Central bankers and regulators have greatly underestimated the negative impact their actions may have on the economic “multiplier.” Over the next two to three years this miscalculation may settle into a permanent drag on global growth. Forget fears of bloated central bank balance sheets and their potentially inflationary effects – rather than generating credit in the consumer sector, much of that “liquidity” is being used to meet new capital requirements.
In the aftermath of the financial crisis in 2008 and 2009, central banks and regulators made great strides to make the system safer, reduce the chances of another major financial institution failure and, in the event such a failure does occur, prevent taxpayers from paying for recoveries. We have seen the passage of the Dodd-Frank Act (DFA) and the Volcker Rule in the U.S., implementation in Europe of Markets in Financial Instruments Directive II and Markets in Financial Instruments Regulation, and global implementation of Basel III and living wills, bank leverage limits, the supplemental leverage ratio (SLR) and bank stress testing by regulators and other safeguards.
These regulatory initiatives have clearly furthered the goal of stabilizing the system and reducing systemic risk. On average, bank balance sheets are in better financial shape, and banks continue to make money based on low interest rates and attractive net interest margins.
The costs to the economic multiplier, however, are only starting to become apparent.
Economies grow (or shrink) as a function of both the amount of money in the financial system and the speed at which it moves. For example, if a central bank puts $100 into the system and it grows to $2,000 with the help of fractional reserve banking (banks hold a small portion of deposits and lend the rest), then the economic multiplier is 20. The speed at which this $100 becomes $2,000 is the velocity of the money – the higher the velocity and the larger the multiplier, the more growth is expected to increase.
One example of the impact of regulation: Many investment banks’ leverage ratios were over 20x before the financial crisis, but now they average below 10x. Because banks are the primary facilitators of credit creation, such leverage reduction can have the effect of almost halving the economic multiplier – meaning that $100 is now only $1,000 in the economy, not $2,000.
Regulations have created new complexities – and costs
The DFA and the European Market Infrastructure Regulation require that many over-the-counter (OTC) derivatives now be centrally cleared. Among other things, central clearing of derivatives requires the daily mark-to-market of positions (to prevent a repeat of the AIG debacle), posting initial margin against derivatives (to reduce jump-to-default risk) and using a Futures Commission Merchant (FCM) to act as an intermediary for trades (to allow for the portability of cleared transactions and to reduce the direct-type OTC bilateral counterparty risk we saw in the collapse of Lehman Brothers). Other crucial markets, such as the market for repurchase agreements (repos), may also move toward a central clearing model, adding another layer of complexity.
Regulations also require additional systems and monitoring – all of which need to be built out. Firms have been spending from earnings to upgrade technology and compliance. These ongoing costs increase the need for a higher return on equity (ROE) and decrease the bank’s effective multiplier.
While the steps taken by central banks and regulatory bodies have been successful in increasing the strength of the markets and reducing systemic risk, they are not free. PIMCO estimates that the additional amount of initial margin required to be posted by market participants will be over $1 trillion once all derivative positions (excluding physically settled foreign exchange transactions) are moved to central clearing. Guarantee fund contributions by FCMs and capital reserves needed as a result of customer margin segregation rules such as “legally segregated, operationally commingled” reserves could add another $300 billion to $500 billion on top of that figure. Add to this the potential capital requirements for non-cleared derivatives, and the total amount may be over
$1.5 trillion of additional collateral needs.
The result of all this regulation is to raise the cost of capital. As cost goes up, banks will either pass it on to borrowers, hurting investment, or allow it to reduce profit margins, hurting stockholders. While these safety and soundness measures have the benefit of reducing systemic risk, there are real costs to the economy.
Anticipate a slower velocity of money in The New Neutral
While the Federal Reserve’s balance sheet has grown by almost $3 trillion, and with the ECB about to embark on its own asset-purchase program, much of that “money” in the system is captive, as it is being held to meet regulatory requirements for lower leverage and central clearing, and the implementation and monitoring of new rules. While the Federal Reserve is executing its reverse repo program to help reduce some of these issues, there are concerns that the Fed could begin to dominate the market and become seen as the borrower of last resort in times of stress, potentially putting more pressure on faltering institutions. This will most likely limit the overall size of the program that the Fed offers to the wider market.
Thus, as banks look for higher ROE targets and more stable earnings, growth will be lower from a lower economic multiplier and a higher cost of capital, slowing the velocity of money. Consistent with PIMCO’s The New Neutral thesis, these structural changes will play a substantial role in central banks moving less quickly and to a lower neutral rate than in previous cycles.