Dealing with risks in the shadow banking system. Globally, the value of financial assets outside banks, insurers, pension funds and central banks rose by about 7% in 2013 over the previous year, to a total of $75 trillion. This is almost back to the pre-crisis level as a share of GDP. Not all of this should be considered “shadow banking” as such and, whatever name we use, not all of it is necessarily a risk to the system. But it does point to a growing volume of financial activity outside the bank regulatory perimeter that could give rise to maturity and liquidity mismatches, and cannot be easily monitored or managed by traditional regulatory tools. Some measures have been taken to reduce the risk of runs on money market mutual funds, especially here in the United States, but also in Europe3 – time will tell whether they are enough. The Financial Stability Board (FSB) has set out a regulatory framework for haircuts on certain non-centrally cleared securities financing transactions. It has also put out for comment a proposal for minimum haircuts (numerical haircut floors) for transactions between non-banks backed by collateral other than government securities. Such minimum haircuts would tend to make the financial system less procyclical.
I shall not go into details about the state of play in each of these four areas. Let me just mention a few matters that remain to be decided:
• TLAC in resolution. As you know, the FSB and the Basel Committee have proposed total loss-absorbing capacity in resolution. Why TLAC? In the event of resolution, global systemically

TLAC in resolution. As you know, the FSB and the Basel Committee have proposed total loss-absorbing capacity in resolution. Why TLAC? In the event of resolution, global systemically important banks need to have sufficient loss-absorbing debt to allow an orderly resolution that avoids falling dominoes, maintains critical functions and minimises taxpayers’ risk. Both bondholders and shareholders should have a stake in banks’ managing risk properly. An impact study is scheduled to be published by August; calibration is to be done by September; endorsement by the G20 Leaders is expected in November; and implementation may be as early as January 2019.

In his famous quote, Buffet is referring to a phenomenon known in
academic circles as a “peso problem”—a term commonly attributed to
Nobel laureate Milton Friedman for comments he made about trading
in the Mexican peso in the early 1970s. At the time, the exchange
rate between the U.S. dollar and the Mexican peso was fixed at that
time as both countries were following the Bretton Woods
Agreements. However, looking at interest rates on government bonds
in Mexico and comparing them to interest rates on similar-maturity
government bonds in the United States, one found that the interest
rates in Mexico were far higher—despite the fixed exchange rate. This
posed a bit of a puzzle. Investors could borrow U.S. dollars and pay a
low interest rate, convert these dollars into pesos, and then invest the
pesos into Mexican government bonds and earn a high interest rate.
When the Mexican bonds matured, the investor could simply convert
the peso principal and interest back into dollars at the same exchange
rate that he did the initial conversion. He could then pay back the dollar
borrowings and he would be left with a profit, equal to the interest
rate differential between Mexican and U.S. interest rates times the
principal amount borrowed. In modern terms, this is known as a carry
trade. However because the exchange rate was fixed, there was no risk
in this carry trade. Therefore the profit from the carry trade could be
earned with no risk—a condition that financial economists refer to as
an arbitrage, or free money. How could this prevail in the financial
markets? In trying to explain this phenomenon, Friedman noted that
perhaps the interest rate differential between the two countries
reflected a hidden risk factor that no one could observe in financial
market data because the downside effects of this risk had not occurred
yet. He speculated that this risk factor was the possibility of a devaluation
of the Mexican peso. And sure enough, in August 1976 the peso
was allowed to float against the dollar, and the peso promptly fell 46%.

Time series graph of WorldCom’s default probability from the equity
markets

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