New Research: Post-Crisis Reforms, Borrowing, and Liquidity

New Research: Post-Crisis Reforms, Borrowing, and Liquidity

A new paper from the Annual Review of Financial Economics documents the effects of post-2008 reforms on liquidity and leverage during the financial crisis. Overall, they find that these reforms made the financial system more stable, with relatively modest effects on liquidity in the financial sector:

The financial system has undergone far-reaching changes since the global financial crisis of 2008. We cast those changes in terms of shifts in the manner in which financial intermediaries manage their balance sheets. We also discuss the regulatory reform agenda, and we review the impact of regulations on market liquidity and credit availability. Current evidence suggests that the financial system has become safer, at limited unintended cost.

Throughout the ‘90s and into the ‘00s, the financial system was highly leveraged, both in the U.S. and around the world (though U.S. banks were better-capitalized than their international peers, particularly in Europe). The ‘08 crash had a “deleveraging” effect as banks looked to get toxic assets off their balance sheets and debtors were unable to pay back their creditors.

That our financial system is too reliant on debt is certainly true, but the paper offers some interesting insights on the costs of various forms of financial regulation, namely higher capital requirements, such as those included in the Basel III accords.

We know that banks prefer debt financing to equity financing and are willing to forego some profit to avoid financing via equity, but an interesting argument made in the paper is that greater equity financing can in fact make it cheaper to borrow.

A better-capitalized bank is less risky, making lending to that institution a safer investment than one leveraged to the hilt. In their review of the literature, the authors find that “a 1 percentage point increase in the equity to total assets ratio is associated with a 4 basis point [0.04%] reduction in the cost of borrowed funds.” The cost reduction is greater for more thinly capitalized banks.

For the broader economy, better capitalization can also lead to increased lending, as “banks with lower leverage…expand their lending at a faster pace. [A] 1 percentage point increase in the equity to total assets ratio is associated with a 0.6% uptick in the subsequent growth in lending.”

As to liquidity, the paper finds negative, albeit modest, effect of post-crisis reforms. The main mechanism by which liquidity decreased is a change in the way broker-dealers functioned. Previously, the paradigm involved these institutions purchasing assets and keeping them on their books, waiting for others to purchase them. Today, the model has shifted more towards “offsetting,” where they will wait for an investor to purchase a given asset before first buying that asset from another institution. Even so, the paper finds “only limited evidence that this has led to a widespread deterioration of bond market liquidity.”

Given these results, the paper finds that financial stability has, on balance, improved relative to the pre-crisis landscape.

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By |2018-12-13T12:19:43-08:00December 13th, 2018|Blog, Financial Regulation|