A senior Bank of England official has warned that leaving collateral demands free to fall in good economic times could leave the financial system at “a significant risk of systemic collapse”.
International debate over the potential to regulate collateral demands, or “haircuts” in banker parlance, is growing because of their role in exacerbating the boom and the crisis by first encouraging borrowers to take on risk with low rates, then worsening the crisis where spiking rates led panicked lenders to hoard cash rather than put it back into the system.
Andrew Haldane, the Bank’s executive director for financial stability, suggested in a speech on Monday that central bankers could consider limiting the levels haircuts may rise to, or even leaning against the economic tide by requiring banks to hold larger buffers of liquid assets if haircuts are trimmed.
“Thin haircuts made it cheaper for banks to mobilise collateral to finance borrowing when the credit cycle was in the upswing, adding momentum to the upward pendulum of asset prices and credit,” Mr Haldane said. “And fat haircuts immobilised collateral when the credit cycle reversed, exaggerating the downward pendulum swing.”
He added: “A hands-off haircuts policy runs a significant risk of systemic collapse if haircuts are pro-cyclically trimmed during the upswing.”
The comments echoed remarks made recently by Timothy Geithner, the US treasury secretary, who called for regulators to develop global margin requirements for derivative trades that are not centrally cleared, or risk building up fresh unknown dangers.
Secured financing became increasingly important in many countries during the boom years – for example the US repo market financed about half the growth in US investment banks’ balance sheets between 2002 and 2007 while the UK securitisation markets trebled in size, Mr Haldane said. Both those markets remain deeply subdued today.
Mr Haldane’s speech drew on an academic paper he recently co-authored which studied how the increasing complexity and concentration of the interbank market potentially amplified the danger that any problems would spread rapidly.
Relatively few studies of the banking network currently exist because data have previously tended to be collected on an institutional basis. However, the new focus on macro-prudential regulation is leading to increased attention on this area.
The UK’s new interim Financial Policy Committee – of which Mr Haldane is a member – is due to advise the government on a range of possible macro-prudential tools over the next year.
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