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It must be pretty hard to be a Financial Stability Oversight Council. Or easy? Two key facts about the FSOC are that (1) its job is to prevent a crisis in the U.S. financial industry1 and (2) it was established a year or so after a once-in-a-generation-or-lifetime-or-whatever crisis in the U.S. financial industry. So if you work there now you’ll probably retire with a warm but statistically-indistinguishable-from-chance feeling of success even if you spend your career playing video games.2
To their credit, though, they’re not, instead producing an annual report that is I guess intended to be a list of things that might cause the next financial crisis? Really, what are your odds on that? Especially if, as is true of the actual FSOC 2013 annual report, you omit possibilities like “asteroids” or “sudden recurrence of tulip mania” or “Ben Bernanke is actually an alien sent from the future to destroy mankind.” The swan will always be the color you least expect.
But while I would have just listed things in order of increasing implausibility, the actual report is instead a mix of:
- general backgroundy charts about the financial system and the economy;
- mild we’ve-got-this-covered fretting about things that are always discussed as potentially destabilizing – market infrastructure, flash crashes, derivatives counterparty risk, bank capital structures,3 the possibility of orderly liquidation of giant banks, tri-party repo and general overreliance on skittish short-term wholesale funding,4 money market funds, the interest-rate risk of banks who borrow short at zero rates to lend long at not-all-that-much-above-zero rates, etc.; and
- adorably idiosyncratic fretting about things that … well seem unlikely to cause the next financial crisis but who knows really?
My favorite example of the last category is Libor:
Another concern is if market participants were to rapidly and precipitously move to divest investments and contracts linked to LIBOR. While such an
event is currently not expected, such an event could destabilize markets. If such a shift occurred gradually, it could be seen as market participants effectively solving their own problem. However, if appetite for LIBOR-linked investments and contracts was severely reduced and led investors to rapidly and precipitously shift out of these instruments, the normal functioning of a variety of markets, including business and consumer lending, could be impaired.
Umm?5 Like, okay, the Libor scandal is bad and all, but probably not because it will cause everyone to suddenly dump interest-rate contracts. That seems like the sort of thing that, if it was going to happen, would have happened after the first or second or tenth batch of Libor manipulation emails.
Do you feel better? Worse? The same?
And then there’s “convexity event risk” in agency MBS, in which interest rates rise a little bit, prepayment speeds go down, agency MBS duration increases, hedged holders of agency MBS dump Treasuries to reduce duration, and this causes a vicious cycle of rising interest rates. This section of the report reads more like “here is an opportunity to explain negative convexity” than like “here is thing that might happen and be bad,” but who knows, I guess it’s possible. So might as well have it on the list.
1. Ooh actually the official job is in three parts (from page i of the report):
1. To identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or that could arise outside the financial services marketplace.
2. To promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties of such companies that the U.S. government will shield them from losses in the event of failure.
3. To respond to emerging threats to the stability of the U.S. financial system.
That second job is a little silly isn’t it? “Setting up this institution to worry about the failure of large interconnected banks will eliminate the perception that we’re worrying about the failure of large interconnected banks.”
2. Of course there are obvious parallels to the bankers they regulate, replacing “play video games” with “take unjustified risks with creditors’ money” or whatever you want to call it.
3. This chart might be worth staring at for a bit:
4. You could title this chart “the next financial crisis will be caused by Citi”:
5. I’m being a touch unfair to the Libor discussion; further up there’s this:
LIBOR, EURIBOR, and other similar benchmarks play a key role in the financial system’s core functions of pricing and allocating capital and risk. The Council believes that the price signals derived from such benchmark interest rates must have integrity; be based upon competitive forces of supply and demand; and be free of fraud, manipulation, and other abuses. For capital and risk to be efficiently allocated within the economy and risk to be appropriately measured, such interest rate benchmarks should reflect actual price discovery anchored in observable transactions.
I guess? Libor manipulation probably did misallocate capital, in a vague basis-point-at-a-time sort of way, though I don’t know that that’s, like, a financial stability issue.