I’ve been reading a lot about the Dodd-Frank Act recently. Blessedly I haven’t had to read Dodd-Frank itself (all 2,319 pages of it), but it bears the hallmark of a good compromise- nobody seems happy with it. And, while there’s plenty to gripe about and speculate upon, what’s caught my interest is the failure of the Act to address what I think remain important issues: rehypothecation and international regulatory arbitrage.
Rehypothecation starts with hypothecation- the act of posting collateral in exchange for cash. This is a harmless proposition that provides lenders with a secure asset in case of borrower default. However, many pledge agreements also contain the right to rehypothecate as a sweetener for the lender. Rehypothecating is the act of taking the assets you’ve just acquired as collateral for a loan and using them as collateral yourself. It’s like borrowing money from a friend that insists on holding onto your watch until you pay him back. The next day you return the money- only to find that he’s used your watch as collateral to borrow from a different friend.
This can create a problem for you when your friend runs into trouble. The lender’s right to rehypothecate is not automatically balanced by borrower protection in the case that the lender becomes insolvent. This was what happened to customers of the United Kingdom-based Lehman Brothers International Europe when that brokerage firm collapsed. Customers returning for posted collateral found it had simply disappeared, transferred away via rehypothecation, and found themselves without effective legal recourse.
This isn’t the only problem with how the technique has been used. Rules regarding rehypothecation in the US are significantly stricter than in the UK and continental Europe. Thus, prior to the crisis US hedge funds seeking to use assets as collateral found much readier sources of funds across the pond, where brokerage firms were able to alchemically transmute pledged collateral into cash for lending over and over again through rehypothecation. Meanwhile, the effect of this money manufacturing was a higher degree of leverage in the shadow banking system on both sides of the Atlantic than was realized by many market participants. And higher leverage meant a harder crash.
When the financial crisis hit, the system was convulsed by an extraordinary liquidity crunch. This problem was made worse by a gap between the scale of the money supply contraction indicated by traditional measures of the money supply, and the scale of the contraction of a real money supply that had been swollen through rehypothecation and other activities of the shadow banking system. As a result, not only was the actual contraction sharper than was immediately understood, it was far more massive.
This brings me to the point of this piece. The Dodd-Frank Act fails to adjust the regulatory framework of the US to address the type of regulatory arbitrage conducted here (among other failings). And that’s a problem. But it’s also a small problem relative to a larger issue- the incongruity inherent in national regulators and regulations facing the challenge of overseeing internationally mobile capital. Regulatory mismatches are opportunities for profit that are simultaneously legal and destabilizing. They allow the accumulation of risks in national financial systems that are outside the purview and training of domestic regulators to track. Fixing this problem will require the efforts and expertise of an extraordinary number of people. It will not be accomplished soon. But it is important because the outcomes our financial system produces will only be as good as the system of rules that governs it.
Aitken, James, and Manmohan Singh. 2010. The (sizable) Role of Rehypothecation in the Shadow Banking System. IMF Working Paper. International Monetary Fund. http://ideas.repec.org/p/imf/imfwpa/10-172.html.
Dewatripont, Mathias, Jean-Charles Rochet, and Jean Tirole. 2010. Balancing the Banks: Global Lessons from the Financial Crisis. Trans. Keith Tribe. Princeton University Press.
Johnson, Christian A. “Derivatives and Rehypothecation Failure: It’s 3:00 P.m., Do You Know Where Your Collateral Is?” SSRN eLibrary. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=584102.
Metrick, Andrew, and Gary B. Gorton. 2010. “Haircuts.” SSRN eLibrary (May 12). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1447438.
As the United States continues its slow recovery from a deep recession and many Americans struggle to find jobs, the economy is at the forefront of voters’ minds heading into the 2012 election. Given the continued policy gridlock in Congress, economic growth is arguably the most urgent policy challenge facing the next president. But the policy prescriptions are complex, requiring strategies to address the shrinking middle class, reduced consumer demand, the housing market, the national deficit and America’s role in the global economy.
This event will be live webcast, and participants may follow the conversation on Twitter using the hashtag #BIeconomy.
Thursday March 1, 2012
10:00 – 11:00 am EST (15:00 – 16:00 GMT or get your time)
The great recession of 2007-09 has left permanent scars, the global recovery has lost steam, and policy makers around the world are struggling to restore stability and confidence. The remarkable role that emerging markets have played as engines of global recovery is no longer certain. While the 5.4 percent growth predicted for developing countries in 2012 is still high compared with the 1.4 percent expected for high-income countries, this is down almost two percentage points in just two years.
Are emerging markets still capable of saving the global economy? What can the industrialized world do to help ensure that robust global growth is restored? What is the role of government in bringing the world economy back on track?
Otaviano Canuto - Vice President of the Poverty Reduction and Economic Management Network, World Bank
John Maynard Keynes (The General Theory)
“The ideas of economists and political philosophers, both when they are right, and when they are wrong are more powerful than is commonly understood, indeed the world is ruled by little else, practical men who believe themselves to be exempt from any intellectual influence are usually the slaves of some defunct economist”
F.A. Hayek (The Fatal Conceit)
“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design”