Tags: FSB | financial | institutions | risk

Global Financial Institutions Remain Risky

By Barry Elias   |   Friday, 01 Feb 2013 07:47 AM

More than five years have elapsed since the onset of the 2007-08 global financial crisis, yet the world banking system still remains dangerously at risk. At issue is an estimated $67 trillion “shadow banking” market that is severely undercapitalized and threatens the financial and economic stability of the world. For perspective, this market is close to the annual world economic output.

Shadow banking refers to non-bank financial institutions, such as investment banks, insurance companies and pension funds, that are not subject to the strict capital requirements of banks, leaving them more vulnerable to losses. Implicit government guarantees then transfer these private liabilities to the uninvolved and unsuspecting public taxpayers.

One of the key risk strategies used by financial institutions is maturity transformation. This involves the transformation of liabilities to assets by lending lower interest-bearing short-term funds from deposits to higher-rate, long-term borrowers. If done correctly, the risk of loss is low.

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However, many non-bank institutions did not perform this strategy in a prudent manner, since they did not retain adequate capital reserves to protect against possible future losses.

Adair Turner, chairman of the U.K. Financial Services Authority and the Basel-based Financial Stability Board (FSB) Standing Committee on Supervisory and Regulatory Cooperation, recently said, “We have clearly created incentives for people to do maturity transformation outside the banking system. We need to be constructing a regulatory and supervisory regime that guards against shadow banking creating the crisis of 2015 or 2020,” according to the Financial Times.

Several countries have missed the end-of-2012 deadline to present “living wills,” which would ensure cross-border resolution strategies to deal with bank failures — a troubling sign that progress in this regard is not proceeding effectively. This deadline was requested by the FSB in response to the concerns of the 2011 G20 economic summit participants.

The FSB is also investigating the possibility that several financial institutions may have garnered profits on derivative trades that involved illegal manipulation of the London Interbank Offer Rate (LIBOR), which represents the average interbank lending rate.

Described in my previous article, Dallas Federal Reserve Bank President Richard Fisher recommends that we begin to address the issue of undercapitalized “shadow banking” by denying access to taxpayer assistance, including direct payments and low interest rate loans from the discount window of the Federal Reserve Bank. This would undermine the current failed strategy where gains are privatized to the financial institutions and losses are socialized to the general public.

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The FSB would be wise to incorporate the proposal issued by Fisher into their recommendation for the world’s financial institutions. More delay suggests the global politic is more interested in preserving the status quo that benefits the giant financial institutions that are inadequately leveraged at the expense of the general public.

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