Largely unregulated, the implosion of the FTX cryptocurrency exchange has been described as example of an institutional failure. There simply was not enough cash or assets to cover sudden customer requests for their money. Whether you label it as a problem of solvency or liquidity hardly matters.
At the other end of the spectrum, banks are heavily fortified by capital constraints, liquidity requirements and all backed by deposit insurance. These safeguards protect against gyrations in the market that could prove fatal to some other institutions.
A recent news report says the Biden Administration is again looking at stricter scrutiny of the non-bank sector.
This includes insurers and asset managers that may be “systemically important” and thus potentially worthy of macroprudential oversight.
Non-banks also include mutual fund complexes and private capital providers with asset bases sometimes worth trillions of dollars. Strict regulation of banks has pushed some crucial activities, including the trading of US Treasuries, towards less-regulated sectors where risky leverage may be concealed.
The worry is that when asset prices move sharply and quickly, institutions will be caught off guard, unable to cope with customer withdrawals. Recent examples include the collapse of Bill Hwang’s Archegos family office, the tumult in UK pensions during the spike in gilt yields and the collapse of FTX.
Non-banks try to dodge regulation arguing that they do not take what should be riskless customer deposits and then lend these out. Perhaps that is fair. But just being large and interconnected can create the potential for contagion. The insurer AIG, for example, had a complex derivatives trading operation that nearly doomed the US financial system to collapse in 2008.
The paradox of regulation is that it can reduce dynamism, reasonable risk-taking and thus liquidity. It also transfers risk on to taxpayers.
Regulators are understandably jumpy. The FTX collapse could prefigure crises closer to the heart of the US financial system. But when a large but systemically unimportant business fails without contagion beyond its niche, it suggests the regulatory balance is broadly right.
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