New Frontiers in Systemic Risk: Borders & Liquidity

The post-crisis experience provides important guidance for why and how the international regulatory policy process is failing to achieve its goals. While many reforms were implemented, differences in domestic implementation (covered bonds, derivatives margin, CCP oversight) overlap with a range of reforms that have not yet been implemented (LEI, Net Stable Funding Ratio, cross-border resolution).

Policymakers continue to bicker over technical details[1] while wielding equivalency determinations and subsidiarization requirements as negotiating tools. These difficulties should not be permitted to impose debilitating impediments on growth-enhancing intermediation activity.

Two key lessons point the way towards the next round of regulatory policy improvements: barriers to information sharing hinder identification systemic risks and lack of adequate liquidity contributes to suboptimal economic growth. In other words, boundaries and liquidity matter.

Lesson 1: Boundaries Matter

The destabilizing failures of AIG and Lehman Brothers as well as the EuroArea sovereign debt crisis illustrated a deep truth regarding systemic risk: cross-border economic interdependence generates risks as well as benefits. When it materializes, systemic risk imposes material domestic fiscal costs regardless of the country of origin. Nations are thus condemned to cooperation on a cross-border basis regarding financial regulation.

However, informal international consensus cannot substitute for -- or impose obligations on – how national governments spend taxpayer funds. Even well-established, legally binding forms of cross-border economic interdependence stop short of creating open-ended fiscal obligations on national governments. For example, the Maastricht Treaty prohibits fiscal transfers inside the European Union. The IMF Articles of Agreement also limit the liabilities assumed by members providing emergency liquidity funding to other members through a range of mechanisms.

The post-crisis experience suggests the traditional process of articulating top-down detailed regulatory rules at the global level may create more problems than it solves due to a mismatch of authorities. Prescriptive standards are articulated at the international level by entities not formally authorized to engage in normative activity. These minimum standards help facilitate the cross-border flow of investment, funding, and business activity even as they create challenges for national policymaking processes.

Simultaneously, the scale of the 2008 crisis and the scope of reform initiatives shifted the center of gravity into national political arenas where financial stability is defined and implemented domestically. Regulatory discretion to strike informal policy agreements abroad is additionally constrained in the current populist era, particularly if international policy agreements impose burdens on politically powerful domestic constituencies.

At the technical and operational levels, the crisis also created significant deficits in trust among regulators precisely because they acted in accordance with national mandates. The subsequent proliferation of technical regulatory standards inadvertently increased exponentially the areas for divergence, further eroding cross-border regulatory relationships. Nowhere is this more evident than in the architecture for the macroprudential buffer, where national regulators can impose specific add-ons for exposures in foreign countries based on country-specific considerations.[2]

The first lesson of the post-crisis era, then, is that boundaries matter.

The hard work must begin now to re-build the underpinnings of trust that can support welfare-enhancing cross-border economic interdependence rather than retreat behind national boundaries.

One important step toward re-building trust among national supervisors while protecting the domestic financial system from systemic risk is to encourage information sharing among supervisors. By its nature, systemic risk is a “big data” problem. It can only be identified if a sufficient number of observations from different perspectives can be collected.[3] Since markets and firms insist on operating internationally, their regulators must find ways to work together cooperatively. Sharing data and supervisory information is a good place to start.

Regulators’ ability to share information is constrained by domestic laws that limit the kind of data that can be shared and for what purpose. Supervisory data sharing is also constrained by concerns regarding how that information can be used by the receiving entity.

If “data is the new oil”[4] in a world where data privacy is a top political priority, then regulators must urgently find cooperative ways to share information now…before their ability to identify and assess systemic risks is compromised by lack of cooperation.

Policymakers are making solid strides towards enhanced post-crisis information sharing using three key mechanisms.

  • MOUs: Memoranda of Understanding (MOUs) among regulators can provide an alternative framework for sharing supervisory data. While not legally binding, these documents provide a framework for sharing information across borders as well as across supervisory agencies inside the same country. Many have been in place for decades in advanced economies. The new generation of MOUs in the FinTech sector may provide useful templates for how new cooperation mechanisms can be crafted.

  • Coding Identifiers: The Financial Stability Board and the International Monetary Fund indicate that after nearly a decade of work the G20 Data Gaps Initiative is generating traction.[5] Progress regarding individual Legal Entity[6] and Unique Product Identifier[7] codes already enhances automated data aggregation and sharing. However, the report also indicates substantial and troubling delays persist regarding three key sectors: insurance, shadow banking and cross-border exposures.

  • Formal International Agreements: The newly concluded “Covered Agreement” between the United States and the European Union regarding supervisory cooperation in the insurance sector provides another possible model for post-crisis regulatory cooperation. In the United States, “executive agreements” are legally binding under international law but are not subject to full ratification by the United States Senate. The Covered Agreement provides a framework for providing mutual recognition to foreign regulatory capital standards upon conclusion of an MOU executed by national/state level regulators in the insurance sector. Since the international agreement includes a template MOU as an appendix, it incorporates by reference and elevates the status of the MOU within an internationally legally binding document.

Lesson 2: Liquidity Matters (But In Unexpected Ways)

The post-crisis reform agenda sought to address systemic risk in part by increasing bank funding liquidity levels (Net Stable Funding Ratio, Liquidity Coverage Ratio) and collateral liquidity levels (central clearing and settlement for derivatives[8]). Where access to liquid trading markets was judged to generate inappropriate incentives (i.e., securitization, derivatives), bank participation in those markets was either severely constrained or prohibited.

The goal was to address systemic risk by lowering the velocity of intermediation. It seems this goal has been achieved, but not all the outcomes have generated positive net benefits for the economy:

  • Lack of access to securitization markets exacerbated the overhang of non-performing loans (NPLs) at European banks, constraining their ability to underwrite new lending that can help generate economic growth.[9]

  • In trading markets, regulatory reform coincided with a range of separate shifts (electronification, deleveraging, changes in expectations regarding returns, upgraded internal risk management), making it difficult to determine whether -- or how much --regulatory reforms contributed to market fragmentation.[10] Even if no single cause can be pinpointed, the reality is that capital market transaction costs are increasing and dealer liquidity support for corporate bonds is decreasing following the financial crisis.[11]

  • Perhaps relatedly, online (non-bank) marketplace lending has begun to occupy the markets left vacant by regulated financial firms, providing consumers and small businesses with new funding mechanisms to support growth objectives, accelerating disintermediation trends.

  • Finally, cross-border capital flows have fallen-65% since 2007 even as foreign direct investment (FDI) skyrocketed after the crisis. [12]

The second major lesson from the post-crisis era, therefore, is that the economy requires access to liquidity. Lower rates of financial intermediation may be safer from a systemic risk perspective, but they may also be generating suboptimal economic growth trajectories that help feed political extremism.

Overall, the post-crisis regulatory architecture may increase bank funding liquidity but trading and regulated credit markets no longer have the liquidity they need to perform growth-enhancing maturity transformation functions at a scale needed to fund sufficient economic growth to generate a sustainable recovery once monetary policy normalization commences.

Regulatory simplification can provide part of the answer. European policymakers have already taken an important step in this direction by implementing new rules to support local securitization markets. Various regulatory simplification initiatives are underway in the United States as well. The Chairman of the Federal Reserve recently endorsed initiatives designed to simplify the regulatory architecture.[13] The Department of the Treasury has also released wide-ranging simplification proposals.[14] The House of Representatives has passed The Financial CHOICE Act of 2017[15] which includes a range of regulatory simplification initiatives in addition to rolling back some post-crisis regulatory reforms.

Policymakers should seek to simplify regulatory standards where possible, with the goal of freeing more funding into the economy. A number of simplification initiatives are controversial. Robust debate is appropriate regarding the scale, scope and content of the reform initiatives.


Enhanced information sharing designed with the data revolution in mind and regulatory simplification may provide a solid foundation to rebuild badly battered regulatory relationships while enhancing regulators’ ability to address systemic risks in a proactive manner.

An earlier version of this essay first appeared on the website of the Bretton Woods Committee:

[1] Global Bank Capital-Rule Revamp Postponed as Europe Digs In, Bloomberg (3 January 2017).

[2] Basel III, Section IV (Countercyclical buffer)(June 2011); ESRB Handbook on Operationlizing Macroprudential Policy in the Banking Sector, European Systemic Risk Board (March 2014).

[3] The Financial Crisis and Information Gaps, Financial Stability Board (October 2009).

[4] The Economist (6 May 2017).

[5] Second Phase of the G20 Data Gaps Initiative (DGI-2), Financial Stability Board and International Monetary Fund (September 2017)

[6] A Global Legal Entity Identifier for Financial Markets, Financial Stability Board (June 2012)

[7] Consultation Paper: Governance Arrangements for a Unique Product Identifier, Financial Stability Board (September 2017).

[8] In the process, policymakers inadvertently created a new kind of systemic risk by centralizing default waterfalls within institutions (central clearinghouses) previously not subject to extensive direct regulation. Policymakers currently are struggling to define orderly liquidation procedures for these entities.

[9] European policymakers recently rectified this situation by completing legislation that permits banks to participate in “simple, safe, securitization.”

[10] Market Liquidity after the Financial Crisis, Federal Reserve Bank of New York Staff Report No. 796 (October 2016, revised June 2017).

[11] Id., p. 3.

[12] The New Dynamics of Financial Globalization, McKinsey (2017).

[13] Yellen Says Fed Is Working on Tailoring Regulations to Bank Size

[14] A Financial System That Creates Economic Opportunities (Capital Markets), U.S. Department of the Treasury (October 2017).; A Financial System That Creates Economic Opportunities (Banking and Credit Unions), U.S. Department of the Treasury (June 2017)

15 The Financial Choice Act of 2017, H.R. 10