How Regulators Are Making Finance More Fragile 1
Where things get really interesting, and much scarier, is how the post ‘08 regulatory and legislative environment has failed to take convexity into account.
Instead of working to reduce the impact of the financial system’s inherent short convexity position, the people in charge allowed them to continue.
Their solution was, and still is, to make banks, especially those deemed to be systemically important, “stronger” by holding more capital.
The regulatory response then went one step further and pushed standardized OTC (over the counter) derivatives to be cleared by central clearing houses.
But does this actually make the system stronger?
From the regulators’ current perspective, holding higher levels of capital means that these banks can weather economic/financial storms that they could not before. And this is true, the short lived nature of 2020’s Covid related financial turmoil has proved this.
However, and unfortunately for everyone else, this perspective is very limited.
It is limited because it doesn’t consider how creating ever larger entities with more capital also concentrates risks from all over the financial system into the same place.
Why is this important?
If a financial system is made up of many small and medium sized banks and a banking crisis occurs, a portion of these banks will become insolvent.
The clients of these banks will be badly affected, but the system as a whole will survive, simply because the economy’s savings and sources of lending (i.e. money creation) are spread out across a large number of banks.
This is in effect, diversifying systemic risk.
On the other hand, if there are only a handful of very large mega-banks and a severe enough banking crisis occurs, the system will immediately be on the brink of disaster.
This is because each of these mega-banks account for such a large percentage of the economy’s savings and loans that their failure instantly affects a wide swath of the population.
Moreover, given how everyone holds the (mis)perception that bigger banks are stronger banks, the failure of just one immediately calls into question the viability of the others (Paradigm shifts are powerful things).
Which is of course what happened in 2008 after Lehman’s fall.
Hence, the system where risk is centralized is perceived as stronger, but is actually more fragile and prone to massive negative feedback loops which exacerbate this fragility.
To be concluded…
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