Solvency, Prudence, Market Regulations


In February 2007 HSBC gave the first warnings from a major global bank of oncoming sub-prime mortgage losses. In March of the following year, Bear Stearns collapsed. The following September Lehman Brothers failed. The financial sector would never be the same again. 

Regulation and compliance have loomed ever larger in the workloads of finance professionals in the intervening years. Insurance companies and banks are required to compile endless risks reports for ever more demanding regulators. Asset management has been no exception to the regulatory trend. Thanks to regulatory frameworks such as EMIR, buy-side players are now required to put up securities as collateral, and then manage it afterward. Some such regulatory developments involve cultural changes. 

Other developments involve migration into unfamiliar asset classes. Quantitative Easing drove bond yields down to unprecedented levels, forcing players out of sovereign bonds and into asset classes such as corporate bonds which offer slightly better yields but come with liquidity issues in the case on a recurrence of crisis. Many financial sector players may be said to be out of their comfort zones.

The Basel III capital adequacy model defines parameters such as the Liquidity Coverage Ratio under which liquidity operations are managed. Standardized regulatory approaches require coherent approaches across markets.  It can be easy to get lost in the detail of the process.  After the Lehman Collapse, the one question that stood out over all the others was whether the crisis was one of liquidity or solvency. Central Banks responded by slashing interest rates to zero in many cases and injecting massive amounts of liquidity into markets. UK interest rates going back to the 1600s had never been so low. Rates almost a decade on are stuck near zero. Generous liquidity has pumped up asset prices, helped by those ultra-low interest rates. 

But the global financial system is not out of the woods yet. Martin Wolf of the Financial Times calls the situation a managed depression. Managed by Central Banks. Ultra-low interest rates are no panacea, as it happens.  A healthy economy prices time and risk into the future with real interest rates of 2-4% along the term structure. There is also too little real money being channeled into real investment with a realistic patient time horizon. Profit is a function of investment, not financial engineering. 

The Financial system operates on the basis of trust. Without trust, no asset has an intrinsic value. Prudential financial management includes the use of collateral to manage trades. 
The trend in regulation is for centralized and standardized oversight. Where 20 years ago companies might have had a capital buffer to cope with unexpected developments, the focus now is on principles-based regulation. Regulations also tend to be linear, relatively rigid and based on the assumption that debt is risk-free.    

The global economy faces a binary future. It will either find its way back to equilibrium, defined as 4% interest rates, strong payrises and strong private sector demand for credit, or it will return to a state of crisis, overwhelmed by the quantum of debt in the system. 

Regulation now should reflect this binary reality. The future may be calm and productive or it may not. Regulation should be ready to cope with both possibilities. Whether or not the economy moves in the direction of stability or instability is a function of what happens at the macro level. This can be measured to give a probability level for stability/instability. The Bank of International Settlements has written about its fears that Central Bankers are reduced to relying on asymmetric policymaking that encourages asset bubbles which amongst other things do not support growth. The concern is that monetary policy normalization may not be possible
If instability is the result liquidity considerations will need to be strengthened.   Higher levels of volatility require higher levels of capital. The key is to be ready for whatever happens. This is the ultimate purpose of liquidity, collateral and the other tools of prudential financial management.

Algorithms will also need to reflect the outlook for the system since trading strategies will vary depending on the state the system is in.

The most important point is that the meaning of prudence should never be lost. Solvency must be supported at all times, regardless of what is happening in the system. If it is necessary to boost regulation for a time, regulators should have the courage to do so.  

Authors:   Cathal Rabbitte and Fernando Walter Lolo