Thursday, March 18, 2010

Banking, risk and regulation

Excellent article on risk and regulation that looks at the key issues of failure in safe securities and repo markets.

The financial crisis of 2007-09 featured large-scale losses to financial institutions from assets such as AAA rated tranches of mortgage-backed securities. Simultaneously, markets for collateralised borrowing (“repos” or repurchase agreements) froze or experienced severe stress. Investors lending in repo transactions started charging large “haircuts”. In other words, repos could be rolled over only with successively high levels of over-collateralisation, which disrupted the financing model of broker-dealers and in fact caused Bear Stearns to fail in March 2008.

The moral of the story is that regulators need to impose tighter constraints, such as higher capital requirements, on activities such as holdings of AAA rated tranches and repo financing of risky assets where there is a conflict of interest between the privately optimal and socially optimal choices. Bankers will fight such a proposal. But it should be well understood that they have all incentives to ignore the attendant systemic risk

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