Forbes: December 8, 2014
1. The financial system is a fragile and complex network of financial relationships that has built into it a tendency for periodic disturbances that can produce “huge, unanticipated changes,” which at times spin out of control into a catastrophe as took place in 2008. This is the thesis Harvard professor Niall Ferguson put forth in his 2012 book The Great Degeneration, How Institutions Decay and Economies Die, a must-read for all economists, stock pickers and investment bankers. Fragile, as in “a system prone to crash,” says Andrew Haldane, today the chief economist of the Bank of England. “Lending within the financial system… raises inter-connectivity in the system, thereby amplifying systemic risk.” Ben Bernanke, former Fed chairman, puts the quandry in a pithy manner: “Assets are observable,” he says,” but the whole story is not observable.”
2. Wall Street is a highly concentrated politically powerful industry while the regulators of Wall Street are a highly fragmented group of institutions like the Fed, the SEC, the Treasury and the FDIC unused to working in tandem with each other. The financial system’s complexity of operations and nontransparent web of interconnections means that the worrisome problems of the financial institutions always slip below the regulatory radar.
3. The next crisis is bound to involve the Too Big To Fail Banks that have highly leveraged their hold on 68% of the banking industry’s deposits. As Federal Reserve Board Vice-Chairman Stanley Fischer has put it, “We should never allow ourselves the complacency to believe we have put an end to TBTF.” In short, real lasting financial stability requires reducing the system’s degree of concentrated risk in a mere handful of giant institutions that may be Too Big To Manage and Too Big To Regulate as well as Too Big To Fail. The dangerous bottom line: there is no pragmatic method that readily comes to mind that involves breaking up the TBTF banking system while maintaining a market-based financial system, according to former Treasury Secretary Timothy Geithner.
4. No one understands the derivative risk positions of the Too Big To Fail Banks, JP Morgan Chase, Citigroup, Bank of America, Goldman Sachs or Morgan Stanley. There is presently no way to measure the risks involved in the leverage, quantity of collateral, or stability of counter-parties for these major institutions. To me personally they are big black holes capable of potential wrack and ruin. Without access to confidential internal data about these risky derivative positions the regulators cannot react in a timely and measured fashion to block the threat to financial stability, according to a National Bureau of Economic Research study.
5. The Dodd-Frank legislation does not reform Wall Street. Rather it preserves the system that existed prior to the 2008 crisis, according to Martin Wolf of the Financial Times of London. According to former Treasury Secretary Tim Geithner, “The goal of financial reform was to make the system safe for failure. It wasn’t to prevent the failure of individual firms that take on too much risk, but to make the aftershocks of failure less threatening to the system as a whole.” Most importantly, Dodd-Frank amended the Federal Reserve Act of 1913 to prohibit the central bank from bailing out an insolvent financial institution on the verge of bankruptcy. It can only lend or inject capital if the bank is solvent. According to Harvard economist Larry Summers the Fed is simply not capable of understanding even when a member bank becomes insolvent.
6. The Fed’s monetary policy model at present does not take into consideration any factual or numerical input from events either in domestic financial markets or global markets. This lack of input means the Fed will always have trouble spotting a bubble that is developing out of speculation in the financial or commodity markets.
7. Nor does the Fed have any oversight powers over the Shadow Banking System, which amounts to $75 trillion worldwide of financial activities by non-banks that in 2008 triggered runs on the system that threatened its stability. Shadow banking, which runs the gamut from money market mutual funds to short term repurchase financing agreements, commercial paper and other aspects of investment banking, are activities that can trigger panicky runs on the financial system. Shadow banking is also inherently fragile due to the lack of a central bank safety net or the deposit insurance that supports bank deposits. The whole inter-relationship between shadow banking and traditional banking is not very well understood. In short, shadow banking increases the likelihood that systemic risk will be triggered from the breakdown and gaps that exist between it and traditional banking.
8. Wall Street pressure has awed its government overseers into a deadly form of “regulatory capture” especially as regulators lack the resources, the motivation, and in the last resort, the knowledge, to keep up with the main players in the financial hierarchy, according to Martin Wolf, author of The Shifts and the Shocks, a recent book on the 2008 financial crisis.
9. There has been very little progress on building an international framework to resolve failed financial firms, according to a House of Representatives report prepared by the Republican staff of the Financial Services Committee published in July 2014. Christine Lagarde, Managing Director of the International Monetary Fund, described this absence of a cross-border regime for resolving large banks as “a gaping hole in the financial architecture” in a May 27, 2014 speech. Or as Treasury Secretary Jacob Lew put it in December 2013, “the failure of Lehman Brothers demonstrated that the absence of cooperation between domestic and foreign authorities to resolve a financial company can endanger the global financial system.”
10. The United States has experienced periodic financial panics or crises since its founding. From 1792, 1837, 1873, 1893, 1907 to 1929 and more recently 2000-2002 and 2008-2009 there have been bank closings, bankruptcies, massive stock market sell-offs and painful recessions. Many financial problems are hidden in the plumbing of the financial markets, which are not transparent and make the financial system exceptionally vulnerable. To some extent we are always flying blind. That is why we should have a serious fear of the unknown. As former Treasury Secretary Tim Geithner puts it, “financial crises cannot reliably be prevented.” Its impossible to predict how and when the next financial crisis will occur. We can’t count on fallible central bankers to stop financial booms before they become dangerous, because by the time the danger is clear, it’s often too late to defuse the problem. There is a Black Swan tail risk in our future some day. We just don’t know when and how it will happen. ” There is no mechanism for determining when there actually is a crisis” says Yale economist Gary Gorton in his 2012 book “ Misunderstanding Financial Crisis Why We Don’t See Them Coming.”
(read the full article at : Forbes