A perverse shadow-banking fix?

Barclays Building in New York, formerly the HQ of Lehman Brothers

Among the acknowledged causes of the 2007-8 markets meltdown and banking crash is a global financial system that encourages the creation of debt at an exponential growth rate in boom times.

And just one fragility of this system is that when it goes into reverse gear - the withdrawal of credit - the speed of contraction is even faster.

One example is the operation of so-called repo markets, where banks lend to so-called shadow banks, such as hedge funds, against the security of bonds. This is debt created and lent against the collateral of other debt - debt manufactured on the back of extant debt.

The risk, as the world witnessed in horror just over six years ago with Lehman's demise, is that when a lender cannot get its money back and sells the bonds held as collateral, this can lead to a collapse in the price of those bonds - which has the duel pernicious impact of generating huge losses for the lender, imperilling its ability to lend, and causing haemorrhages in bond markets, thus undermining the ability of households and business to raise precious funds around the back of the banking system.

Massive deflationary credit contraction sets in, of the kind that transformed the financial debacle into the worst economic contraction the world has seen since the 1930s.

So it is not trivial that guidelines have been published overnight by the world's top rule-writer for banks and securities firms, the Financial Stability Board, stipulating that banks should apply new discounts or "haircuts" to bonds used as collateral for repo loans.

As and when they are imposed, by the end of 2017, they will apply haircuts of up to 4% on long-maturity corporate bonds and 7% for mortgage-backed and consumer-debt-backed bonds.

Or to put it another way, if a hedge fund wishes to borrow $100,000, it will have to pledge corporate bonds worth $104,000, for example.

In practice this means borrowing will become more expensive for the likes of hedge funds. And the repo market will shrink and become less profitable for banks - reinforcing what has already been happening.

And some would say the long-term contraction of a market that over a certain size contributed to fragility of the global economy, would be no bad thing.

Except that the FSB has done something which may be regarded as perverse in two important senses.

First the FSB is making it more expensive for businesses and households to borrow independent of the banking system, by shrinking available liquidity or funding in bond markets.

In other words, in a Europe where bloated banks are widely perceived as having far too much of a role in the creation of credit, the FSB is reinforcing the hold of banks over the economy - when arguably it should be doing the opposite.

Second, it is imposing a zero haircut on government bonds used in repo operations, so no discount will be applied when a shadow bank pledges French, Spanish or Italian government debt, for example, to borrow from an official bank.

There is short-term economic logic for discriminating in favour of government debt in this way.

At a time of deflationary threat to the prosperity of the eurozone, the FSB would not want to be seen to be increasing the squeeze on government finances.

But can it be healthy in the long term, when excessive government spending is seen by many to be a prime source of eurozone malaise, to reinforce the relative ease for governments to borrow as though there is no tomorrow?

If there is a bubble in the world right now it would be in the price of sovereign or government debt. So perhaps the FSB is simply closing the door on one tired old nag, repos based on private sector debt, while allowing another to bolt.