The recent financial crisis has exposed the failures of regulation.Not of de-regulation, we stress. Nor does he appear to be overly impressed with the re-regulation of Basel III. That that approach may prove problematic, because;
... there is a range of fundamentals of the investment portfolio of the bank for which the entity is solvent but illiquid. The intermediary faces a coordination failure that leads to fragility in the sense that a small change in the environment may move the equilibrium of the investors’ game from safe to unsafe.Which is not exactly a news bulletin, but maybe regulators don't pay enough attention to, or fully appreciate, it.
In an environment with weak balance sheets and market stress, bad news provided by a strong public signal may coordinate expectations on a run equilibrium.
Again, that's not new. SIVs are structured investment vehicles, i.e. non-banks . They earn their profits on credit spreads between long and short term securities.This is what seems to have happened with the SIVs crisis in 2007.
Which were a tiny part of the mortgage business until the 1990s, when the federal govt decided to mount an assault on traditional home lending.The SIVs were mostly funded short term in the wholesale market, and investors had poor information when deciding whether to roll over their loans given the opaque nature of residential-based subprime securities.
And the ensuing financial crisis. Thanks to a failure on the part of the regulators;The introduction of the ABX index [of credit derivatives] in 2006 provided a potent public signal about the state of subprime mortgages, and when this index started to decline in early 2007 it eventually triggered a run on the SIVs.
Which is why we said this is the best sentence we've read lately; The recent financial crisis has exposed the failures of regulation. The most recent version (2013) of Vives's academic paper can be found here. Abstract;With hindsight, and according to my analysis, the regulator should have tightened liquidity requirements when the ABX index was established. If properly calibrated, the liquidity requirement would have decreased the profitability of SIVs but avoided the run.
We show how the balance sheet composition of a financial intermediary, precisions of public and private information, and market stress impinge on fragility through the degree of strategic complementarity of investors' strategies. We show how a solvency and a liquidity ratio are required to control the probabilities of insolvency and illiquidity: With more competition the solvency requirement has to be strengthened, and with higher fire sales penalties and more conservative fund managers the liquidity requirement has to be strengthened while the solvency one relaxed. Higher disclosure may aggravate fragility and require an increase in the liquidity ratio; the regulator should set together disclosure and prudential policy.