Bank regulation on capital has made financial system more fragile

The writer is head of research at Barclays

Regulators and investors are worried about the fragility of government bond and funding markets.

This is understandable. These markets are vital for financing governments, for monetary policy transmission and for the hedging of interest rate risk for banks, investors and corporations. But they are experiencing repeated bouts of instability, such as the frenzied “dash for cash” in early 2020 and the 2019 blow-up in repos, a market for interbank lending.

Such concerns have sparked a series of reforms, including new rules from the Securities and Exchange Commission requiring more trades in US Treasuries to be cleared centrally, in line with other assets such as equities, futures and swaps.

Clearing will provide some capital relief for banks, by allowing them to net off exposures. But in themselves, the new rules are no panacea. Short-term funding markets have become more fragile largely because of a recent shift in the constitution of the financial system: the segregation of bank capital by jurisdiction.

Until 2016, banks were primarily regulated at a global, consolidated level, by their home regulators. Banks could shift capital more or less seamlessly between their subsidiaries, across products and currencies, as market conditions warranted. This was particularly the case when moving capital between activities with similar implications for consolidated capital, such as positions in US, UK and European government debt.

Things changed in July that year, when the Federal Reserve began to require foreign banks with more than $50bn of US assets to set up special holding companies for their local operations. Each of these holding companies is governed by its own board of directors and is subject to the full rigours of US banking supervision, including local capital and liquidity standards as well as annual stress tests. In 2019, Europe followed suit with a similar set of rules; the biggest US and UK banks were compliant within about a year.

The new regimes were well-intentioned, of course: the US reforms were part of the Dodd-Frank Act, a sweeping provision aimed at preventing a repeat of the 2007-08 meltdown. But the result is that shifting capital between bank subsidiaries now requires the recommendation of the local management team, the approval of the local board, consideration of local stress tests and, at times, approval from local regulators. Capital mobility has become time-consuming, costly and uncertain.

In short, bank capital is trapped. When capital can no longer move across jurisdictions, balance sheets in each region are fixed. It is no surprise that markets have stiffened, and that policymakers now have to stabilise markets more often. The official sector is filling a role that was once left to bank capital.

The best illustration of this is in the repo market, a liquid market with trillions of dollars in daily volumes. Before 2016, repo shocks often spilled across borders. Our analysis shows that when the US market was disrupted, a dislocation normally occurred somewhere in European or UK repo, too. Contagion was global, in this respect, as banks shifted capital towards trouble-spots and out of equivalent activities elsewhere. This spread shocks across multiple jurisdictions, reducing their severity.

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Now, shocks are more localised. When volatility spikes in US repo, other parts of the front end — including short-dated Treasuries — also experience disruptions. Dislocations in Europe, too, are more likely to affect multiple types of collateral. And as it is now harder for capital buffers to be deployed across borders, the hits are harder. In the US, repo shocks are 26 per cent more frequent than they were pre-2016 and 31 per cent more severe, and tend to last much longer. It’s a similar picture in Europe and the UK.

Further regulations, mandates and constraints are likely to compound this calcification of markets. Among the most significant are the Basel III reforms, due to be phased in from 2025, which look set to push up banks’ capital requirements. This would make it more expensive for banks to intermediate in government bond markets, which would in turn raise costs for participants trying to arbitrage price differences. Persistently wider spreads and lower volumes would add to price and yield volatility — which would increase banks’ regulatory requirements once more.

The US is looking especially vulnerable given that the Treasury market is on course to expand rapidly as federal deficits remain wide. More bonds outstanding implies a greater need for financing and hedging, as well as for transactions in futures and swaps. Market stability is likely to remain under pressure.