Britain’s Financial Services Authority (FSA) will soon require financial institutions to hold more of their investments in “liquid” assets — not fine wine, but assets that banks and investment firms can sell quickly in a crisis, the Financial Times has reported. The rule may not prevent the next crisis, but invite it.

The point of the rule is to insulate financial firms and the broader economy from the kind of panic that engulfed world markets last year. When the regulation takes effect, which won’t be until after the recession has ended, financial firms that borrow more heavily from lenders on a short-term basis — that is, from lenders who can pull their money out in as little time as a matter of minutes — will also have to hold a bigger store of cash and “liquid” bonds in reserve.

That way, if a bank’s lenders were to desert it in a panic, the bank could sell its liquid bonds quickly without sacrificing those assets’ value. The bank could then use its cash and the proceeds from these sales to stay afloat.

So far, so good. But the problem is in the kind of investments that Britain considers liquid: “high-quality” government bonds.

Britain is stepping back into the trap that closed around the financial industry starting more than two years ago. It is lulling itself — and its financial industry — into thinking that a particular investment is safe because that investment has been safe in recent decades. Three years ago, mortgage-backed debt seemed, to lots of smart people, as safe and liquid an investment as . . . government bonds, until it didn’t anymore.

The next financial crisis may not be a crisis of complex, structured debt securities, but a crisis of the simplest investment of all: government debt, as much of the West tests peacetime borrowing records.

Britain’s new rule could make such a crisis a little bit more likely. In pushing financial firms to buy more government debt, the government will create a bigger, captive investment class for much of that borrowing.

In such a crisis, government bonds wouldn’t be so liquid anymore, at least not at a price that wouldn’t bankrupt some of their sellers — just as happened with mortgage-backed securities starting in 2007.

With everyone selling government bonds rather than buying them, the financial firms’ supposedly protective investment would strangle them just when the government couldn’t raise new resources to rescue the companies.

British regulators, in their rule, are trying to protect the financial industry from "systemic" risk — but instead, they may create a new systemic risk.

It’s a lesson for the U.S. and other governments that are thinking about creating "systemic-risk regulators" to protect the economy from the financial system. Such institutional efforts are likely to push more regulators to walk into the same trap as the FSA has.

Instead of determining liquid investments based on what’s liquid today, regulators should apply uniform borrowing limits across financial investments, because the biggest risk is the one that nobody sees.

Original Source: http://corner.nationalreview.com/post/?q=ODI1YjFjNTljYTJmYjM2YmU0MGI1OGIyYmM5OWExYTI#