In the wake of the Global Financial Crisis in 2008, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) was introduced under the regime of President Barack Obama through the sponsorship of two Democrat politicians, Barney Frank and Christopher Dodd. This was a complex piece of legislation that spanned 848 pages of text and took several years to pass. Its intended purpose was to prevent a repetition of the Global Financial Crisis by increasing control by politicians over financial markets and to obligate large, too-big-to-fail banks to raise their capital buffers. When Donald Trump reached the White House in 2017, some aspects of the Act were repealed – only to be re-introduced when Joe Biden became president in 2021.
The purpose of this newsletter is not to examine all aspects of the Dodd-Frank Act but, instead, to analyse whether any aspects of the Act are not only relevant to the financial market turmoil of today but, furthermore, could be seen as contributing to the serious parallel upheaval in the UK gilts markets. Also to be seen is whether and how this turmoil could be repeated in other countries or currency zones (such as the US Dollar zone or the Eurozone) and destabilise the vast amounts of pension funds that are, by force, obliged to invest the lion’s share of their portfolios in fixed income securities.
Many public figures condemned the Dodd-Frank Act as curtailing the competitiveness of US financial institutions and opening the door to foreign competition, where the Act did not apply. An essential part of the Act was the so-called Volcker Rule, named after the renowned former US Federal Reserve Chairman, Paul Volcker.1 Coming on top of the higher minimum capital requirement for US banks, the Volcker Rule placed a limit on the amount of proprietary capital a bank can deploy towards making two-way prices in certain financial markets. Prior to the Act, banks were large operators in securities markets, acting as buyers or sellers, with the result that market liquidity was in abundance. After the introduction of Dodd-Frank, banks were not only required to hold higher amounts of cash, they could also not trade in a way intended to make profits which, as a result, constrained their ability and appetite to act as market-makers and liquidity providers in areas where their activities were crucial to a functioning market. So, whilst smaller banks and their customers were undoubtedly safer from another financial Armageddon, as a result of the more stringent capital requirements, shrunken liquidity in financial markets caused other risks to increase – risks that can be recognised today.
This shrunken liquidity is most relevant in the fixed income markets, where marking a bond price to market does not apply across the board and where a constant supply of buyers and sellers is not uniformly available. In the UK, when the then-Chancellor Kwasi Kwarteng shocked the world through the announcement of irresponsible financial measures in his mini-budget during the last month under review, liquidity in the gilts market dried up as defined-benefit pension funds were forced through margin calls to jettison their holdings of what should have been their most liquid assets – government bonds – all at the same time. As everyone was selling, there were no more buyers which caused the price of these bonds to plummet further and yields to soar even higher in a self-perpetuating feedback loop, until the Bank of England stepped in at the last minute. The irony is that the problem was caused by a risk-management strategy called liability-driven investing, which is supposed to protect against interest rate moves. It was a moment of shock and awe, causing the young British government to fall as all eyes were centred on the travails of the City of London. All observers asked the same question: where is the next shoe to drop?
Time will tell what advice or rules governments will be advancing in the weeks and months to come. British legal experts are now working on reform measures that would enable affected pension funds to post non-cash assets as collateral with their hedge providers, thus avoiding a universal run on the gilts market, as recently witnessed. In contrast, however, the observer is struck by the advice handed out by the Dutch government to their own pension funds. The government is urging pension funds to increase their liquid assets by selling bonds for cash in anticipation of a similar crisis erupting in Holland. In other words, dear pension funds, you must cement a permanent loss of capital to your pensioners by selling these assets at rock-bottom prices as soon as possible.
This needs to be seen to be believed.
The UK pension debacle is a reminder that risk can’t really be eradicated; often it is merely shifted to another corner of the system. The question is where? Part of the answer is probably ‘not banks’, owing to the reforms introduced by the Dodd-Frank Act.
Who then has replaced the former bank proprietary traders to make a market in otherwise illiquid securities and to what extent does transparency exist? Can prospective bond buyers find their counteracting sellers or, as is much more important in this frantic period of rising interest rates and bond yields, where can sellers find buyers? The importance of this topic cannot be overstated. The main problem in financial markets today is the liquidity squeeze that has been in place for many months. This risks turning into a liquidity crunch, followed by a solvency crisis stretching into many corners of the market.
Another, more telling, part of the answer might turn on shadow banking. Below is some insight into the shadow banking arena given by the Central Bank of Ireland:
In traditional lending, the volume of lending by a bank is linked to the volume of deposits the bank receives and what it can borrow on the markets. Shadow banking works on the same principle. So, for example, an investment fund takes in money from investors, issuing shares in the fund in return. In order to earn a return on the investment for its investors the fund uses this money to buy securities (for example, a bond issued by a country or company).
Just as the bank acts as the “middleman” between savers and borrowers to earn a specified interest rate, the investment fund acts as the channel linking investors and countries/companies to earn an investment return. By raising funds from investors and then lending this money to countries/companies, shadow banking entities act like banks”.2
By definition, because this activity is not being undertaken by systemically important banks, it is less tightly regulated and monitored. Shadow banks can include the likes of investment funds, such as bond and equity funds, hedge funds and private equity funds. Apart from the magnitude of today’s shadow banking sector, estimated at over US$60 trillion by narrow definitions, and as much as half of all financial assets by broader measures,3 bond funds around the world have taken centre stage in this space.
Like banks, the activities of these funds are procyclical. Liquidity has been supportive on the way up, as the growth in the assets under management (AUM) of these funds has enabled their bank-like activities, buying (and selling) the bonds of corporates and/or governments with the capital raised from their investors, in exchange for shares issued in their funds. Sometimes, the debt of multiple (often junk-rated) companies is bundled together and packaged into slices of bond-like securities, called collateralised loan obligations (CLOs); investors such as pension funds are implicated in these shadow banking activities when they invest in funds that own these CLO bonds.
It is difficult to understand how these open-ended funds that promise on-demand convertibility of their shares into cash can rely on an orderly and liquid market if outflows begin to outpace inflows, turning them into net sellers. Like banks, they are vulnerable to ‘runs’ when investors move at once to redeem their shares in order to raise cash. As we saw in the UK pension market, the use of leverage can add to this destabilising dynamic if price falls induce forced selling to meet margin requirements.
Whereas the Dodd-Frank Act promoted accountability and transparency in the banking sector, the irony is that the opacity of these ‘shadow’ banking activities make it difficult to quantify how far and deep they extend, and into which corners of the market. How will, for example, rising borrowing costs and the strengthening US Dollar affect the companies whose debt promises to be the saleable securities on which these bond funds’ AUM has been built? It is not just outright defaults, but ratings downgrades which could spur ‘runs’. Financial markets are more interconnected today than they were during the Global Financial Crisis. Can we be sure that no individual fund or firm is so big or interlinked with others that it sets off a chain reaction? The problem is that policymakers are always fighting the last war.
Admittedly, we have asked more questions than we have sought to answer. For the quality growth investor, our companies, many of the most liquid and highest quality businesses in the world, may not be immune to the gyrations of what may follow on from a liquidity squeeze in the current market environment. But an awareness of what may be affecting share prices, namely flows rather than fundamentals, gives us comfort to focus on what matters; and that is to be as confident as we can in the ability of our companies to consistently grow their earnings over time, because over the long-term, it is earnings which ultimately drive share prices.
P. Seilern-Aspang & C. Hoelzl,
31st October, 2022
1Paul Volcker’s fame was reached during the period in the 1970s and early 1980s when world inflation was rampant, even more so than today. His claim to this fame lies in his conquest over inflation through ruthless monetary tightening and which was to last until inflation’s unpleasant resurgence in 2021, and exacerbation following Putin’s barbaric attacks on Ukraine this year.
2Central Bank of Ireland, Explainer – What is Shadow Banking? (2022)
3At the end of 2020: Financial Stability Board, Global Monitoring Report on Non-Bank Financial Intermediation (16 December 2021) Global Monitoring Report on Non-Bank Financial Intermediation 2021 (fsb.org), p.3.
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