How prepared are we for the next international financial crisis?

Adam Tooze’s magisterial Crashed: How a Decade of Financial Crises Changed the World emphasises the role of wholesale financial markets in the global turmoil. Retail financial markets involve deposits placed in banks and other financial institutions. Wholesale markets are where banks and other financial institutions, including quasi-banks and shadow banks, lend and borrow among themselves.

Wholesale markets are vital for cash settlements and market stability. A bank may one day have more withdrawals than deposits. It uses the wholesale market to borrow the difference (usually from another bank) secured on some security it holds. The following day it may be in surplus and do the opposite.

The banking system has considerable experience dealing with problems which occasionally arise in the simplest wholesale markets. Suppose there is a ‘run’ on a trading bank in which depositors take all their money out (perhaps because they do not trust it). Typically they turn it into notes, which are a kind of receipt for deposits at the Reserve Bank of New Zealand – the lender of last resort. The RBNZ will typically cover the withdrawals, secured on assets held by the trading bank. (In extreme situations where the bank is in deep financial trouble, there is the open bank resolution system.)

An example was the British building society Northern Rock. It was unusual in that it was borrowing about three-quarters of its funds for its mortgage lending in the wholesale market (i.e. from other financial institutions). It is typical of a bank to borrow short and lend long but usually it relies on deposits as its source of funds. When the wholesale lenders became nervous and stopped rolling over loans, depositors began withdrawing their funds – or they tried to and ended up queueing in the streets outside the bank’s branches. The resolution by the Bank of England was messy – it involved nationalisation – but simple in comparison to the mess of the Global Financial Crisis.

Northern Rock’s borrowing was straightforward – vanilla, you might say. But the global wholesale markets are much more complicated with a spectrum of  deals – such as swaps and derivatives. I sometimes describe that market as ‘Neapolitan’ given the variety and the slicing and dicing of deals. No one has a comprehensive overview of what is going on and there is no overall regulator because it exists outside national jurisdictions. (In comparison, the RBNZ’s knowledge of New Zealand’s wholesale markets is near comprehensive and it has the powers to regulate them.)

The wholesale markets are also  vital for foreign exchange transaction which need ‘cover’ – protection from fluctuations. But are the more mysterious transactions necessary? Participants insist they are. Once upon a time they said they were used to reduce risk. Perhaps they did on the margin, but the evidence is they amplify it when things go wrong.

What seems to happen is that transactions for practical purposes get overwhelmed by what is, essentially, gambling. An example you may have come across is in Michael Lewis’s book and film The Big Short, which portrayed those who bet that a bubble would burst. They proved right so they are presented as heroes. But they were gambling.

What differs from you, say, taking out a lottery ticket is not just that the magnitudes involved are huge but they involve betting with other people’s money. The result is considerable instability in times of turmoil, as the GFC illustrated.

Even the mighty Fed(eral Reserve of America) had great difficulty dealing with it. (Even so, Tooze argues that by its actions during the GFC the Fed strengthened its international role. It does require a supportive president. In contrast, the lack of supportive political leadership in Europe worsened the European outcomes.)

There is a glitch in the simple New Zealand system. Their main source of funds for their lending are retail deposits, but like Northern Rock, they source some funds from the wholesale market, although not to the same extent. Moreover they have to go to the international wholesale market. So in 2008, New Zealand banks found their vanilla borrowing affected by turmoil in the Neapolitan part of the international market.

Since the banks do not borrow in the domestic currency they require exchange rate cover so it is not quite vanilla; let’s call it ‘hokey-pokey’. As a result the Reserve Bank cannot simply support them if the cause of turmoil is offshore. (In 2008 it was assisted by the Fed.)

It seems likely that there will be another international financial crisis within a decade or so. (Notice I have put this in the middle of the column; put it at the top and it would be all over the business pages.) The reason is, as in the case of the Bush tax cuts, the ballooning US deficit injects liquidity into the international wholesale market which creates opportunities for gamblers which eventually results in instability and turmoil. What can we do to soften its blow on New Zealand?

The Reserve Bank has already required our trading banks to lengthen the average maturity of their offshore borrowing, so that there is less to be rolled over in the months of turmoil. Its other changes mainly affect domestic market regulation. They include new ways of macro-prudential regulation and the open bank resolution policy mentioned earlier. It has approached the government for more funding for better surveillance of trading banks’ offshore activities.

The RBNZ is also proposing to require the banks to increase their capital reserves, which give a return to shareholders but which are also a vital buffer during a crisis. (A simplistic account is that a bank’s reserves are a kind of offshore investment which is very stable.) The logic of the above is that the more hokey-pokey in the balance sheet relative to the vanilla the larger the reserves should be. (Indeed I wonder whether there might be an additional requirement for offshore liabilities with very short maturities, say below three months.)

The Reserve Bank’s foreign currency reserves also need to be increased. Of course they were not enough to deal with the GFC but they gave breathing space. Given that the economy has expanded as have the international risks, it seems sensible to increase them.

Ultimately, though, the less we depend upon the international wholesale markets, the less vulnerable we are in the next international financial crisis (as the Asians concluded after the Asian financial crisis of 1997-8). How to raise national savings is a government responsibility, not merely that of the Reserve Bank.

PS. Geoff Bascand, the Deputy Governor of the Reserve Bank – he’s responsible for supervising financial stability policies – recently presented Financial stability – ‘risky, safe, or just right?’. So the RBNZ is reviewing the issues raised in this column.