Financial stability: Leveraging the past

Author: | Published: 8 Jul 2019
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As part of this month's cover feature looking at the most influential people, institutions and events in financial regulation, during a conversation with Congressmen Barney Frank – co-author of the Dodd-Frank Act – IFLR asked what he sees as the biggest threat to financial stability in the US. It wasn't the banking system, or cybersecurity, or anything like that. It was "risks we don't even know about yet".

"There is no risk from what we know. At some point, technology is going to produce a new ability to amass a lot of debt without being able to keep track of it – and we don't know where it will come from," he said.

Echoing this sentiment was outgoing chairman of the CFTC Christopher Giancarlo, who in response to the same question explained the reason behind his insistence on future-proofing the Commission during his tenure. "The next crisis won't look like the last crisis. Our markets have been going through very profound market structure changes. We have to be better-prepared when the inevitable credit cycle change happens."

These two individuals of course have a cognisant grasp of the financial sector, but when it comes to speculation, anyone can be proven right or wrong – especially in this industry.

The US markets have been going through very profound changes in market structure and participation. During the first 20 years of this century it was banks at the centre of financial markets. Nowadays things look a little different: there are new players on the scene, non-bank participants. The markets have been profoundly digitised, and when the credit cycle does change it is likely to uncover whatever shortcomings are hidden in that structure.

One potential disruptor is shadow banking. Non-bank lenders now have as much as $52 trillion in assets and are in the process of taking over in certain areas of the economy entirely. Couple this with the credit cycle, which has moved a risk-taking appetite firmly back into the foreground, and there is room for disaster.

In the financial services industry it is leveraged loans that are ringing alarm bells. Collateralised loan obligations – or CLOs – are marketed as bitesize pieces of existing debt and assets that can be digested by companies with existing debt or low credit ratings. There is little in the way of protections or restrictions on CLOs, which increases the risks substantially.

The process is allowing the banking system to offer these risky businesses loans of significant size, then farm them off to more risk-loving investors in the industry. These CLOs are being snapped up in their trillions by hedge funds and the like, yet US banking regulators like the Office of the Comptroller of the Currency (OCC) or the Federal Reserve are doing nothing to step in and mitigate the risk.

These regulators have the tools and the means to step in before it is too late, but at the orders of a Republican risk-hungry administration, have not.

Frank and Giancarlo may yet be wrong, and the cause of the next financial crisis could indeed be right under all of our noses. But as to whether those in a position to do something about it will or not? The jury is out.