In recent decades the structure of financial markets has change from a bank-based to a market-based financial system - an Originate, Rate and Relocate model. Financial regulation and crisis management have not kept pace with these changes. A lack of focus on the changing systemic characteristics of the financial system is a significant characteristic of Basel 2 and of the Capital Requirements Directive.
The threat to liquidity: homogeneous behaviour of market participants
If markets are to be liquid and reasonably stable they should have a wide range of participants with heterogeneous objectives and methods. Markets become illiquid when actions become homogeneous especially in the face of extreme events when everyone wants to sell. The liberalisation of financial markets has reduced heterogeneity in financial markets. Financial sector regulators are reinforcing the homogenising process by encouraging firms to use the same risk management techniques.
Disintermediation and crises generated by market “gridlock” As the global capital markets have evolved over the last thirty years a new source of credit “bank disintermediation” has grown exponentially:
The corporate bond market disintermediated the banks by directly pairing off non-bank providers of liquidity directly with corporate and sovereign borrowers:
• Assets traditionally funded on bank balance sheets (corporate loans, mortgages etc.) were moved into separate companies.
• Bank loans, bonds, credit derivatives and a growing array of retail asset backed securities (ABSs) were packaged into collateralised debt obligations (CDOs) and structured investment vehicles (SIVs) and sold to non-bank investors.
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Financial Supervision and Crisis Management in the EU
