November 25, 2010 5:28 pm

The lessons

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When the US Congress passed the monstrously large Dodd-Frank financial reform bill last summer, it was clear that surprises were lurking in those 2,300 pages. This week one has cropped up.

On Wednesday, the US Federal Reserve released the details of the liquidity measures and loans it extended during the financial crisis, totalling an eye-popping $3,300bn. Previously, the Fed fiercely resisted publishing this. And it is easy to see why: this release names individual institutions in a potentially embarrassing way – and shows that the Fed has supported foreign banks, ranging from Barclays Capital to Dexia, to a striking degree.

But while that is profoundly sensitive stuff, the Fed was forced to publish because of a tiny, hitherto ignored clause inserted into that Dodd-Frank bill. Hence that surprise.

So what should investors make of all this? One lesson is that it shows the Herculean and creative lengths the Fed went to, to keep the system afloat during 2008 and 2009. During the past two years, the government actions that have grabbed most voter attention have been the injection of capital into banks, or the bail-out of the auto firms.

But what Wednesday’s release shows is that this focus on the “obvious” bail-outs misses the point; instead (as I noted in a recent column) the crucial issue in the recent financial crisis was the fact that the murky, shadow banking world froze up. What the Fed was essentially doing with much of its $3,300bn programme – under all those strange acronyms – was replacing the securitisation market, and providing liquidity to the system; in a sense, the Fed became the market in 2008 and 2009, not just in the US but parts of Europe too.

This carries sobering lessons for European leaders. Personally I think that the Fed was correct to act in this way; extraordinary times call for extraordinary measures, and without action there is a risk the entire system would have frozen up. But the Fed only had the freedom to act because it was a clearly centralised body. The European Central Bank could only dream of such powers, in Europe’s fractured political landscape.

However, there is a second, related point to ponder too: namely that the Fed data also show just how ill-informed most politicians, investors and bankers have been about how modern finance really works. Before 2007, most regulators vaguely knew that European institutions were loading themselves up with US securities; they also realised that the shadow banking world was creating tight interconnections between US and European banks. But it was not until the crisis that it became clear just how widespread and dangerous those linkages were.

This shows why it is so vital now to have a new public debate about the shadow banking world – and the degree to which it could or should be backstopped by the state. It also underscores the need for international regulators to
co-ordinate far more closely, and to receive real-time, detailed data about cross border financial flows. Trying to closely oversee integrated global financial markets and institutions on a purely national basis, in other words, looks increasingly ridiculous; joined-up action and surveillance is inevitable. So is aid in a crisis.

And that raises a third point: namely that investors should keep a close eye on another, clause buried in the Dodd-Frank bill, which calls for the creation of a so-called “Office of Financial Research”. This idea has also been widely ignored so far. But it calls for a body with a mandate to watch aspects of the financial system, including cross-border financial flows and shadow banks.

And behind the scenes, regulators and academics are already talking to tech companies about how to use innovations to track financial data in real time. They are trying to force banks’ back offices to produce more standardised information, across the world, to provide the type of snapshot that was missing in 2008.

Now, it is still unclear whether this initiative will ever amount to anything. Many financial companies hate the idea of more intrusive surveillance. And some Republicans are fighting hard to kill the OFR. But that would be a mistake. After all, this week’s Fed release shows exactly why better monitoring of the financial system is now so badly needed – not just in the US, but Europe too.

It also shows exactly why regulators and politicians now have the right to demand reform.

After all, having used $3,300bn to support the financial system, the Fed (and others) have every right to demand as much as they can in return, from both US and non-US banks. Extracting much better data from the banks (and others) would be a good place to start; not just to make it easier to fight today’s crises in Europe, say - but also to prevent European and US banks from becoming entangled in such a dangerous web of interconnected deals again.

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