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by Viral V. Acharya and T. Sabri Öncü

Although one of the main concerns of the Dodd-Frank Wall Street Reform and Consumer Protection Act soon to be signed by President Obama to law is systemic risk, it is disconcerting that the Act is completely silent about how to reform one of the systemically most important corners of Wall Street: the repo market, whose size based on daily amount outstanding now surpasses the total GDP of China and Germany combined. The financial crisis of 2007-2009 to which the Dodd-Frank Act is a response was a crisis not only of the traditional banks, but also of the shadow banks, those non-bank financial institutions that borrow short-term in rollover debt markets, leverage significantly, and lend and invest in longer-term and illiquid assets. Unlike traditional banks, shadow banks did not have access to the safety nets designed to prevent wholesale runs on banks - namely, deposit insurance and the central bank as the lender of last resort - until 2008. Although there was no wholesale run on the traditional banking system during the crisis of 2007-2009, we effectively observed a run on shadow banks that led to the demise of a significant part of the shadow banking system. Since repo financing was the basis of most of the leveraged positions of the shadow banks, a large part of the run occurred in the repo market. Indeed, the financial crisis of 2007-2009 was triggered by a shadow bank run on two Bear Stearns hedge funds speculating in the potentially illiquid subprime mortgages by borrowing short-term in the repo market.

The Paradox of "Too Safe to Fail" Assets

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by Viral V Acharya and Arvind Krishnamurthy

While the House and the Senate Bills empower the regulators to impose greater capital requirements on banks and systemically important institutions, they provide little guidance on how we might have to improve design of capital requirements going forward. In particular, how should we deal with fail-safe assets such as AAA-rated tranches of mortgage-backed securities and liabilities such as overnight secured borrowing ("repos") which were not capitalized, were held in large quantities, and ended up bringing down the entire financial sector through losses and runs? The Financial Times oped at the link below (joint with Arvind Krishnamurthy) argues that the entire risk of these "too safe to fail" transactions is systemic in nature, and hence financial sector has incentives to essentially ignore the risk, unless we reform capital requirements to be higher for these transactions. This is in fact the opposite of how (Basel) capital requirements are currently designed, which is to in fact give higher incentives for such transactions.

Financial Times Market Insight column

Why bankers must bear the risk of "too safe to fail" assets.

March 18, 2010

http://www.ft.com/cms/s/0/9575ec0a-31e6-11df-a8d1-00144feabdc0.html

 

About RegulatingWallStreet.com

The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

About Restoring Financial Stability

Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

About the Authors