Bank capital controls are making the financial system more vulnerable

Unlock Editor’s Digest for free

FT editor Roula Khalaf has chosen her favorite stories in this weekly newsletter.

The author is head of research at Barclays

Regulators and investors are concerned about the vulnerability of government bonds and funding markets.

This is understandable. These markets are essential for funding governments, communicating monetary policy, and hedging interest rate risk for banks, investors, and businesses. But they have experienced repeated destabilizing events, including the frenzied “dash for cash” in early 2020 and the collapse of the repo market in 2019.

Such concerns have prompted a series of reforms, including a new Securities and Exchange Commission requirement to centrally clear trades in U.S. Treasuries, along with other assets such as stocks, futures and swaps. It also includes rules.

Liquidation provides banks with some capital relief by allowing them to offset their exposures. But the new rules themselves are not a panacea. Short-term funding markets have become more vulnerable primarily due to recent changes in the composition of the financial system, namely the segregation of bank capital by jurisdiction.

Until 2016, banks were primarily regulated at a global consolidated level by their national regulators. Banks can move capital more or less seamlessly between subsidiaries, across products and currencies, depending on market conditions. This is especially true when moving capital between activities that have similar effects on consolidated capital, such as positions in US, UK and European government debt.

The situation changed in July of that year, when the Federal Reserve began requiring foreign banks with more than $50 billion in U.S. assets to establish special holding companies for local operations. Each of these holding companies is governed by its own board of directors and is subject to strict oversight by U.S. banking regulators, including local capital and liquidity standards and annual stress tests. Europe introduced similar rules in 2019. Major banks in the US and UK were compliant within about a year.

Of course, the new regime had good intentions. The U.S. reforms were part of the Dodd-Frank Act, a comprehensive set of provisions aimed at preventing a repeat of the 2007-2008 meltdown. However, as a result, capital transfers between bank subsidiaries now require local management recommendation, local board approval, local stress testing consideration, and, in some cases, local regulatory approval. The movement of capital has become slow, expensive, and uncertain.

In other words, bank capital is locked up. When capital cannot move across jurisdictions, each region’s balance sheet becomes fixed. It is no surprise that markets are becoming more rigid and that policymakers need to stabilize them more often. The public sector is now fulfilling the role that was once left to bank capital.

The best example of this is the repo market. The repo market is a highly liquid market with trading volumes in the trillions of dollars per day. Before 2016, repo shocks often spread across borders. Our analysis shows that disruptions in the US market usually lead to disruptions elsewhere in the European or UK repo markets. In this respect, the epidemic is global and banks have shifted funds away from problem areas and other comparable activities. This spread the shock across multiple jurisdictions and reduced its severity.

The shock became more localized. Spiking volatility in the U.S. repo market also creates disruptions in other parts of the front end, including short-term Treasuries. Dislocations in Europe are also likely to affect multiple types of collateral. And now that it’s harder to deploy capital buffers across borders, it’s harder to hit. In the United States, repo shocks are 26% more frequent, 31% more severe, and more likely to last than before 2016. The situation is similar in Europe and the UK.

Further regulations, mandates and constraints could further exacerbate market calcification. Among the most important are Basel III reforms, which are expected to be phased in starting in 2025 and will increase capital requirements for banks. This would make it more costly for banks to intercede in the government bond market, and would also raise costs for participants trying to arbitrage price differences. Continued widening of spreads and declining trading volumes will lead to greater volatility in prices and yields and once again tighten regulatory requirements for banks.

The United States appears particularly vulnerable given that the federal government’s budget deficit remains high and the government debt market tends to expand rapidly. More debt outstanding means an increased need for financing, hedging, and even futures and swaps trading. Market stability is likely to remain under pressure.