, but they anticipate they'll have to make more downward corrections.

⛈🌤   STORM CLOUDS BREWING   🌧🌦

Leverage ratios for everyone from homeowners to businesses will be important to watch.  Manufacturing, production, and services can all be negatively impacted by trade disputes (notably U.S. and China) and governmental fractures (like Brexit, Venezuela).  These can cause capital flights where investors quickly pull money from areas they deem too risky, poking holes in the infallibility of the macroprudential approach.  

Digital currencies issued directly by central banks have the intention of keeping major means-of-exchange within protected regulation; yet they might have the unintended consequences of hiking interest rates as a result of liquidity shortages.

In the United States, discussions are currently going away from Monetary Policy as seen with Chairman Powell's testimony in U.S. Congress.  Check out this video on macro-policy talks in the U.S. from Wednesday:

What (non)Banks do in the Shadows and the Regulatory Climate of (in)Stability

The term shadow banking is loosely used to describe financial activities that go very lightly regulated, if at all.  Let's not forget that it can include unregulated activities being conducted by regulated entities.  But part of the trouble is that everyone's definitions are different.

One group of researchers who published a piece in the Journal of Financial Economics defines 'shadow banking' as, "credit intermediation involving activities outside of the traditional banking system."

It carries a very loose and ambiguous connotation, which is something many politicians love: a blanket Boogeyman label that can be tossed out to blame for criminal negligence and regulatory failures.  It's much easier to blame a poorly defined and ill-regulated concept than to name names and criminally prosecute or indict people (see my post on Accountability as the Hot Potato nobody wants to touch.)

But regulators have the tough position of writing and enforcing the laws around that phrase...

Evidence from China suggests that entrusted loans (lending from non-bank creditors such as commercial companies) were the largest component of the shadow banking sector up until 2014, when China's largest shadow-banking component became WMPs (wealth management products.)  As a measurable segment of the Chinese economy, shadow-banking made up about 82% of China's GDP by the first half of 2016.  This is tremendously difficult to wrap one's head around, but when you consider the relationship that PBoC has with borrowers as a lending agency, the rise in non-bank borrowing makes total sense.

China loans - TSF: PBOC data for Jan showed first increase in shadow banking in 11mths -

Bberg pic.twitter.com/XhV3ygRdoJ

— EMgist 🗣I.O.U-kinda-M.O.U (@EMgist) February 22, 2019

Meanwhile in Europe, regulators have seen what's been happening in China and other countries with large segments of unregulated lenders, and are trying to get ahead of the curve.  ECB policymaker Hernandez de Cos said earlier today (26 Feb. 2019) that Europe needs to implement Pan-European banks to consolidate the lending power of institutions.

European Central Banker Hernandez de Cos; (image credit: Bloomberg, LP)

By doing this, the hope is that regulatory oversight will operate much more smoothly and provide the Euro area with greater stability.

Over in the U.S., regulators have shifted their understanding of the definition itself, effectively creating a legislative delay, and (for the time-being) gave large amounts of discretion to various agencies as to how they choose to investigate and prosecute.  The U.S. Federal Reserve last year produced a compelling report that drew an empirical parallel between shadow banking and its source.  It's a nail-biting thriller of a read, but spoiler alert: undercapitalized banks (especially ones subject to higher capital requirements) have a tendency to reallocate credit to partner non-banks, which they describe as a risk transfer maneuver.  Because regulators squeezed banks so tightly with policies and capital requirements after the '08 crisis, lenders that weren't subject to those rules came in to sweep up.

What does all of this tell us?  First, internationally uniform language needs to be agreed-upon between major, developed economies with the stipulation that smaller (and as a generalisation, more vulnerable to corruption) governments must follow suit.  This sets the stage for an enforceable platform of regulations so that violators of these policies aren't playing the banking cartel equivalent of Whack-a-Mole by jetting off to the next least-regulated place on the map.  This is at least someplace reasonable that regulators can start.

Also, sharing information across borders and between agencies is critical for authorities, and current levels of info-sharing are poor at best (though they have improved from pre-2008 levels.)

Last, any institution that lends out capital beyond the capital-ratio capacity of banks should be required to obtain a loan-default guarantee from their sponsor-bank where the credit spillover originated.  This keeps a continuity in accountability where there is currently a shadowy gap, and while does not eradicate the dangerously high endemic risk posed by this issue, it does tie some liability to institutions that currently roam unaccountable.

The "Hot Potato" That is Fiscal Accountability

"Passing the Hot Potato"

In terms of accountability, very often frustration is expressed with the low levels of responsible persons answering for their negligence (or active involvement in a crime).  This applies to frustrated and unanswerable persons in both the government and corporate sectors.

The matter of handling these tasks properly in the future cannot be addressed without considering the historical track-record of how successfully past regulations have held responsible persons' feet to the proverbial fire and serving appropriate levels of fairness and justice. 

Here are the most prominent things being said about potential red-flag accountability issues that need to be handled, and soon.

1. Tax negligence needs to be spot-checked with scrutiny, system-wide.  Vast amounts of tax revenues are lost along the whole filing process (Todres, 2014).  Between late filing, non-filing, negligent preparation, and deliberate tax fraud, the existing tax code should be producing much more money that it does.
2. Public benefit programs such as housing financing for the elderly is taking on increasing demand, as many developed economies face aging populations.  This is a concern that government treasuries and regulators have largely not dealt with yet, and if unaddressed, could haunt more than just their career (Ng, et. al., 2018).
3. The relationship between government guarantees for corporate accounting needs to be articulated with far more clarity and transparency than it is.  Details on where within government budgets the provisions come from are frequently non-existent on national accounts and barely discernible on corporate financial documents (Heald & Hodges, 2018).  In the UK this is seen to be the case, but has been submerged beneath the cacophony of Brexit coverage. I would argue that with Brexit on the horizon, now more than ever is the time to be talking about government & corporate tax regulations.  As its own concern, it presents many large-scale dilemmas that could affect aggregate small business, equity markets, currency exchange rate stability, and believe it or not there's even national security implications here.
4. Credit markets need regulatory guidelines that don't exist, specifically for micro-lending institutions (which often end up being subsidiaries of much larger companies) like Rocket Mortgage.  But credit crises could swell up from a number of places, so take your pick.  Student debt in the US, automobile financing, pay-day loan houses, car-title loan shops, all of these lending sources have one frightening thing in common: regulators have no detailed and realistic plan in place for quelling potential credit shocks (Linarelli, 2018).

The status quo has been to pass the hot potato of responsibility because nobody wants to take the heat or get burned for people losing money.  It's time for regulators to scrap the strategy of turning a blind eye, and to clearly explain that which is shrouded in the obscurity of occult ambiguity.

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Reference List

Heald, D., & Hodges, R. (2018). Accounting for government guarantees: perspectives on fiscal transparency from four modes of accounting. Accounting and Business Research, 48(7), 782-804.

Linarelli, J. (2018). Debt in just societies: A general framework for regulating credit. Regulation & Governance.

Ng, A. W., Leung, T. C., & Tsang, A. K. T. (2018). Social Enterprise for Elderly Housing: Policy for Accountability and Public-Private Responsible Financing. Journal of Population Ageing, 1-20.

Todres, J. L. (2014). Bad Tax Shelters-Accountability or the Lack Thereof: Ten Years of Tax Malpractice. Baylor L. Rev., 66, 602.

The Wealth Tax Divide

Up to this point there have been many who argued on both sides of this debate.  Interestingly, there are now indicators that point to culture and geography as primary determinants of which side of the wealth tax "fence" someone places himself or herself.  Here are the basic arguments:

In Favor of Net Wealth Tax

• World Inequality Report projects that if current trends continue, the top 0.1% will own more of the world's wealth than the entire global middle class by 2050.
• Most wealthy nations have up to six or seven times the annual national income held in private wealth.  Figure 1.1 credit to FT:
  
• The tax burden is shifted away from productive investors and toward unproductive investors who sit on their fortunes.  Thus, gross capital is increased in productivity by incentivising higher returns for the investing class, and taxing overall lower return capital

Against the Net Wealth Tax

• The World Inequality Report's projections are unreliable because their own report cites deficiencies in available wealth data.
• As Karl Marx would have wished, a net wealth tax ultimately subsidizes economic lethargy by punishing those who carry the largest cost and liability burdens.
• Wealth tax codes are tethered to fixed locations on a map.  By hiking a wealth tax in one place, it only incentivizes the wealthy to evacuate and take their capital elsewhere.  In essence, it creates a massive capital vacuum, and an exodus of economic potential.
• Most reports that focus on inequality between wealth classes almost always neglect to report the corresponding levels of economic mobility.  So while in the United States wealth inequality has been increasing over the past decade, so too has the potential for "lower" classes to travel up the ladder into higher circles of wealth.
• Governments are replete with historical evidence of their ineptitude for smart spending.  On the other hand, there's nothing to say that if governments indeed taxed their fill of the wealthy class that their budgetary departments wouldn't just blow it anyway. 

Regulators need to be thinking about these issues going into 2019.  What is economic fairness?  Who is better-suited to mobilize capital efficiently?  Readers, what do you think?

Regulatory Macro-Themes for 2019

During the build-up to 2019, both markets and banks have seen history-in-the-making level changes in several key areas.  I've compiled a list of the top three macro-scale themes on this year's agenda for financial regulators around the world:


Crypto-regulation:

Oversight committees and regulatory bodies are struggling to keep pace with the day-to-day changes in the crypto space.  Last September, a panel of industry experts suggested that smaller governments (like Malta and Estonia) are quickly and efficiently facilitating digital processes to oversee crypto transactions and investments; while larger governments (most notably the United States with its Regulation D) are lagging behind.  In the UK, The FCA (Financial Conduct Authority) has only recently begun discussions to decide which cryptocurrencies should be regulated, and in which ways.  Developments in this segment includes the rapid expansion into crypto tools like security tokens, utility tokens, and ICO's which are akin to crypto-crowdfunding; additional info on these here.

Central Banking Policy: 

World leaders meeting in Davos, Switzerland are discussing ways for central banks to manage post-crisis monetary policy.  2019 will most likely be a year of fiscal tightening in developed economies, applying pressure to borrowing costs and upward inflation.  A World Bank report indicates the world's major central banks are discontinuing the QE lending practices, and trade conflicts between major economies could escalate, both of these causing the outlook for global economic growth to taper down:

Anti-Money Laundering & Anti-Terrorism Financing: 

There is a a litany of evidence to suggest that increased legislation and budget toward AML and CFT to not have any notably effect on battling the amount of crimes being committed in money laundering and terrorism financing; one paper suggests this is primarily due to lack of cross-border information sharing.  Ultimately, regulators need to get creative because the existing strategy is not working.  Empirical case evidence even shows that the biggest private banks (who ironically have the most oversight coverage) have the largest concentration of these crimes.  The manner in which regulators choose to tackle this area in 2019 will either signal an era of punitive accountability, or it will do very little to deter these crimes.  You can check out the European Commission's policy page on AML here.