Brookings: Projects - Initiative on Business and Public Policy

Dealing with “Too Important to Fail” Banks

Fri, 14 Jun 2013 10:00:00 -0400

Event Information

June 14, 2013
10:00 AM - 11:30 AM EDT

Falk Auditorium

1775 Massachusetts Ave., NW
Washington, DC

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There is a heated debate about how to handle banks that are too big or otherwise too important for governments to allow them to fail in a crisis. Some call for the largest banks to be broken up, or for them to divest all or part of their investment banking operations, in the spirit of the old days of the Glass-Steagall Act. Others suggest forcing banks to be funded with much more shareholder money to try to make failure very unlikely. Still others assert that the Dodd-Frank Wall Street Reform and Consumer Protection Act and global regulatory reforms have reduced the problem so much that major structural reforms such as these are unnecessary.

On June 14, the Economic Studies program at Brookings reviewed and debated the issue of bank size and bank funding. Panelists included FDIC Vice Chairman Thomas Hoenig, banking expert Rodgin Cohen, and Senior Fellow and Director of the Initiative on Business and Public Policy Martin Baily. Douglas Elliott, fellow in Economic Studies, served as moderator.

Join the discussion on Twitter using hashtag #TooBigToFail.

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Dealing with “Too Important to Fail” Banks

Event Materials

14 dealing with too important to fail banks baily presentation

Participants

Panelists

Ted Gayer

Co-Director, Economic Studies
Joseph A. Pechman Senior Fellow

Douglas J. Elliott

Fellow, Economic Studies, Initiative on Business and Public Policy

Martin Neil Baily

Senior Fellow, Economic Studies
Bernard L. Schwartz Chair in Economic Policy Development

H. Rodgin Cohen

Senior Chairman

Thomas Hoenig

Vice Chairman

Fed Policy, Stock Markets and Japan

Douglas J. Elliott — Thu, 13 Jun 2013 08:45:00 -0400

The 6.4% fall in the Japanese stock market overnight, and the general retreat in global stock markets since late May, underline the importance of monetary policy for financial markets. There’s a reason for the old Wall Street saying that you should “never fight the Fed.” Monetary policy is a major determinant of economic activity and therefore of the value of the stocks and bonds of companies, since they are all affected by the level of economic growth. It also affects the cost of funding investment activities; lower interest rates make virtually all investments more attractive. Securities purchases by the Fed and other central banks around the world have a similar effect by bidding up prices. Further, the level of a country’s interest rates has a major impact on currency rates, with money tending to flow to where it can earn the highest interest and away from where it can be borrowed most cheaply. (The so-called “carry trade” focuses specifically on borrowing in currencies with cheap money and investing in currencies with higher interest rates.)

The Japanese are engaged in a massive exercise of monetary loosening in an attempt to increase asset prices and lower exchange rates in the anticipation that both factors will spur economic growth. This has led to sharply higher Japanese stock prices over the last half year, a gain that is being partially unwound as new doubts arise about how fully effective the new policies will be. The big question is whether this is (a) simply an adjustment to a more realistic view of policies that should remain quite supportive of the markets and economic growth or (b) a realization that the policy may be ineffective or ultimately counterproductive. I suspect that the answer is (a), but that the adjustment has further to go, since hopes have been quite inflated and there was insufficient recognition of the dangers and costs of the approach. That said, Japanese stock prices were massively beaten up over the last two decades and it may be that they are responding substantially to a reduction of an excessive and pervasive pessimism.

Markets around the world are also responding to the likelihood that the Fed will begin tightening monetary policy soon. For more on the implications of this, please see my recent presentation at an investor conference.

Authors

Douglas J. Elliott

Image Source: © Toru Hanai / Reuters

Quantitative Easing Withdrawal: How Bad Will it Hurt?

Douglas J. Elliott — Wed, 12 Jun 2013 16:09:00 -0400

The Fed's quantitative easing program and ultra-low interest rates will eventually come to an end, with purchases of new securities by the Fed potentially being reduced as early as this autumn. Financial markets are very focused on how this will occur and what effect it will have on securities of all kinds and on the economy as a whole. Economic Studies fellow Douglas Elliott recently gave a presentation to an investor conference on this issue. These slides are adapted from that presentation.

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QE Withdrawal: How Bad Will it Hurt?

Authors

Douglas J. Elliott

Image Source: © Brendan McDermid / Reuters

Why Isn’t Disruptive Technology Lifting Us Out of the Recession?

Martin Neil Baily and James M. Manyika — Tue, 11 Jun 2013 13:34:00 -0400

The weakness of the economic recovery in advanced economies raises questions about the ability of new technologies to drive growth. After all, in the years since the global financial crisis, consumers in advanced economies have adopted new technologies such as mobile Internet services, and companies have invested in big data and cloud computing. More than 1 billion smartphones have been sold around the world, making it one of the most rapidly adopted technologies ever. Yet nations such as the United States that lead the world in technology adoption are seeing only middling GDP growth and continue to struggle with high unemployment.

There are many reasons for the restrained expansion, not least of which is the severity of the recession, which wiped out trillions of dollars of wealth and more than 7 million US jobs. Relatively weak consumer demand since the end of the recession in 2009 has restrained hiring and there are also structural issues at play, including a growing mismatch between the increasingly technical needs of employers and the skills available in the labor force. And technology itself plays a role: companies continue to invest in labor-saving technologies that reduce demand for less-skilled workers.

So are we witnessing a failure of technology? Our answer is "no." Over the longer term, in fact, we see that technology continues to drive productivity and growth, a pattern that has been evident since the Industrial Revolution; steam power, mass-produced steel, and electricity drove successive waves of growth, which has continued into the 21st century with semiconductors and the Internet. Today, we see a dozen rapidly-evolving technology areas that have the potential for economic disruption as well in the next decade. They fall into four groups: IT and how we use it; machines that work for us; energy; and the building blocks of everything (next-gen genomics and synthetic biology).

Wide ranging impacts

These disruptive technologies not only have potential for economic impact—hundreds of billions per year and even trillions for the applications we have sized—but also are broad-based (affecting many people and industries) and have transformative effects: they can alter the status quo and create opportunities for new competitors.

While these technologies will contribute to productivity and growth, we must look at economic impact in a broader sense, which includes measures of surplus created and value shifted (for instance from producers to consumers, which has been a common result of Internet adoption). The greatest benefit we measured for autonomous vehicles—cars and trucks that can proceed from point A to point B with little or no human intervention. The largest economic impact we sized for autonomous vehicles is the enormous benefit to consumers that may be possible by reducing accidents caused by human error by 70 to 90 percent. That could translate into hundreds of billions a year in economic value by 2025.

Predicting how quickly even the most disruptive technologies will affect productivity is difficult. When the first commercial microprocessor appeared there was no such thing as a microcomputer—marketers at Intel thought traffic signal controllers might be a leading application for their chip. Today we see that social technologies, which have changed how people interact with friends and family and have provided new ways for marketers to connect with consumers, may have a much larger impact as a way to raise productivity in organizations by improving communication, knowledge-sharing, and collaboration.

There are also lags and displacements as new technologies are adopted and their effects on productivity are felt. Over the next decade, advances in robotics may make it possible to automate assembly jobs that require more dexterity than machines have provided or are assumed to be more economical to carry out with low-cost labor. Advances in artificial intelligence, big data, and user interfaces (e.g., computers that can interpret ordinary speech) make it possible to automate many knowledge worker tasks.

More good than bad

There are clearly challenges for societies and economies as disruptive technologies take hold, but the long-term effects, we believe, will continue to be higher productivity and growth across sectors and nations. In earlier work, for example, we looked at the relationship between productivity and employment, which are generally believed to be in conflict (i.e., when productivity rises, employment falls). And clearly, in the short term this can happen as employers find that they can substitute machinery for labor—especially if other innovations in the economy do not create demand for labor in other areas. However, if you look at the data for productivity and employment for longer periods—over decades, for example—you see that productivity and job growth do rise in tandem.

This does not mean that labor-saving technologies do not cause dislocations, but they also eventually create new opportunities. For example, the development of highly flexible and adaptable robots will require skilled workers on the shop floor who can program these machines and work out new routines as requirements change. And the same types of tools that can be used to automate knowledge worker tasks such as finding information can also be used to augment the powers of knowledge workers, potentially creating new types of jobs.

Over the next decade it will become clearer how these technologies will be used to raise productivity and growth. There will be surprises along the way—when mass-produced steel became practical in the 19th century nobody could predict how it would enable the automobile industry in the 20th. And there will be societal challenges that policy makers will need to address, for example by making sure that educational systems keep up with the demands of the new technologies.

For business leaders the emergence of disruptive technologies can open up great new possibilities and can also lead to new threats—disruptive technologies have a habit of creating new competitors and undermining old business models. Incumbents will want to ensure their organizations continue to look forward and think long-term. Leaders themselves will need to know how technologies work and see to it that tech- and IT-savvy employees are included in every function and every team. Businesses and other institutions will need new skill sets and cannot assume that the talent they need will be available in the labor market.

Authors

Publication: Yahoo! Finance

Image Source: © Yves Herman / Reuters

Time to Start Experimenting with Macroprudential Regulatory Policy

Douglas J. Elliott — Tue, 04 Jun 2013 10:36:00 -0400

I firmly believe that the U.S. needs to use macroprudential tools as a way of reducing the harm from cycles in the financial system. The traditional options—monetary policy and standard safety and soundness regulation—have real weaknesses. Monetary policy is generally too blunt a tool, since forcing interest rates up or down for the whole economy is an inefficient way to deal with issues specific to the financial system. On the other hand, traditional financial regulation is so focused on each individual financial institution that it often misses larger trends in the system as a whole. Macroprudential tools have the corresponding advantages of operating on the financial system as a whole, but without doing unnecessary collateral damage to the rest of the economy.

The recent study that I did with Greg Feldberg and Andreas Lehnert solidifies my view that macroprudential policy is valuable, but that we also must be aware of its limits and of the need to develop a better framework for understanding the tools and how best to use them. Our comprehensive review strongly suggests that the macroprudential actions of American authorities over many decades achieved their purposes, at least in part. To be fair, the analysis shows a relatively weak effect and the results are not always statistically significant. However, this is the first study to provide such a comprehensive analysis and it is very likely that more refined approaches to analysing the data will find clearer results. We see promising ways to improve the analysis and doubtless other researchers will find even more. Our collective understanding of macroprudential theory is also much better now than it was a few decades ago, which should allow us to optimise our actions in ways that we did not do in the past.

While I’m confident that macroprudential policy is useful, it is critical not to overstate what it can achieve or the ease with which it can be implemented effectively. We are in the early days of macroprudential policy, akin perhaps to where monetary policy stood in the 1950s. We need more refined theory, better statistics, and, unfortunately, we will also need to learn by experimentation. The good news is that any moderately intelligent macroprudential policy is likely to be better than our de facto policy of recent decades, which was never to use these tools, effectively leaving their setting at “off” even in the midst of the biggest credit bubble in history.

Macroprudential policy may be particularly helpful in the next decade or two, because the other choice is likely to be the blunt application of monetary policy. Non-intervention will not be politically viable in the wake of the financial crisis. Some may argue that the quantitative easing belies this, with authorities deliberately creating a bubble, or at least risking one. Whatever one’s views of the value of QE, the current situation is a transitional one and there will be a need to counteract any credit boom, or to prepare for the consequences of its eventual reversal, whether that boom is in process now or is a future contingency.

American policymakers generally view macroprudential policy favorably, but we do not have a good governance structure for it and the resources being put into considering it are far less than those devoted to implementing Dodd-Frank, for understandable reasons. We do not need to instantly get the macroprudential policy framework right, but we should be shifting our attention increasingly to that topic. It may not be all that long before we have to choose whether and how to use macroprudential tools. The tools to be considered should include the core tools of counter-cyclical capital buffers, counter-cyclical liquidity buffers (after we settle on the base liquidity rules and have some experience of them), and limits on loan-to-value (LTV) ratios for mortgages or capital requirements that vary with LTV ratios. We may also wish to consider setting minimum collateral requirements or haircuts for transactions involving the repurchase agreements and securities lending.

Authors

Douglas J. Elliott

Publication: The Economist

Image Source: © Brendan McDermid / Reuters

The Fed Will Soon Be Regulating Some Major Life Insurers

Douglas J. Elliott — Tue, 04 Jun 2013 11:58:00 -0400

The Federal Reserve will soon be an important regulator of the largest insurers, which will be a major change in regulatory regime that could have real effects on how these insurers operate, including what products they offer and how much they charge.

The Financial Stability Oversight Council has announced a preliminary determination to designate several major financial institutions as systemically important. The specific names were not announced, since the firms have 30 days to appeal the designation, though two major insurers were apparently included (AIG and Prudential) and MetLife is likely to follow soon. Designation as a SIFI (Systemically Important Financial Institution) could carry with it a considerably greater regulatory burden, as the Fed will have quite wide powers over all SIFIs. The Fed automatically has these same regulatory powers over medium-sized and larger banks, so the real issue has been which non-bank financial institutions would be designated.

The big question now is how the Fed will choose to regulate these insurers. They have given little clue so far and, frankly, their thinking is probably not yet very advanced. They focused on the designation process first and they are already overwhelmed with concrete deadlines imposed by other parts of the Dodd-Frank Act. However, the act of designation will start to concentrate their mind on some important choices to be made.

For those who want to know more, please read my recent paper providing a detailed overview on how life insurance SIFIs ought to be regulated.

Authors

Douglas J. Elliott

Image Source: © Brendan McDermid / Reuters

Why Investors Should Brush Up on Their Political Science and Economics

Douglas J. Elliott — Fri, 17 May 2013 16:38:00 -0400

Newspapers have been reporting the possible misuse by hedge funds of confidential information about proposed government actions. Whatever the truth of these particular allegations, it is a sign of the intense interest that much of the “smart money” displays in the specifics of government policy.

This runs counter to the misconception, still held by many investors, that we will eventually return to the “good old days” when they can focus again on businesses and ignore governments. They believe that the current need to actively scrutinize the likely actions of the U.S. and other governments is a fluke resulting from the financial crisis and the ensuing severe recession. This seems very unlikely. Governments should always matter a great deal to investors: they establish the framework of laws and regulations that rule business transactions, set taxes, establish monetary policies, decide government spending levels, choose among infrastructure projects, etc.

A return to the norm

The truth is that the 20 or so years preceding the financial crisis was the aberration and we are returning to more normal conditions. In the U.S., we went through a couple of decades in which governments were relatively laissez faire, intervening less than usual in business operations and continuing a trend of deregulation.

Further, the Fed, in line with central banks in other advanced economies, began to believe that a “Great Moderation” had occurred in business cycle conditions as a result of better central bank operations based on an accumulation of understanding of monetary policy over the years. Financial markets operated fairly freely, as the government held the reins with a light hand.

Do not expect these conditions to recur anytime soon. In the short to medium term, the memory of the terrible economic and political damage from the financial crisis will certainly keep the level of government intervention in the U.S. at high levels. Further, the need to resolve our fiscal problems will involve major decisions about what the government does and how it pays for it. This will have knock-on effects throughout the economy, both by affecting general conditions and by hitting particular industries, such as defense contractors or hospitals. This will come on top of activist monetary policies at the Fed that will bring years of critical decisions about the level of purchases of bonds by the Fed, their eventual disposition as the inventories are worked down, and, of course, an eventual rise in interest rates that will need to be carefully managed.

World markets increasingly important

Beyond our shores, the global economy is increasingly influenced by emerging market countries that believe in much more active government policies and even state ownership of major businesses. These nations will also make key decisions about where to invest public funds, and where to encourage the investment of private money, as they continue to develop rapidly. The choices of their governments, and the reactions of our own, will have a major impact on U.S.-based companies and on our own stock markets and interest rates, as well as the value of the dollar in foreign currencies, and therefore our trade balances.

Europe, for its part, is going through a prolonged set of inter-related political crises that aggravate economic problems, in turn worsening the political difficulties. The impacts on businesses and the overall economy have had, and will have, substantial effects on America and the rest of the world. Europe is likely to remain in political turmoil for years, even if the potential short-term disasters are overcome. If things work out on the positive side, reshaping their joint political institutions will still take years and will have major effects on their economies and therefore ours.

Government actions matter

This pattern, where government decisions have determining effects on business choices and investor returns, is typical of preceding decades and even centuries. Sometimes this has been vividly demonstrated by decisions about war or the trade equivalent -- trade wars or competitive devaluations of exchange rates. Other times, the big impacts have come from tax and regulatory policies that differ greatly from that of neighbors and trading partners. Other times it has been massive infrastructure projects such as the creation of the transcontinental railroads and the federal give-aways of free land to homesteaders. Even the abolition of slavery had massive economic impacts. Government actions going forward may be less dramatic than these examples, but there is no doubt that what happens here and abroad will be profoundly influenced by political decisions and the implementation of these decisions by bureaucracies.

So, pay attention to politics here and around the world and the intersection of those politics with underlying economic issues. Government decisions may sometimes prove to be more important than the intricacies of business strategies in determining the fate of investments.

Authors

Douglas J. Elliott

Publication: Yahoo! Finance

Image Source: © Kevin Lamarque / Reuters

The History of Cyclical Macroprudential Policy in the United States

Douglas J. Elliott, Greg Feldberg and Andreas Lehnert — Wed, 15 May 2013 00:00:00 -0400

Since the financial crisis of 2007-2009, policymakers have debated the need for a new toolkit of cyclical “macroprudential” policies to constrain the build-up of risks in financial markets, for example, by dampening creditfueled asset bubbles. These discussions tend to ignore America’s long and varied history with many of the instruments under consideration to smooth the credit cycle, presumably because of their sparse usage in the last three decades. We provide the first comprehensive survey and historic narrative of these efforts. The tools whose background and use we describe include underwriting standards, reserve requirements, deposit rate ceilings, credit growth limits, supervisory pressure, and other financial regulatory policy actions. The contemporary debates over these tools highlighted a variety of concerns, including “speculation,” undesirable rates of inflation, and high levels of consumer spending, among others. Ongoing statistical work suggests that macroprudential tightening lowers consumer debt but macroprudential easing does not increase it.

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The History of Cyclical Macroprudential Policy in the United States

Authors

Douglas J. Elliott
Greg Feldberg
Andreas Lehnert

Publication: Office of Financial Research, U.S. Department of the Treasury

Image Source: © Larry Downing / Reuters

Regulating Systemically Important Financial Institutions That Are Not Banks

Douglas J. Elliott — Thu, 09 May 2013 09:00:00 -0400

Certain financial institutions are so central to the American financial system that their failure could cause traumatic damage, both to financial markets and the larger economy. These institutions are often referred to as “systemically important financial institutions” or SIFIs. The Dodd-Frank Act, the comprehensive reform legislation signed into law during the summer of 2010, requires financial regulators belonging to the Financial Stability Oversight Council (FSOC)[1] to name those financial institutions that it believes are systemically important.[2] Such SIFIs are to be supervised more closely and potentially required to operate with greater safety margins, such as higher levels of capital, and to face further limitations on their activities.

Throughout Dodd-Frank the focus is principally on banks, particularly commercial banks, and the act effectively designates all commercial banking groups with $50 billion or more in assets as SIFIs. However, it requires regulators to consider whether other financial institutions are systemically important, leaving the decision about which non-bank financial institutions should receive that designation up to the FSOC, with advice from the Federal Reserve Board (Fed). The FSOC is in the process of determining what non-bank institutions it will designate as SIFIs, but it seems clear that several large life insurance groups and at least one large finance company (GE Capital) will be named. Eight “financial market utilities” have already been designated. (These are firms such as clearing houses that do the back office transactions that make many financial markets function.) Other financial institutions may be added as well, such as hedge funds or money market funds.

Dodd-Frank also authorizes the FSOC to designate certain types of activities as systemic regardless of what institution is conducting them, giving the regulators greater powers to control those activities. There is some potential for this to be invoked in regard to money market funds and that possibility has given the FSOC greater leverage in pushing for changes to the rules governing money market funds even if the systemic activities designation is never used. This paper will generally not discuss the activities clause, but will focus instead on the regulation of entire institutions designated as SIFIs.

Once a non-bank financial institution has been designated as a SIFI, very real questions arise as to how best to regulate these institutions. The Fed becomes the regulator for SIFI purposes, alongside the existing primary regulator. However, the Fed has little previous experience of overseeing some of these types of institutions, particularly insurers. Therefore, it needs to figure out how to evaluate their safety and how to coordinate with existing supervisors. Doubtless, the Fed will end up falling somewhere on a spectrum between simple reliance on existing regulatory paradigms and procedures and developing an entirely separate approach that may rely excessively on its prior experience as a banking supervisor.

The Fed should not simply defer to existing regulators and view non-bank SIFIs as safe if they say so. It has a legal obligation to form its own conclusions. Further, viewing the institutions systemically may provide a different perspective, perhaps pointing to systemic risks that would not be given adequate attention by traditional industry regulators who are not responsible for the safety of the financial system across the country or concerned about linkages to the rest of the world. This could be particularly true in insurance, which is regulated at the state level and therefore has not historically had any body whose primary responsibility was to look at national systemic risks. The National Association of Insurance Commissioners (NAIC) acts as a coordinator for the state insurance commissioners and works to ensure high standards across the country. However, these standards are aimed at ensuring the safety of individual institutions with little emphasis on the linkages between these institutions that could lead to systemic problems.

On the other hand, there is a real risk that the Fed will give insufficient deference to the extensive experience and knowledge residing with the existing regulators, particularly in regard to insurance, which has so many differences from banking. Decision-makers at the Fed would be only human if they relied excessively on the tools with which they were already familiar and if they were more comfortable starting from scratch in designing regulation and supervisory tools, instead of relying on the experience of others.

There are multiple dangers in taking an idiosyncratic Fed perspective that pays too little attention to existing regulatory approaches:

The Fed may simply get a decision wrong, out of an insufficient level of understanding of the new industry. It is one thing to study an industry intensively, it is another to have lived with it for many years, as the primary regulators have.

The Fed could be “right” from the point of view of reducing systemic risk, but the economic cost of eliminating or reducing a particular source of risk may far exceed the benefit. Dodd-Frank did not call for the elimination of systemic risk, but rather appropriate control over it. As with so many areas of life, absolute elimination of risk would require forbidding a great deal of beneficial activity. The bureaucratic peril here is that the Fed’s mandate from Dodd-Frank may bias the organization towards elimination or sharp reduction of systemic risk, with insufficient regard to the economic costs that would show up in day-to-day operations.

New Fed regulations could effectively force “relitigation” of a myriad of issues that have already been decided by the primary regulators. Sometimes there are multiple legitimate ways to approach an issue and it may be better to stay with the existing decision than to go through the industry upheaval of adopting to a new approach that simply has a different set of pros and cons, but may not be substantially better.

Lack of sufficient coordination with existing regulators could result in contradictory requirements that hamper operations. The Fed and the primary regulators will presumably manage to avoid outright contradictions, although there is definitely the possibility of temporary stand-offs as the two sides feel their way to a working arrangement. Beyond that, though, there is the risk that the approach of the Fed and of the primary regulators will be incompatible in practice, even if this is not obvious on the surface of the written regulations. One side or the other may believe it is possible to meet their requirements without infringing the rules issued by the other, but it may not in fact be feasible.

Pointing out these dangers of inappropriate regulation is not intended to argue against the designation of non-bank SIFIs, which I do favor and which is clearly the intent of Dodd-Frank. There are legitimately differing views on whether insurers, for example, are ever systemically significant, but I am among those who believe that a few very large life insurance groups likely do merit this designation. The key message of this paper, however, is that non-banks are not just funny looking banks, but operate in truly different industries, providing different services, and facing a different balance of risks and opportunities than do banks. Therefore it is very important that Fed regulation of non-bank SIFIs is tailored to each distinct industry and is managed with appropriate humility about the Fed’s level of understanding and with appropriate deference to primary regulators, while meeting the Fed’s obligations to develop their own independent judgments. This is a difficult balancing act, but not fundamentally different than the balancing acts that all regulators face between the risks of action and inaction. The bulk of this paper delves deeper into these issues in the context of life insurers.

The Fed is most definitely aware of the dangers and is intent on avoiding them. However, it is virtually certain that mistakes will be made in an area of this complexity where there are at least two sets of perspectives and experiences coming together, especially given the novel nature of the task of regulating systemic risk. One concerning point is that there is not a clear agreement yet on what systemic risk is and how it ought to be measured, adding still more uncertainty about how best to regulate it.

Systemic Risk

There is some disagreement about the best definition of systemic risk. A report by the International Monetary Fund and two global financial regulatory bodies defined systemic risk as:

“a risk of disruption to financial services that is (i) caused by an impairment of all or parts of the financial system and (ii) has the potential to have serious negative consequences for the real economy. Fundamental to the definition is the notion of negative externalities from a disruption or failure of a financial institution, market or instrument. All types of financial intermediaries, markets and infrastructure can potentially be systemically important to some degree.

Three key criteria that are helpful in identifying the systemic importance of markets and institutions are: size (the volume of financial services provided by the individual component of the financial system), substitutability (the extent to which other components of the system can provide the same services in the event of a failure) and interconnectedness (linkages with other components of the system).”[3]

Dodd-Frank defines systemic risk in terms of a situation in which “material financial distress at the [financial institution], or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the [financial institution], could pose a threat to the financial stability of the United States.”[4]

There is substantially more disagreement about how to measure the level of systemic risk in the aggregate. Breaking this down to the contribution from individual institutions is yet trickier still. As a further important complication, systemic risk arguably varies over time. An entity could be systemically significant under some circumstances and not others.

The FSOC’s evaluation process to decide which institutions to designate as SIFIs relies heavily on subjective judgments of the relative importance and inter-relationships of the relevant qualitative and quantitative factors. This is not a criticism. Objective, quantitative criteria will require both a detailed analytical model of how the financial system works that is well beyond the current state of research and considerably more and better quality data than currently exists. Many academics and official researchers are working to create those prerequisites, but it will be years before they can hope to succeed, if they ever fully do.

There are multiple ways in which a financial institution can be systemically important – by its size, the degree to which to which it is “interconnected” with other parties, or conceivably by its reputation and thus influence on financial markets. The central concern is that a SIFI’s failure would cause serious damage to the financial system, and thereby to the rest of the economy. The sources of that damage could be any one or more of the following, and perhaps others as well:

Counterparty and other credit risks. One of the most obvious concerns is that when a SIFI goes under it may impose substantial, if not crippling, losses on other financial institutions and parties who are owed money by the institution. This could cascade throughout the financial system with knock-on damage to the wider economy.

Contagion. Sometimes the principal damage from the collapse of a financial institution comes from serving as a “bad example” that causes the market to reassess which other organizations might wind up in the same difficulties.

Problems with deposit-taking activities. One of the key reasons that banks are regulated so highly in the first place is that consumers and businesses place deposits with them which they count upon to be readily available and riskless. There can be severe economic disruptions if depositors find their funds suddenly unavailable.

Maturity mismatches. Financial institutions often operate by “borrowing short and lending long”, since the interest rates on short-term borrowings are typically below the interest rates earned on longer-term loans and other assets. This strategy usually is exposed to the risk of a sudden liquidity freeze that makes it highly expensive or impossible to “roll over” short-term liabilities. Excessive maturity mismatches become a systemic problem if they are too widespread or concentrated at one or more SIFIs.

Market utility interruptions. Some institutions play a central role in the day-to-day functioning of financial markets, resulting in the potential for widespread damage if they fail.

Types of non-bank SIFIs

There are several major categories of non-banks that could be systemically important; the considerations that could lead to their designation are discussed briefly below. (A fuller review of the issues is available in the paper I wrote with Robert Litan, referenced in footnote 1, which focuses more on the issues surrounding designation of SIFIs.) The discussion excludes banks of all types and their close affiliates, which are effectively already designated as SIFI’s under Dodd-Frank.

Finance companies. Until the recent crisis, there were a number of major lenders to consumers and small businesses that financed themselves by issuing short to intermediate term debt in the wholesale financial markets, in contrast to commercial banks that raise their funds primarily with insured deposits. When financial markets froze, this finance company business model proved to be too risky, except in special circumstances, since it exposed the firms to the danger that they would be unable to “roll over” their debts. Borrowing short-term and lending long-term only works if the ability to borrow short-term is not interrupted for any extended period. The recent crisis showed once again that such liquidity freezes occur too frequently to be assumed away.

Smaller finance companies may not pose a systemic risk if they fail, since in a crisis the markets may still be willing to fund their larger competitors. However, when large finance companies are threatened with failure, they may indeed pose systemic risks. Because of the risks of the finance company business model that were revealed in the recent crisis, a number of the solvent finance companies that have survived have converted to bank status in order to have access to insured deposits even in difficult economic conditions.

Securities firms. Investment banks and brokerages can clearly create risks to the financial system, as demonstrated by Bear Stearns, Lehman, Merrill Lynch, and others in the recent financial crisis. However, the most important of these firms are affiliated with commercial banks and are therefore already considered SIFIs for that reason. It appears unlikely that any of the stand-alone securities firms based in the US will be designated as SIFIs, but one or more could expand over time to the point where they might be designated in the future. It is also possible that a large US subsidiary of a foreign securities firm could be designated as a SIFI.

Life insurers. Some life insurance entities are so large that their sheer size makes them obvious candidates for designation since other financial institutions will have major credit exposures to them. On the other hand, the types of activities they undertake tend not to be as risky for the system, especially since they are generally funded by quite long-term liabilities, such as life insurance policies and annuities that have substantial fees for early surrender. In general, the systemic risk created by a life insurer is likely to be considerably less per dollar of asset size than would be true for a bank, taking into account probabilities rather than just worst cases. However, each case must be examined on its own merits and regulators must watch out for the development of activities at one or more life insurance groups that might spawn greater systemic risk in the future. Life reinsurers, which provide wholesale insurance protection to life insurers, have greater risk per dollar of assets because they are interconnected with many other insurers and reinsurers. However, none of the US-based life reinsurers are of sufficient scale to be likely to be designated as SIFIs.

Property/casualty insurers. Insurers providing protection against accidents and lawsuits are important financial institutions and sometimes very large. However, the nature of traditional property/casualty insurance creates little risk for the financial system as a whole. The investments of these firms tend to be very conservative and liquid, since they could be needed quickly in the event of a natural catastrophe. As a result, the big risks to these insurers are on the claims side, which has little correlation with financial crises. (Financial crises do not spawn natural disasters and even extremely large hurricanes and earthquakes are too small to trigger a financial crisis.) There is no indication that any property/casualty insurers will be designated as a SIFI, with the exception of AIG. That firm will be designated for political and historical reasons more than anything else, although the stated rationale will doubtless refer to its life insurance business and activities outside of traditional insurance.

Hedge funds. These funds cover a very wide range of activities, most of which would not warrant SIFI designation. If any do, it would almost certainly be because they operated with quite significant amounts of financial leverage and were of considerable size (as was LTCM in the late 1990s before the Fed helped arrange a private sector reorganization). The combination of size and leverage could generate sufficiently large credit exposures for other SIFIs to merit inclusion of these funds or they might exacerbate other potential sources of risk, including contagion.

Other fund models. Two other important fund business models are venture capital (VC) and private equity (PE) funds. Neither would appear to create any significant systemic risk when they are run in a traditional manner. However, the legal structure could be used to operate more like a highly leveraged hedge fund, in which case there is at least the theoretical possibility of being a SIFI. In practice, it is unlikely that the FSOC will designate any of these funds as SIFIs for some years, if ever.

Mutual funds. These fund groups are an interesting case, since some of them are of very large size, yet they are essentially pass-through entities and seldom use very much in the way of leverage. The small amount of leverage employed means correspondingly less credit exposure to lenders. There may be significant credit exposures for trading counterparties, but the lack of leverage makes it hard for the funds to go broke and therefore fail to be able to meet their obligations. Given their importance in the financial system as a whole, regulators may wish to know what these funds are up to and thus possibly demand additional information beyond what they are required to submit now, but because of their pass-through nature they are likely to be small contributors to systemic risk. Here, too, it is unlikely that the FSOC will designate any mutual funds or their management companies as SIFIs anytime soon.

Money-market mutual funds. Consumers often use money market funds almost as if they were bank accounts, including writing checks against them in order to make day-to-day transactions or to easily withdraw cash from them. These funds are also large purchasers of commercial paper (CP) issued by both financial and non-financial corporations. In the midst of the recent financial crisis when the main alternative to CP financing -- bank loans -- was often unavailable, the continued viability of these funds was (and remains) especially important.

It was for both these reasons that the federal government felt compelled to guarantee money market funds in the recent crisis. The government feared that a potential major run on many, if not all, money market funds constituted a substantial risk to the financial system.

A number of changes have already been made to the regulation and operation of money market mutual funds in order to reduce their systemic risk, including a shortening of the maximum maturities of their investments and the creation of expanded disclosure. However, it remains an open issue as to whether one or more money market funds will be designated eventually as SIFIs.

Other institutional investors. There are numerous other categories of institutional investors whose members could theoretically be designated as SIFIs, but where this is unlikely to occur in practice. These include pension funds, endowments, and sovereign wealth funds, among others. In general, these share the characteristics of very low leverage, long-term funding, and the absence of a primary role as a financial intermediary. As a result, even the largest of these organizations is unlikely to represent sufficient system risk to be designated as a SIFI.

Financial market utilities. There are many entities that operate behind the scenes to implement financial transactions, such as stock and commodities exchanges, clearing houses for derivatives transactions, etc. Some of these, such as the largest clearing houses, will definitely present enough systemic risk to qualify as SIFIs, in part because of their combination of sheer size and their volume of counterparty credit risk, as well as their overall centrality to important markets. In fact, the FSOC has already designated eight financial market utilities as systemically important and may designate more.

Regulating SIFIs

Once SIFIs have been identified, it is almost certain that they will then be regulated differently from other financial institutions. An important underlying decision is whether the Fed’s regulation should focus solely on sources of systemic risk, holistically on the entirety of safety and soundness issues, or somewhere in between. Dodd-Frank does not clearly answer this question. On the one hand, federal regulation is imposed on non-bank SIFI’s precisely because of systemic risk issues, suggesting that such issues should be at the core of the Fed’s supervision. On the other hand, Dodd-Frank calls for heightened prudential standards for SIFI’s of all kinds, presumably on the theory that the failure of a SIFI, no matter what the cause, would have systemic repercussions.

Blending these two viewpoints, the Fed is almost certain to look at a wide range of prudential concerns, but perhaps with a sharper focus and tougher rules for those aspects that appear to increase systemic risks. For example, the Fed would be particularly inclined to be concerned about maturity mismatch and liquidity issues because they are significant safety and soundness issues in their own right while also bearing the potential to make the system as a whole riskier by triggering the equivalent of a “run on the bank”, with all the potential for contagion that would bring. On the other hand, operational issues that carry idiosyncratic risk may be given a lower priority and left largely to the primary regulators. For example, internal accounting weaknesses could help to sink a single entity, but might not have any larger systemic significance. Similarly, issues that are likely to arise at a time of wider financial crisis may garner more attention than items that are random or more likely to surface during good times, when any potential systemic problems would be easier to handle.

What can the Fed do as a supervisor? There are at least five ways additional regulation of SIFIs could occur:

Regulating at least certain non-bank SIFIs in a manner consistent with banks. One of the hardest questions in financial regulation is where to place the “perimeter of regulation.” In this case, the key question is which entities should face the heavy regulation that banks and their close affiliates do. (Banks also benefit from special privileges, such as access to deposit insurance and the Fed’s discount window, but regulation of other SIFIs may not bring such advantages in the current environment.) One of the concerns expressed in the Dodd-Frank debates was how to prevent some institutions from acting very similarly to banks, but retaining the advantage of lighter regulation. Dodd-Frank provides quite considerable powers that could be used to add many bank-like regulations (such as activity restrictions) for certain non-bank SIFIs.

If such a broad scope of regulation is applied, it is likely only to be for institutions regulators view as acting like banks. Finance companies could be caught in this net and it is theoretically possible that a large hedge fund that went after banking type business could also be brought in. This is unlikely to be an issue for most categories of non-bank SIFIs, such as insurance groups that do not already own deposit-taking institutions. That said, Dodd-Frank does provide that certain restrictions should apply to all SIFIs even though the specifics appear to have been designed primarily with banks in mind.

Information reporting. SIFIs will doubtless be mandated to provide a great deal of information, with particular emphasis on aggregate credit and counterparty exposures to other SIFIs and near-SIFIs. Other information requirements will likely include exposures to particular asset classes, capital levels, and the results of stress tests. It is also likely that many non-SIFIs will be subject to some additional reporting obligations as well, both to determine whether they qualify at some point as SIFIs themselves and also for the FSOC and its new agency in the Treasury, the Office of Financial Research, to better monitor overall system-wide financial risks.

Counterparty exposure limits. Dodd-Frank requires that banking groups limit their total exposure to individual counterparties. Non-bank SIFIs could be faced with similar requirements.

Activity limits. Banking groups are also limited by the “Volcker Rule” included within Dodd-Frank, which requires them to limit or eliminate certain types of proprietary trading and investment activity. Similarly, provisions pushed by Senator Lincoln created restrictions on the ability of banking entities to act as derivatives dealers. Non-bank SIFIs might be placed under similar restrictions on activities that are perceived as being particularly risky and not at the core their business models, or at least the business models policymakers view as being in the public interest.

Capital requirements. One of the most important ways that regulators can encourage safety at financial institutions is to require appropriate levels of capital as a margin for error against losses that might come through bad luck or errors. Banking groups already face substantial capital requirements that are being tightened significantly through the so-called Basel III process, coordinated by the Basel Committee on Banking Supervision. Insurers also have substantial capital requirements imposed by their regulators for similar reasons. Dodd-Frank specifically calls for SIFIs to face higher capital requirements than non-SIFIs, with the details to be determined by the regulators.

Capital requirements are such a universal, and important, element of the regulatory approach to banks that there is a strong likelihood that non-bank SIFIs will be subjected to similar requirements. This is most likely for SIFIs that perform a classic intermediation function and have large balance sheets, such as finance companies, which play a role fairly similar to banks. Some sort of capital regulation might also be extended to hedge funds, although these funds may be able to argue that their differences from banks justify an exemption from any capital regulation. Other asset managers, such as mutual funds or venture capital management companies, are the least likely to have this requirement, because their business models create little need for capital. As discussed below, capital requirements already exist for insurers and may be expanded or altered by the Fed in its role as a regulator of SIFIs.

Capital regulation is an extremely powerful tool to affect the behavior of financial institutions, since it very directly alters their ability to provide an adequate return to their shareholders. This is even more powerful since top managers in financial institutions almost invariably hold a considerable amount of their net worth in company stock. If this powerful tool is applied too widely, such as to funds managers that act as pass-through entities and not true intermediaries, it could substantially change the ability of otherwise valid business models to work. Ironically, adding an unreasonable burden to, say, mutual funds could push financial assets into the hands of financial intermediaries instead that present greater systemic risks.

Liquidity requirements. The recent financial crisis underlined the importance of liquidity, the ability to come up with cash, potentially on short notice, to cover deposit withdrawals, debt redemptions, and other needs. Banks will have quite extensive liquidity requirements going forward and the Fed will certainly consider appropriate liquidity requirements for other SIFIs.

Principles for regulating non-bank SIFIs

Some key principles should guide the Fed’s regulation of non-bank SIFIs.

Carefully balance the costs and benefits when designing regulation and supervision. This is important for all regulators and is so basic that it probably needs little further elaboration. However, it will be critical not to lose sight of this key principle. It will always be tempting for the Fed to add yet further constraints and safety margins on non-bank SIFIs, in its pursuit of systemic stability, particularly as the Fed will take the blame if a serious future crisis develops. However, safety margins come with costs and it would be harmful to the economy if those costs were excessive compared to what may be only a modest increase in stability from a given regulation. For example, equity capital is significantly more expensive, in practice if not always in theory, than other sources of funding. Requiring more capital therefore adds a cost that will have to be absorbed by some combination of customers, employees, stockholders, and others who deal with the firm[5]. Deciding what regulations to impose and choosing which firms they are imposed upon must be a balancing act between the improvements in safety and the economic costs of achieving the improvements.

Defer to primary regulators as appropriate while maintaining the ability to perform the Fed’s mission. The Fed will have to balance a second set of considerations, which is how to coordinate with primary regulators, such as the state insurance commissioners and the National Association of Insurance Commissioners, their coordinating body. The Fed should take advantage of the decades of experience and the specific expertise of the primary regulators. It should also avoid conflicts in regulations with those promulgated by the primary regulators, except where the Fed believes that an important principle is at stake. This should leave room for compromise on the many judgment calls that will exist on precisely how best to deal with a particular type of risk. At the same time, the Fed has a different mission from the primary regulators and cannot, and certainly will not, simply assume the primary regulators will take care of the job for them.

Do not impose excessively bank-like regulatory approaches. Many of the non-banks, particularly insurers, have quite different business models, and even purposes, from banks. It will be critical to take account of these when designing regulation and supervision. This is discussed in considerably more detail below in regard to the life insurance industry.

Avoid the dangers of a business “monoculture.” SIFIs are likely to be regulated in a common manner on many important dimensions. If this is carried too far, as it easily might be, institutions with quite different business models may be regulated in the same way[6]. For example, if capital regulations are applied to institutions for which capital levels are actually relatively immaterial, it may force them to hold considerably more capital and to make business decisions based on the effects on their actual capital relative to what is required. In essence, this kind of decision-making could force any non-bank SIFIs to act more like banks, even when their business models would not otherwise push them in that direction. This reduction in diversity could expose the system to greater risk from factors common to the regulatory approach. A useful analogy is the danger of a “monoculture” in crops. If the entire Midwest is planted with wheat, for example, then the dangers of contagion from a virus that attacks wheat become more severe than if multiple crops were grown. The same kind of risk may be created when otherwise different kinds of institutions are effectively forced to behave in a similar manner.

Support useful innovation. If SIFIs were to be regulated in an excessively uniform way, then it may become more difficult for organizations to develop innovative new approaches to business. In particular, if SIFI regulation and supervision entails any sort of ex ante or ex post approval of innovative products or ways of doing business, this prospect could be enough to keep the innovation from being introduced. At the same time, the greater regulatory costs of SIFI designation may also spur some organizations to use “financial engineering” to create new securities or transaction types that appear to pass risk on, without in fact fully doing so. Again, the SIV structures that were created during the boom period and contributed to the recent financial crisis are an example of this type of structure.

Try to minimize the inevitable uncertainty about future regulation and supervision. The cost of regulation does not come just from the actual regulatory choices of policymakers. The sweeping powers of the FSOC and Fed over SIFIs create considerable uncertainty for shareholders, creditors, and counterparties, which is likely to be priced into any transactions. Equity investors would demand higher expected returns to compensate for the greater risk and opacity of the business. Debt holders would similarly increase their demanded interest rates and some would switch to investing in other industries. Lenders and insurers may feel compelled to charge customers more to compensate for the greater uncertainty about the rules under which they will be operating. There is a limit to how much the Fed can do to alleviate these concerns as it is itself determining how best to operate in this new area, but transparency, clarity, and an appropriate level of deference to existing regulators should help.

Regulating Life Insurers as SIFIs

One of the trickier tasks for the Fed will be to determine how best to regulate groups that are centered around life insurers. Life insurers have a considerably different business model than the banking industry with which the Fed is familiar, yet they also have some important similarities as financial intermediaries. Some of the key points to consider are as follows:

The core task of an insurer is to take risk. The central economic role of an insurer is to pool risk. An isolated family can be devastated financially by the premature death of a breadwinner, but a thousand or a million families pooling their risks together can easily bear that random risk by spreading the cost of premature deaths over the entire group. Paying a thousand dollars a year for life insurance may be feasible for a family who could not have afforded to bear the full cost of a death on their own. For this reason, life insurers have often been founded as mutual aid organizations that eventually converted to a legal status as “mutual” insurers, owned by their policyholders. In many cases, these mutual eventually converted to stock form in order to gain the full benefits of market access. Pooling of risks has costs that raise the average expense level of dealing with the accidents and tragedies that befall us, but virtually all people and firms would rather pay a bit more on average to avoid the chance of financial catastrophe.

Banks also exist to take risks, particularly the risk that a loan will not be repaid, but their central historical economic role has been to channel funds from depositors to borrowers with worthy projects while providing liquidity to depositors and even borrowers. Risk is inherent in those roles, but it does not have the same centrality as risk-taking does for traditional insurance.

However, life insurers are also financial intermediaries, like banks. Much of what life insurers do is to provide attractive investments to their clients, generally with tax advantages. Even traditional whole life policies do this. A life policy that charges the same premium every year of one’s life effectively overcharges in the early years for the mortality risk, allowing a build-up of value that pays for undercharging in the later years. This build-up of value beyond what is needed for the mortality charges and other expenses accumulates as a cash value that can be withdrawn, or borrowed against at a fairly attractive interest rate. Economically, this is equivalent to buying a term life policy and investing the difference between this policy’s premiums and what a whole life policy would charge in order to build up cash value, which can be used to pay the rising premiums as one ages[7].

Beyond that, life insurers sell large amounts of annuity products that are generally used as tax-advantaged investment vehicles. The simplest form of an annuity is an immediate annuity, which pays out a fixed amount each year for as long as the annuitant lives. This provides valuable insurance against living too long and running out of money. Most annuities, though, are deferred annuities. For these one pays in advance, with the annuity payments starting some years in the future, such as at one’s expected retirement age. The initial investment builds up a cash value that can, and usually is, withdrawn prior to annuitization. Clients often buy these with the expectation of cashing them in, taking advantage of the tax deferral of income in the meantime. On these products, the insurer does take a risk that the contractually promised annuitization terms will prove too generous in the long run, but by far the larger portion of the insurer’s risk is from financial intermediation, the danger that it will not invest the funds in a manner that provides a high enough return to cover the increases in cash value plus its expenses.

Life insurers are usually also asset managers. Some life insurers manage client money without taking on investment risk, such as by running a family of mutual funds, just as banks manage trust accounts and often have their own mutual fund offerings. In addition, all of the life insurers that are likely to be SIFIs also do a large volume of business in “variable annuities” and “variable life insurance” products. In purest form, these are identical to traditional annuities and life insurance policies, except that the investment risk resides with the policyholder. (This is accomplished in part by keeping each policy in a “separate account” from a legal point of view.) Instead of building in a fixed rate of increase in cash values, there is a formula based on the performance of an agreed financial instrument or basket of investments. For example, a client who wants to own an insurance product, but desires the potentially higher returns of the stock market, would buy a variable product with a cash value that increases based on a stock market index or on the performance of what is effectively a dedicated mutual fund attached to the variable product.

In many ways, the safety and soundness risks of variable products are low, since investment risk vanishes for the insurer in the purest form of the product. The prudential risk is not zero, since the stream of future fees will generally depend on the underlying cash values and particularly bad performance of a variable fund could lead to lawsuits or certainly to redemption of the insurance products by withdrawing clients. However, the risk in the pure form is quite low.

The risk is somewhat increased by the practice of providing certain guarantees of the investment performance. For example, some deferred annuities carry a guarantee that if the owner dies before the start of the annuitization, their heirs will receive the original investment amount even if market performance has caused the cash value to be below that level. Other guarantees, potentially more costly, are sometimes provided.

The provision of guarantees complicates some regulatory decisions. In particular, there is the question as to whether to include the assets from variable products in simple ratios, such as the “leverage” ratio. This is a straightforward calculation in which the total capital of a financial firm (the value of its assets beyond those required to pay its obligations) is divided by the total amount of its assets. Although simple, this is a much-used and valuable indicator of the margin of error a financial firm has to cover any mistakes or accidents. Further, this ratio is enshrined in many regulatory requirements, often with mandatory effects. Given the high volumes of assets life insurers have in variable products, their inclusion can have a major impact on the ratios.

The obvious, and probably correct, answer is to count only a portion of separate account assets in these calculations, perhaps only a small fraction. However, adjusting asset values for the amount of risk they entail risks reducing the benefit of using a straight leverage ratio. Banking regulators already use a separate, and much more complex, set of measurements to determine a risk-weighted capital ratio. One of the main arguments for using a straight leverage ratio is to complement the risk-weighted one by providing a test that is much harder to “game” since there is minimal discretion in calculating the figures.

Life insurers take on much longer maturity obligations than banks do. Traditional life insurance is mostly issued with guaranteed terms for long periods, often up to the full lifetime of the insured party. There are some term life insurance policies without guaranteed renewability, but they represent a small fraction of a typical life insurer’s total assets and liabilities. In contrast, a typical bank loan is for a few years at a time. Even mortgages tend to roll over roughly every seven years on average, due to refinancings or home sales.

The long-term nature of the liabilities gives life insurers more time to respond to problems. Banks can fail very quickly if markets lose confidence in them. Life insurers are much more resilient in the short run, since much of their funding is from liabilities that are long term, giving them time to restore confidence or to find alternative funding. This is a critical difference, but not an absolute one. Sometimes banks fail because they have been slowly deteriorating over a long period and eventually a crisis arises which highlights their vulnerability; something similar could conceivably happen with life insurers. For their part, life insurers do have many obligations that can be redeemed over a shorter period, although there is often a significant penalty charged to customers for doing so, which reduces the net damage to the insurer. A bad enough scare could certainly create the equivalent of a bank run, since many customers would be willing to sacrifice 5-10% of their policy’s value in order to be sure of keeping the remainder. That said, there are at least two factors besides the penalties that might discourage a “run”. First, there is a system of statewide guaranty funds for insurance benefits, analogous to federal deposit insurance. This may reduce the propensity of policy owners to flee, although concerns about the ability of the guaranty funds to cover an insolvency of the size that a SIFI might bring would raise questions about this safety benefit. Second, some policy owners may no longer be able to replace the death benefits provided by their existing policy at a reasonable price, because they have aged, exited a job that provided group benefits, or have suffered from deteriorating health. If those death benefits were a significant factor in the decision to buy and hold that particular policy, then there would be a substantial disincentive to flee.

Long-term liabilities also mean life insurers need long-term assets. Life insurers make commitments that run for many years, meaning that they also need to own assets with long durations, otherwise they run re-pricing risk. That is, if they commit to provide a return of 5% for the next 30 years and invest the funds initially in an investment returning 7% for 5 years, they may find at the end of 5 years they can only earn 3% going forward, turning their 2 point positive spread into a 2 point negative one. Thus, the danger for life insurers is often that their investments are of shorter maturity than their liabilities, because financial markets are substantially shallower in the long end. This is the opposite problem from that of banks, which usually make loans and investments of 3 years or longer, but fund them quite substantially with liabilities that are well shorter than that, including deposits that can be cashed in on any given day without penalty.

The long maturity of insurance liabilities has important policy implications. Bank regulators worry a great deal about banks “borrowing short and lending long,” so they have devised rules to push banks towards shorter-term assets and longer-term liabilities. Using that same approach with life insurers could expose them to dangerously high levels of re-pricing risk. It would also lower their average returns, since longer-term investments tend to pay more, so insurers would have to raise their prices to make up for reduced investment income. The economy as a whole could also suffer in another way, since life insurers are one of the larger providers of long-term investment funds. This would be unfortunate, since many commentators have pointed out the need to increase the supply of such funds, especially with regard to the massive investments in U.S. infrastructure that are needed in the years ahead. (Life insurers are already significant funders of infrastructure projects in the US through their holdings of municipal bonds and sometimes through other investment vehicles.)

There are several factors that could have the insidious effect of pushing the Fed towards encouraging a perverse interest rate mismatch at life insurers. First, using market valuations for longer-term investments can substantially increase their volatility over shorter time horizons. Current GAAP accounting rules often use mark-to-market values and some market participants take the same approach whether or not the figures appear in the accounting statements. This provides incentives for the Fed to take the same approach. (State regulators decided years ago to avoid that level of volatility by not marking bonds to market and they have stayed with that decision.) Volatility in the results reported to markets or regulators, especially if they trigger regulatory pressures, could push managements to optimize their short-term situation at the expense of the long-term. In particular, it could push them to shun investments in long-term assets even though this provides both a better match with the maturity of their liabilities and higher rates of return.

Second, and related, the Fed may be concerned that such variations in market value may lead insurers to participate in “fire sales” to get out of market segments that are being hit badly in a market panic, exacerbating wider systemic problems. Third, as good bureaucrats, they may simply not want to have to answer questions as to why they allow insurers to hold such long assets, especially questions that would arise in the midst of a market crisis. It may be easier for them to apply an investment model closer to that of banks.

Life insurer failures, which are fairly uncommon, can be triggered by misjudging their obligations, not just their investments. Life insurers can fail because they have mispriced their promises through careless underwriting or faulty assumptions about death rates or health or accident risks. They can also experience a run of bad luck among their clients. These problems are more likely to occur in their related business lines that involve health risk, such as health insurance or long-term care insurance, than in traditional life products. However, it can certainly happen even in traditional long-term life insurance policies. They can also fail because of bad investments, just as banks can do. Many times, it is a combination that does an insurer in, when investment returns fail to keep up over the long term with insurance payouts that rise more steeply than expected.

For their part, virtually all bank failures revolve around asset problems – bad loans or bad investments – since their obligations are generally known with certainty. Some might dispute this characterization, arguing that bank runs result from deposits and other liabilities turning out to be much shorter-term in practice than expected. This is certainly true, but it is fairly rare for a bank run to occur unless it is triggered by losses on assets, especially since the advent of modern deposit guarantee systems.

Thus, there is a significant difference in the sources of failure for life insurers compared to banks.

Maintaining appropriate liability reserves is critical for life insurers. A consequence of the importance of the variations in the cost of future obligations is that regulators need to pay careful attention to the techniques used by insurers to set their reserve levels. These are the amounts set aside on an insurer’s books to reflect payments that must be made in the future for insurance claims of various kinds. If too little is set aside, then an insurer is operating with a much lower margin for error than will be shown on its books, since its true capital will be overstated. If too much is systematically set aside, then insurers will overcharge for their services in order to cover these inflated expectations of future payments. State insurance commissioners in the US pay considerable attention to reserves for future claims and have detailed rules about their calculation, given their importance.

Capital Requirements

For their long-term survival, all businesses need to have a positive net worth, that is, assets worth more than their liabilities. This is critically important for financial institutions and other confidence-sensitive businesses, since they must not only be able to survive, but it must be clear that they can do so. In the financial industry, net worth is referred to as “capital” and the concept can become a lot more complicated. For example, for some purposes the only portion of the financial institution’s balance sheet that may be considered as capital is the accounting value of its common stock, which means that preferred stock and some other non-liability items are treated as if they were liabilities for this measurement. For other purposes, some liability items may be treated as if they were common stock. There are good reasons for these different measurements, depending on the particular purpose of the calculation, but the details are unimportant for this paper. (Please see my primer on bank capital for a fuller description of capital at financial institutions http://www.brookings.edu/~/media/Research/Files/Papers/2010/1/29%20capital%20elliott/0129_capital_primer_elliott.PDF )

Bank capital requirements
Before considering the capital requirements that will be placed on life insurers, it is useful to consider the approach taken to banks. The Fed will be strongly influenced in its thinking about life insurance capital requirements by its experience with these bank capital rules. This is both because it is the Fed’s experience with capital requirements, and therefore permeates their thinking on the topic, and because the asset-related risks of life insurers have considerable similarity to the risks for banks. (Realized losses on securities or loans are the same whether held by a bank or by an insurer, although the ability to bear “paper losses” does vary due to differing funding structures.) As discussed in detail below, there are also many differences in how capital requirements should be considered for the two different types of financial institutions.

Formal capital requirements have been imposed on banks for decades, both here in the US and in most of the world, including all of the advanced economies. They are considered important enough that there are global agreements intended to ensure that all major economies meet at least certain standards for the capital of their internationally active banks. Generally the same or very similar rules are used in these countries for their more purely domestic banks as well. The rules are promulgated by the Basel Committee on Banking Supervision (Basel Committee), which reaches them based on a consensus among its members, consisting of the central banks or banking supervisory authorities of all of the most important banking centers and many other nations as well. The original Basel Accord was agreed in 1988 and very substantially revised and altered in 2004 with the resulting version known as Basel II. The global financial crisis has spurred another round of revisions that will sharply increase the total amount and quality of the capital banks are required to hold. The upcoming version is known as Basel III. (There were also important interim changes that have already taken effect known, perhaps predictably, as Basel 2.5.)

The heart of the Basel approach is a calculation of the ratio of capital to risk-weighted assets.

This was incorporated in the first accord and has been considerably expanded with each revision. The idea is that the amount of capital required should be based not just on the size of the bank in terms of assets, but on the total level of risk created by those assets. (Note that liability risk was almost completely absent from Basel I and II. Liquidity issues are being given prominence in Basel III, which goes beyond the capital required to look at maturity mismatches between assets and liabilities. However, there was seen to be no need to reflect the possibility that liabilities might vary in value, since this just is not a serious issue with banks, as opposed to insurers.)

Each asset type is multiplied by a risk weighting, which can range from zero to 1250% depending on its risk compared with a standard loan that receives a risk weighting of 100%. Government bonds of major countries are considered to have no risk and therefore have a zero risk weighting, although there has been serious pushback on this score by outside analysts, spurred in part by the sovereign debt crisis in Europe. Most mortgages have a 50% risk weighting. Very risky tranches of securitized products have risk weightings well north of 100%. There are a large number of other categories with their own explicit risk-weightings.

The total level of risk-weighted assets at a bank is calculated by multiplying the amount of each asset type held by the appropriate weighting and then adding them up. The average risk weighting for banks in the US is about 80%, while it is about half that in Europe and Asia, for a variety of reasons, including varying accounting rules which exaggerate the difference with the US.

The Basel II accord introduced an innovation that has been retained, the use of internal risk modeling by the more sophisticated banks. The core concept is that major banks have a strong economic interest in evaluating the riskiness of their loans and therefore have developed very detailed models, influenced by the latest thinking among financial economists. It was considered desirable to bring this more advanced thinking into the calculation of risk weightings, in part to encourage all banks to move to better risk models and for the major banks to expand and improve their use of such modeling. Therefore, banks can use their own calculations to determine the risk weightings for certain types of assets, subject to supervisory approval of their models.

Some observers expressed concern at the time about the fact that banks would have an economic incentive to bias their estimates of risk to the low side once the results of these internal models took on regulatory implications. These concerns have intensified in light of the under-estimation of risk in the run-up to the financial crisis, but have been handled in the Basel process by stricter rules about how models should be constructed, rather than by abolishing their use in the capital calculations.

Insurance capital requirements
For their part, US insurers have for many years been subject to their own risk-based capital (RBC) requirements, promulgated by the National Association of Insurance Commissioners and incorporated into law and/or regulation in each state. There are significant similarities to the Basel approach for banks, but the rules are both more and less complex for insurers and reflect the different characteristics of that industry.

The biggest difference with the banking rules is that NAIC RBC requirements take account of risk not just on the asset side, but also in regard to insurance risk (the liability side of the balance sheet), interest rate risk, and other business risks, including litigation. Risk weights are assigned for the different categories of assets, liabilities, and insurance products to reflect their varying risk levels. There are also downward adjustments to account for the interactions between the various sources of risk, recognizing that not all of these areas will necessarily go wrong at the same time and, if they do, they may not all go to their extreme states.

An underlying issue that will have to be resolved is what accounting system the Fed will use in regard to insurers. All insurers that have publicly traded securities report their results using Generally Accepted Accounting Principles (GAAP) as promulgated by the Financial Accounting Standards Board under delegated powers from the Securities and Exchange Commission. However, all US insurers also report to their regulators using a different set of accounting principles known as Statutory Accounting Principles (SAP). The two sets of accounting standards are identical in many aspects, but differ in a few key areas. A crucial difference is that, under SAP, fixed income securities such as bonds are shown at their amortized principal amount (essentially their face value with some appropriate adjustments) and not their market values, as under GAAP. Fixed income securities are a large part of the holdings of insurers and the two valuation methodologies can produce quite different results. In particular, market volatility affects the GAAP valuation of these fixed income assets while it has very little effect on the SAP valuation.

Another crucial difference is that GAAP operates under a “going concern” approach, whereas SAP uses a liquidation approach. Thus, items that would have little value in a liquidation are treated as worth only that much, whereas GAAP rules allow them to be held at the value that will be realized over time. A trivial, but illustrative, example is office furniture. SAP treats it as worth almost nothing since a liquidation would have a fire sale effect. GAAP treats it as worth what was paid for it, minus any depreciation, since it is presumed that its use in the business will justify over time the original purchase price. There are considerably larger items, such as spreading the benefit of up-front sales commissions over the life of the products sold, that make a real difference. SAP is virtually always more conservative in this manner.

There is a good argument for using the SAP approach for regulatory purposes. However, US banking regulators were badly burnt by using Regulatory Accounting Principles (RAP) for banks and savings and loans a couple of decades ago. By allowing non-GAAP rules, they opened themselves up to pressure to soften accounting rules when the savings and loans ran into problems. They switched after the S&L crisis to using GAAP and became allergic to the idea of allowing different accounting for regulatory purposes. It will be interesting to see if the Fed chooses to use different accounting than the insurance regulators do.

Choosing a Fed capital methodology for life insurers
The Fed will clearly focus on capital levels as a major part of its prudential oversight of life insurers. There are multiple methodological choices it could make, broadly including:

Acceptance of the NAIC capital calculations. The Fed could choose to defer to the state insurance commissioners on the capital calculations, in recognition of their role as primary regulators and their far longer experience in analyzing and regulating the industry.

Use of bank capital calculations for insurers. At the other extreme, the Fed could simply try to fit insurers into the bank formulas. This seems unlikely, at least taken to this level, since insurers are so obviously different than banks. It would also expose the Fed to accusations that it was ignoring major areas of risk at the insurers, relating to their liabilities and their pricing of their obligations.

Modification of the NAIC capital calculations. The Fed could accept the basic NAIC approach, but choose to modify parts with which it felt uncomfortable.

Creation of a hybrid NAIC/Basel approach. It is possible that the Fed would choose to use the Basel approach for calculations of risk-weightings for assets and combine that with the NAIC approach for the other categories, perhaps with some modification. This would allow them to argue that they are remaining consistent with the rules for banks, where applicable, while capturing the main elements of difference between life insurers and banks.

Whatever choice the Fed makes, with the exception of simply accepting the NAIC measurements, the devil will be in the details. Insurers are quite different from banks, so even using categories that seem identical between the two industries may be harder than it would first appear. Obviously, this difficulty would be exacerbated the closer the calculations are to those used for banks. A modified version of the NAIC rules would doubtless still require some complex choices, but would be considerably easier to apply to insurers than would be a totally new methodology for them.

What might the Fed do beyond capital standards?

One area of regulation analogous to capital requirements would be liquidity requirements. The Basel III rules, which will be implemented in the US, include quite detailed calculations to ensure that banks have the ability to generate the necessary cash to meet all of their obligations even in a period in which markets freeze up and liquidity vanishes. It is certainly possible that the Fed will apply similar tests to life insurers and other non-bank SIFIs. It is unclear at this point not only what the Fed might do, but how much effect such standards would have. For example, it is possible that life insurers would easily pass the Basel III liquidity tests, since such a high proportion of their liabilities have maturities over one year. However, there is the vexed issue that a large portion of these obligations could be brought forward if the holders were scared enough to pay the full contract penalties. The Fed might choose to make very conservative assumptions about the behavior of these liabilities in a severe crisis that hit the life insurance industry, even though there were relatively few such problems at the life insurers in the recent crisis. They might postulate a future crisis in which life insurers were more central to the problems and therefore suffered higher attrition of their policies. In practice, this would result in a requirement for life insurers to hold large levels of short-term, highly creditworthy liquid assets such as Treasury bills or deposits with solid banks and make it harder for life insurers to hold the long-term assets they need to match their long-term liabilities.

Beyond this, Dodd-Frank gives federal regulators a wide range of powers over SIFIs, including the ability to require the divestiture or cessation of activities that they believe create excessive levels of systemic risk. It would be surprising, however, if the Fed took such an action anytime soon. There is a fairly high hurdle for doing this and the Fed would be under even greater scrutiny in regard to life insurers, since it is not the primary regulator and is known not to have lengthy experience in analyzing them.

That said, the ability to impose tougher capital requirements than those of the primary regulators gives the Fed strong leverage to push for the cessation or modification of activities that it does not like. If, for example, it were to conclude that insurers were taking on too much risk with the guarantees they provide on variable products, it would be easy to discourage this through the risk-weighting procedures. For example, it might decide that any products with the type of guarantees it disliked would be treated for capital purposes as if they were not in separate accounts, with consequent higher capital charges and with inclusion in a straight leverage ratio calculation. There will also be any number of discretionary areas of supervision where the Fed could be more or less sympathetic to management requests depending on how comfortable it was that the company was operating in a sensible manner. It simply does not pay to annoy powerful regulators if one can help it, so there would be a natural tendency to listen to the Fed, even in circumstances where it may seem to be overstepping. Listening may not translate to acting, though, if the economic cost is too high.

One indicator of the Fed’s intentions in regard to detailed supervision will be the size of the staff it assigns to the life insurer SIFIs and whether, and to what extent, it places them on-site at the insurers. Obviously, it will need fewer staff members the more that it relies upon the primary regulators.

Conclusions

In the wake of the recent financial crisis, there is now much more attention paid by policymakers to the question of the overall level of risk in the financial system and the role of systemically important financial institutions in helping to create and spread that risk. This is clearly the case for non-bank financial institutions, especially life insurers. Life insurers are very important financial institutions and have been extensively regulated for centuries for that reason. However, relatively little attention was paid until recently to the ways in which individual insurers might affect the rest of the financial system. Dodd-Frank attempts to ensure that the possible systemic risk created by all the important non-bank financial institutions be considered.

Whatever one believes about the wisdom of designating some life insurers and other types of non-banks as systemically important, it is critical that the ensuing regulation by the Fed of any designated SIFIs be appropriate to their industries. Life insurers in particular are quite different animals from banks and so it is crucial that the Fed not instinctively treat them simply as funny looking banks and try to force them to be more like traditional banks. The most likely place that such a mistake could be made is in the area of capital requirements, where the Fed has extensive intellectual investments in their current approach to bank capital, buttressed by agreements with their peers in other nations. Applying bank capital standards inflexibly to life insurers would run the real risk of forcing them to act more like banks, even when this would actually increase their risk. For example, the long-term nature of life insurance liabilities necessitates the holding of long-term assets in order to reduce the risk that funding costs will shoot up when shorter-term assets are rolled over. Banks, on the other hand, have much shorter liabilities and therefore need to be careful not to lengthen their assets too far.

The Fed has promised to pay careful attention to the differences between banks and other financial institutions that are designated as SIFIs. It is crucial that they be rigorous in doing so.

[1] Members of the FSOC include the Treasury Secretary (chair), the Chairman of the Federal Reserve System, the Comptroller of the Currency, the Chairman of the Federal Deposit Insurance Corporation, the Chairman of the Securities and Exchange Commission, the Chairman of the Commodities Futures Trading Commission, the Director of the Bureau of Consumer Financial Protection, the Director of the Federal Finance Housing Agency, the Chairman of the National Credit Union Administration Board, a member with insurance expertise designated by the President and confirmed by the Senate, and various non-voting members (such as a representative of state bank regulators).

[2] There is some ambiguity in the legislation as to whether all systemically important financial institutions must be designated as such, or only those where the FSOC feels it is necessary to do so. Section 113(a)(1) uses the term “may” whereas Section 112(a)(12)(H) indicates a requirement.

[3] See the report to the G20 Finance Ministers and Governors by the IMF, BIS, and FSB, “Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations”, available at http://www.bis.org/publ/othp07.pdf

[4] See Section 113 of the Dodd-Frank Act.

[5] See, for example, the study by the Macroeconomic Assessment Group set up by the Basel Committee on Banking Supervision and the Financial Stability Board, “Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements (Final report)”, December 2010, http://bis.org/publ/othp12.pdf. This report references a large number of other studies on the effect of capital requirements on credit provision and on the real economy.

[6] Regulators are aware that there are significant differences between different types of institutions and will attempt to take this into account appropriately. However, there will also be bureaucratic and political pressures to use common approaches, even when these are not entirely sensible, in addition to a natural human tendency to use tools with which one is already comfortable.

[7] It would be necessary to have a guaranteed schedule of premium payments to create a true equivalence and there are other differences, such as in tax treatment.

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Regulating Systemically Important Financial Institutions That Are Not Banks

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Douglas J. Elliott

Image Source: © Chip East / Reuters

Regulating Non-Bank Systemically Important Financial Institutions

Thu, 09 May 2013 09:00:00 -0400

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May 9, 2013
9:00 AM - 11:00 AM EDT

Saul/Zilkha Rooms
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

The Dodd-Frank Act requires federal regulators to name financial institutions that are “systemically important” (SIFIs). These institutions will be subject to greater scrutiny by regulators who will have the legal ability to impose additional regulations on them. How should authorities decide which financial institutions other than banks should be designated as SIFIs? Once designated, how should they be regulated? The analysis is particularly challenging for financial groups with life insurance units at their core, given their differences with banking.

On May 9, the Economic Studies program at Brookings reviewed the designation and regulation of non-bank SIFIs, with particular emphasis on life insurers. Panelists included experts from academia, as well as Martin Baily, senior fellow and director of the Initiative on Business and Public Policy at Brookings. Douglas Elliott, fellow in Economic Studies, served as moderator of the panel on the designation of SIFIs and also presented some views on the regulation of non-bank SIFIs once they have been designated.

Read Doug Elliott's paper, "Regulating Systemically Important Financial Institutions That Are Not Banks" »

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Excessive Bank Equity Rules Would Slow the Economy

Douglas J. Elliott — Tue, 09 Apr 2013 00:00:00 -0400

There are serious proposals to force banks to fund themselves with considerably less debt and far more money from their shareholders. This would protect the rest of us, by leaving more of the risk with shareholders and reducing the potential need for taxpayer bailouts. However, there is a trade-off for the greater safety; loans would become more expensive and the economy would slow.

The added safety is well worth the cost when raising equity levels from the risky pre-crisis levels to those being mandated by global regulators under the “Basel III” rules. It might be good to go somewhat further, but not to the extreme levels advocated by some. My fear is that drastic actions may be taken in this area because some argue that it would be economically costless to do so. This idea is wrong in the real world, even if it makes sense under very specific theoretical conditions. There is only space in this column for a high-level discussion of this complex topic. Please see my recent paper on bank capital requirements for a somewhat more detailed explanation.

US banks currently fund about 5% of their assets with money from their common shareholders (“common equity,” one part of the safety buffers known as “capital”), with the rest coming from depositors, bondholders, and a few other sources. This is more than double the pre-crisis levels and is only modestly below the Basel III requirements. Some have called for increasing the level to as much as 30%, a drastic change that would be costly for the economy.

At first blush, it seems obvious that selling stock to investors who want returns of 10-15% a year would increase a bank’s costs, and therefore its loan rates, as compared to borrowing from bondholders or depositors who charge far lower rates. However, the economists Modigliani and Miller won the Nobel Prize in part for showing that, under idealized conditions, it does not matter what proportion of a firm’s funding comes from equity rather than debt. Adding more equity makes a firm less risky and reduces the cost of each unit of equity or debt by an amount that exactly offsets the switch to an otherwise more expensive mix of funding.

This fundamental theory of finance is the core reason some theorists and their followers argue that there is no economic cost to forcing banks to fund themselves much more through common stock. However, there are at least 6 differences between the real world and the idealized conditions necessary for Modigliani-Miller to hold. Taken together, these imply substantial societal costs to mandating extreme levels of equity.

Tax advantages for debt. Modigliani and Miller ignored corporate taxes in their initial work. In reality, interest payments on debt and deposits are tax deductible, while dividends to shareholders are not, creating a major incentive for banks and other firms to fund with debt. Miller later showed that tax advantages at the investor level for owning stock could work in the opposite direction, and would fully eliminate the corporate tax effect under very specific conditions that are not met in the US tax system. The actual offset in the US is perhaps a 50% reduction, maybe less, still leaving taxes as a big factor. This does mean tax collections would be higher, so the net effect on economic growth would depend on what was done with the extra money.

Many advocates of extreme levels of equity call for the abolition of interest deductibility. The same relative effect could be achieved by giving banks a tax deduction on their dividends, as Belgium does. For better or worse, neither of these things is likely to happen, so bank funding costs would go up and some or all of this would be passed on to borrowers. Advocates of extreme capital ratios should offer their proposed back-up plans if interest deductibility is not abolished.

Deposit guarantees and other backstops. Bank deposits are guaranteed up to certain limits, and some argue that federal policies provide protection to uninsured deposits and bank debt through implicit guarantees. Guarantees of debt and deposits block the key mechanism of Modigliani-Miller, since there is little reason for funders with guarantees to lower what they charge as banks become safer. A perfect risk-based pricing system for guarantees would offset the behavioral effect, but we do not have this in practice and are unlikely to achieve it, for both political and technical reasons.

Issuance costs. Modigliani-Miller ignores the transactional costs of raising funding. In practice, the direct issuance costs for equity are much higher than for debt or deposits, although still not huge in the grand scheme of things. More importantly, investors insist on a significant price discount if a firm wants to sell them stock, out of a fear that management knows of reasons why the share price should be lower and therefore is seizing an opportunity to “sell high.” Modigliani-Miller ignores both effects. Recognizing this, some advocates of very high equity levels are willing to allow banks to meet the requirements very gradually through retaining all profits, in exchange for a ban on dividends and share buybacks. This largely eliminates the problem of issuance costs, but would create major market distortions that would potentially last for decades, as some banks would build up their equity levels faster than others and therefore operate with a different, and more expensive, cost structure. There could also be substantial disincentives to increase lending, if doing so would require equity issuance to avoid lowering the equity ratios. If there are no such requirements to maintain equity ratios, then there would be the opposite incentive to increase lending sharply to restore the bank’s lower preferred equity ratios, undoing the effect of setting higher requirements.

Skepticism by investors. Many investors and equity analysts have made clear their skepticism that adding equity increases bank safety as much as the theory says it would. Actions by managements or mistakes by regulators could counteract the positive effects, at least partially. Banks are always going to be “black boxes” to some extent, so there may be a limit to how much investors are willing to drop their required return. Nor is there clear historical evidence to refute the concerns about a partial offset due to investor skepticism. As long as significant numbers of investors are skeptical, the price of equity and debt will not go down to the extent that Modigliani-Miller assumes as banks raise more equity. This will put pressure on financial institutions to avoid operating with the higher equity levels.

Shadow banking. The higher costs that would be imposed on banks because of these real world issues would create strong market pressure to move business out of the highly regulated banking system into various forms of shadow banking. Dodd-Frank has given regulators some powers to deal with shadow banking, but nothing like the authority that would be needed to counteract this level of market pressure. In practice, fully counteracting this pressure may be impossible without rigid government controls that would harm the economy in themselves. Few, if any, analysts believe we would be better off with a massive shift of banking activity into shadow banks. A financial system that relied primarily on shadow banking would be much more vulnerable to crises that would shake the wider economy.

Transition issues. As already noted, there are a host of issues of how to get from here to there without damaging a still fragile economy.

In sum, higher equity levels at banks increase the safety of our financial system in important ways, but we should not overshoot, as there are real costs that we must balance against the benefits.

Authors

Douglas J. Elliott

Publication: Real Clear Markets

Image Source: © Keith Bedford / Reuters

U.S. Productivity Growth: An Optimistic Perspective

Martin Neil Baily, James M. Manyika and Shalabh Gupta — Fri, 29 Mar 2013 00:00:00 -0400

ABSTRACT

Recent literature has expressed considerable pessimism about the prospects for both productivity and overall economic growth in the U.S. economy, based either on the idea that the pace of innovation has slowed or on concern that innovation today is hurting job creation. While recognizing the problems facing the economy, this paper offers a more optimistic view of both innovation and future growth, a potential return to the innovation and employment-led growth of the 1990s. Technological opportunities remain strong in advanced manufacturing and the energy revolution will spur new investment, not only in energy extraction, but also in the transportation sector and in energy-intensive manufacturing. Education, health care, infrastructure (construction) and government are large sectors of the economy that have lagged behind in productivity growth historically. This is not because of a lack of opportunities for innovation and change but because of a lack of incentives for change and institutional rigidity.

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U.S. Productivity Growth: An Optimistic Perspective

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Publication: International Productivity Monitor

The Brookings Survey on Eurozone Progress

Justin Vaïsse and Douglas J. Elliott — Wed, 12 Dec 2012 00:00:00 -0500

For the last two years, the world has closely watched an economic crisis unfold in the Eurozone. In a new Brookings interactive examining the Eurozone crisis, 14 Brookings scholars closely analyze the EU’s stabilization efforts and make their own recommendations for a stronger union going forward. Senior Fellow Justin Vaïsse and Fellow Douglas Elliott summarize the findings of the Brookings Survey on Eurozone Progress.

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Capital Markets and the Fiscal Cliff: A Conversation with NASDAQ OMX CEO Robert Greifeld

Mon, 19 Nov 2012 13:00:00 -0500

Event Information

November 19, 2012
1:00 PM - 2:15 PM EST

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

This event was broadcast live on C-SPAN and CSPAN.org. Click here to watch.

As the saying goes, markets like certainty. Although the election is over, the uncertainty surrounding the impending fiscal cliff, combined with long-term deficit and debt issues, may be affecting the economy—and the Congressional Budget Office estimates actually going over the cliff could push the U.S. into another recession. Business leaders have taken notice, forming coalitions to implore Congress and the White House to work together to avoid what they believe will be detrimental to the U.S. and global economies.

On November 19, Economic Studies at Brookings hosted NASDAQ OMX CEO Robert Greifeld to discuss why he believes the capital markets need a sound federal budget so they can get off the sidelines, instead of waiting for news as to whether Washington can reach a deal.

Brookings Vice Chairman Glenn Hutchins gave introductory remarks and Martin Baily, senior fellow and director of the Initiative on Business and Public Policy at Brookings, served as moderator. Mr. Greifeld also took questions from the audience.

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Foreign Investment, Economic Growth and Job Creation

Mon, 01 Oct 2012 10:00:00 -0400

Event Information

October 1, 2012
10:00 AM - 11:30 AM EDT

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

Register for the Event
A Conversation with Volkswagen Group of America President and CEO Jonathan Browning

Investment in the United States by both domestic and foreign businesses is a major engine of economic growth and job creation, and the United States attracts more foreign direct investment (FDI) than any other nation worldwide. FDI supports more than 5.6 million American jobs, including over two million in manufacturing. Manufacturing jobs tend to pay better – on average one-third more than the national average. These investments also help drive U.S. exports. Foreign affiliates also invest in innovation, spending over $40 billion each year on research and development in the United States.

But the United States faces increased competition for these investments and the jobs they bring with them. Can policymakers help keep America at the top and create even more jobs through these foreign investments?

On October 1, the Initiative on Business and Public Policy at Brookings hosted a forum examining the key factors policymakers should consider in trying to attract global investment in America. President and CEO of Volkswagen Group of America Jonathan Browning gave the keynote address. He was followed by a panel including Assistant to the President and the Principal Deputy Director of the National Economic Council Jason Furman; Brookings Senior Fellow and Director of the Initiative on Business and Public Policy Martin Baily; Executive Director of SelectUSA Steven J. Olson; President & CEO of the Organization for International Investment Nancy McLernon; and New York Times columnist Eduardo Porter, who will served as moderator.

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Foreign Investment, Economic Growth and Job Creation

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Don’t Repeal Dodd-Frank, but Don’t Crush the Banks Either

Martin Neil Baily — Wed, 05 Sep 2012 00:00:00 -0400

In the clamor of election rhetoric it is hard to make clear-headed judgments about what should be done to promote stronger economic growth and more jobs. One piece of the recovery puzzle is to make sure the financial sector can do its job. Political slogans calling for the repeal of the Dodd-Frank financial reform make no sense.

First, that is not going to happen when a few senators can block either new legislation or the repeal of existing legislation. Second, after the massive financial crisis, reforms to restrain excessive risk-taking were essential and Dodd-Frank made a good start on those reforms. At the same time, efforts to blame the entire crisis and the continuing slow economy on Wall Street are equally foolish. And the way the Dodd-Frank rules are being implemented threatens to hold back new lending. Some on the left, and even a few on the right, are calling for the break up of the big banks, under the illusion this huge disruption would help us get through the economic slump.

The Slow Growth Equation

The reasons growth is so slow three years after the economy hit bottom are cautious consumers (understandably so), the weakness in the housing market, and the reluctance of businesses to invest. Nonresidential fixed investment in the first half of 2012 was still below the level reached in 2007. Large businesses mostly have plenty of cash but are hesitant to invest in major new projects. Small and medium-sized enterprises, the ones that typically power employment growth, lack cash flow and face a tough environment for borrowing.

Recoveries can generate their own momentum but this recovery has never hit takeoff speed. An important piece of a stronger recovery is a stronger financial sector. We do not want a return to a speculative bubble, but the willingness to take reasonable risks helps economic growth. The American financial sector must provide fuel to finance business sector recovery.

In the financial crisis small banks, medium-sized banks and large banks got into difficulty. There is lots of blame to go around and good reasons for improved safety and soundness regulation. Once the election is over, it will be time for a thorough review of where the new Dodd-Frank rules are working and where they are not working.

A New Approach to Enforcement

Regulators have been overloaded by the task of implementing Dodd-Frank, so draft rule-making has been handed out to disparate groups with no coherent strategy for creating a regulatory and supervisory system that fosters both stability and economic growth. We want a safer regulatory system, but not every single rule has to be calibrated for maximum safety. Having both seat belts and airbags is good, probably, but seven different restraints would but make it hard to drive or hard to breath.

An important reason to provide breathing room to the financial sector is that it will have to greatly expand its role in lending. The housing market is finally showing signs of recovery after its long swoon. Residential construction is increasing and prices are stabilizing or even rising in some locations. Currently, most new mortgages and refi's are provided through government-backed enterprises, Fannie, Freddie and the Home Loan Banks, but over the next several years there must be a transition to greater reliance on private-sector mortgage lending. In the long run, taxpayers should not be the main source of mortgage funds and guarantor of mortgages, as they are today. Over the coming years, the American financial sector must be ready to take on a much bigger role in mortgage lending.

The idea of breaking up the big banks today is nuts. Yes, many of them behaved badly and needed support from taxpayers. Yes, bankers were making a ton of money. But the Dodd-Frank proposals for higher capital standards and the creation of a "resolution authority" to wind down failing institutions (as well as a half dozen other provisions) have gone a long way to respond to those excesses. Small, medium and large banks all have a role to play, providing different services to different parts of the economy. Large banks have unique expertise and capability in market-making and serving multinational companies. Attempting to break up the big banks, with an inevitable multi-year legal struggle and climate of huge uncertainty, is just a really bad idea at the current time of fragile recovery.

Either a re-elected Obama administration or a new Romney administration will be in place come January. Here's hoping that whichever it is, they will forget the slogans and apply good sense and good economics to implement a set of financial rules that will foster both recovery and safety.

Authors

Martin Neil Baily

Publication: Yahoo! Finance

Image Source: Brendan McDermid / Reuters

Will Greece Kill the Euro?

Douglas J. Elliott — Tue, 05 Jun 2012 00:00:00 -0400

Greece could well be out of the euro soon, depending on the results of the election scheduled there for June 17th. An exit would inevitably be messy and would likely push Europe into a severe recession, the U.S. into at least a modest recession, and to substantially slow the growth of China. The Institute of International Finance has estimated an exit could cost the world economy over $1 trillion and official bodies such as the International Monetary Fund (IMF) have similarly warned of disastrous results.

Part of what makes this so scary is that it is impossible even to accurately estimate the probability Greece will exit, much less know for sure whether it will. Analysts at investment banks are estimating probabilities of a euro exit by at least Greece that cluster around 50%, the traditionally safest percentage to choose when there is a serious likelihood of something happening, but no real way to assess the probability. Various economists and political analysts give opinions ranging from an exit being “inevitable” to “very unlikely,” strongly influenced by whether they view the euro experiment as fundamentally unsound or simply experiencing growing pains.

My personal view is that a Greek exit has a probability of perhaps one in four or five, certainly higher than I have estimated in past months but still reflecting my belief that an exit would be harmful for both Greece and Europe as a whole and therefore will be avoided.

The leading Greek parties all support staying in the euro, as do about three-quarters of the voters. However, an almost equally large majority support parties that favor a rejection of the existing bailout agreement because they believe it has too many cuts in government spending and reductions in labor market and other protections. The problem is that rejecting the bailout agreement is likely to be incompatible with staying in the euro, forcing a choice between these two strongly held views.

The Greek government spends considerably more than it takes in, with Europe and the IMF funding most of the difference. Greece secured that assistance by agreeing to impose tough measures. If a new Greek government rejects the bailout agreement and subsequent negotiations fail, Europe may pull the plug on this funding and on the liquidity assistance that has kept the Greek banking system alive. There are a number of ways in which this dire situation could lead to an exit from the euro.

The elections will be the key to whether Greece exits the euro, at least in the short to medium term. New Democracy and PASOK, the two parties that traditionally dominated Greek politics, support the broad terms of the bailout package which they had signed on to. Syriza is the leading rejectionist party, although most of the political spectrum wants to renegotiate the terms. New Democracy and Syriza are running neck and neck, with the former holding a slight lead in the last polls before a polling blackout kicked in two weeks prior to the election. The party with the most votes gets a 50 seat bonus in the 300 seat parliament and is likely to be able to form a workable coalition.

If New Democracy wins, it will form a coalition with PASOK, and is highly likely to be able to find a workable compromise with Greece’s European funders, although it admittedly will be very tricky to do. If Syriza wins, it will almost certainly play a game of brinksmanship, trying to force Europe to agree to dramatically more favorable terms for Greece by effectively threatening to let the Euro fall apart. This is a plausible threat because if Greece pulls out of the Euro, it will make it considerably more likely that Portugal or another troubled country will be forced out as well, making further exits even more likely, in a domino effect of disaster. Greece would be hurt badly by a withdrawal, but it would not suffer alone, so it hopes that the threat of disaster will force the hand of its European partners.

Why would Greece be badly hurt by a withdrawal? Whatever the medium to long run advantages and disadvantages for Greece in returning to its own national currency, few seriously dispute that the Greek economy would be badly damaged in the near-term. There is no legal mechanism for withdrawal from the euro without also withdrawing from the European Union and even that procedure would take much longer to negotiate than would actually be feasible in this situation. Therefore, we would find ourselves in uncharted legal waters where the Greek and other governments would be making ad hoc decisions and trying to negotiate to limit the damage. This guarantees a huge amount of uncertainty that would weigh heavily on the Greek economy. Few businesses or individuals would dare to invest in Greece in the short run and everyone who could do so would increase their precautionary savings by cutting expenditures to the bone, and there would be huge incentives to move funds out of Greece, despite capital controls that would undoubtedly be put in place.

Many corporations and some individuals would also be bankrupted by the resulting exchange rate movements. The new currency would plunge in value compared to the euro. Anyone who owed money to non-Greek parties in euros could well find that they have to repay that debt with much-depreciated drachmas, making their debt burden much bigger. External financing would also virtually halt, adding to the credit squeeze. Political uncertainty would add its own cost, as there is a considerable likelihood that any government that pulled out of the euro and inflicted these transitional costs on the Greek public would be thrown out of office. All of this, and the riots that might also occur, would be likely to smash the tourism business for some time until relative stability is restored.

In the longer run, a depreciated drachma could make tourism in Greece and exports to other countries much more attractive, allowing Greece to regain access to foreign funds by running a trade surplus. I write “could” because it depends heavily on what else affects the prices and quality of exports and of tourism. In particular, inflation would almost certainly shoot up initially, triggered by rising costs of imported goods, erasing some of the advantage of the price reduction for exports created by the exchange rate movement. Costs would also rise because interest rates would soar due to high inflation and fears of future inflation. In theory, it would be possible for the major segments of Greek society, including the unions, to develop a wage-price policy that would ensure that exports did indeed become more competitively priced. However, this is difficult to do under the best of circumstances and Greece would be trying it under the worst.

The upshot is that Greece, Europe, and the rest of the world, including us, really needs a compromise to be reached. Our very strong mutual need to avoid disaster is my biggest hope for an acceptable solution. However, sometimes the right course can be politically impossible, especially in a situation as complicated as this. In that case, it will pay to be very conservatively invested, because almost anything that carries some risk will go down in value.

Authors

Douglas J. Elliott

Publication: Real Clear Markets

Image Source: John Kolesidis / Reuters

Designating Systemically Important Financial Institutions

Douglas J. Elliott — Wed, 16 May 2012 10:00:00 -0400

The Fed and other financial regulators are generally on the right track and striking the right balance in designating which non-bank financial institutions should be regulated as Systemically Important Institutions (SIFIs), testified Douglas Elliott, Brookings Fellow in Economic Studies, today before the House Financial Services Subcommittee on Financial Institutions and Consumer Credit.

In “Designating Systemically Important Financial Institutions: Balancing Costs and Benefits,” Elliott states, “designating non-bank SIFIs is by its nature a complex endeavor that requires a careful balancing act and substantial human judgment. The rules proposed by the regulators generally reflect those considerations and I believe that the resulting uncertainty about the ultimate outcomes is unavoidable, unless we either abandon the effort to designate such SIFIs or use cruder measurements that would almost certainly produce worse results. I am more concerned about whether those non-banks that are designated as SIFIs will be regulated in a way that fully reflects their differences with banks, but I am hopeful that this can eventually be worked out.

Elliott suggested five core principles to guide the designation process:

No part of the financial industry should receive an automatic exclusion from SIFI status;
There are no absolutes in SIFI designation—judgment is necessary;
Regulators must weigh the safety benefits of designating a firm as a SIFI versus the costs;
Regulation of designated non-bank SIFIs must be appropriate to their business models and coordinated with their existing regulators; and
Similar activities should be regulated in similar ways with similar safety margins.

Some have asserted that a firm which is named as a SIFI would have an implicit government guarantee or at least seal of approval, giving firms a competitive advantage on their funding costs and their ability to sell products. Elliott testified that he does not believe this to be a significant issue because those firms are already viewed by the markets as being safer due to their size and importance. “Regardless of my own views, both the managements and investors of firms potentially designated as SIFIs are sending very strong signals that they see such a designation as a negative. I can assure you that a number of those firms are working very hard to avoid designation, as you have doubtless noticed yourselves. It seems very unlikely that this would be the case were there a significant financial advantage to the designation,” he testified.

Downloads

Download the testimony

Authors

Douglas J. Elliott

Publication: House Financial Services Subcommittee on Financial Institutions and Consumer Credit

$2 Billion Later: Policy Implications of JP Morgan Chase’s Trading Loss

Douglas J. Elliott — Mon, 14 May 2012 10:30:00 -0400

The surprise announcement by JP Morgan Chase (Morgan) of a $2 billion trading loss will clearly have a substantial effect on the politics surrounding the reform of financial regulation. Advocates of reform will have an easier time, particularly in regard to the Volcker Rule, the part of the Dodd-Frank financial reform act that is intended to eliminate “proprietary trading” by banks. Industry arguments about the practical aspects of implementing reform will lose much of the benefit of the forceful advocacy that Morgan’s CEO, Jamie Dimon, had been able to bring with his strong reputation and that of his firm.

Putting aside the politics, what public policy lessons can be drawn from the facts of the Morgan debacle? This paper will lay out what we have learned and not learned. It will not focus on the effects on Morgan, except as there are implications for public policy more broadly. Nonetheless, I would like to be clear that I am an ex-employee of Morgan and retain great respect for the firm and friendship with many of those still there. However, this has not prevented me from being a strong supporter of financial reform and of Dodd-Frank, with a few exceptions that include the Volcker Rule.

The following questions related to the trading losses are at the heart of the public policy debate:

What happened?
Who bears the loss?
How big a loss is this? Did it represent a risk to the larger financial system?
Would the Volcker Rule have affected these trades, if the rule had been in force? Should it?
How is this relevant to other proposed structural changes to banks?
What does this tell us about communications and transparency issues?

What happened?

Morgan took a number of large positions in derivatives and securities, primarily related to the risks that the Euro Crisis would cause substantial credit losses. Morgan says these positions were intended to offset or “hedge” other positions that they held throughout the bank, which would have lost money if the Euro Crisis had developed in that manner. The positions were taken through the unit run by the firm’s Chief Investment Officer. This unit is responsible both for hedging against the large cumulative risks that can build up in the rest of the firm and for making a good return on excess funds that the bank is not employing in other areas. It reportedly managed a total portfolio of about $400 billion.

In the event, these particular positions lost large sums of money, currently about $2 billion, prior to the offsetting reduction in income taxes. This might have been acceptable if the positions had indeed acted as an effective hedge, since this would mean that other parts of the bank would have made corresponding gains from the same market movements that would have cancelled out the large losses. However, Morgan has indicated that the hedges were not effective because “egregious mistakes” were made, partly because the hedging strategy was too complicated and difficult to understand and evaluate. In fact, the mathematical models that Morgan uses to assess its Value at Risk (VAR), a quantification of the short-term market risk of its investments, were found to have errors which helped hide the true volatility and risk of these positions. Morgan has temporarily shifted back to an older version of its VAR model, which it believes to be more accurate in this regard, while working to correct the errors.

Further, Morgan says that the positions, which are proving difficult to unwind at a reasonable price, could produce another $1 billion of losses, depending on market movements. It is also possible that the volatility could work in Morgan’s favor, although the firm did not quantify the upside potential.

As a result of the losses, the Chief Investment Officer will be leaving the firm and it appears that some of the traders involved will also be exiting.

There will doubtless be many additional facts that come out in the weeks ahead, but these are the broad outlines of the events.

Who bears the loss?

The loss will be borne entirely by Morgan’s shareholders. As explained below, the loss is small compared to Morgan’s size and therefore there is no expectation that any external aid will be needed from taxpayers, depositors, creditors, customers or anyone else.

How big a loss is this? Did it represent a risk for the larger financial system?

Two billion dollars is a lot of money, but it is actually fairly small in relation to the size of Morgan. The firm earned about $25 billion pre-tax last year, so the $2 billion pre-tax loss is about one month of earnings. The loss is about a hundredth of Morgan’s $189 billion net worth, which represents the amount the shareholders have at stake, providing protection to depositors and creditors. It is roughly a thousandth of the firm’s $2.3 trillion of assets. Finally, the loss is roughly the same as one quarter’s worth of credit losses on Morgan’s loan business. Thus, the loss does not remotely present a threat to Morgan’s viability and even less so to the strength of the larger financial system.

Some have implied that the loss shows that little has been done to strengthen the U.S. financial system, but such ideas very seriously understate the extent of regulatory reforms and of market-driven changes. To take one very important example, Morgan alone added $52 billion in tangible common equity (a conservative measure of net worth that excludes the value of some assets that are hard to monetize) between the end of 2008 and last quarter, or 26 times the recent pre-tax loss and some higher multiple of the after-tax loss. This occurred despite maintaining nearly flat levels of total assets and risk-weighted assets over the period, meaning that the additional equity is available to cover roughly the same volume of risk.

Some of this increase in conservatism was due to voluntary choices by the firm and other parts reflected market pressure. However, some portion of this was doubtless due to anticipation of regulatory changes that are being phased in over time. For example, the US has agreed in principle to implement the provisions of the so-called Basel III global financial accord, which is to start taking effect in 2013. This accord very considerably increases the level of a bank’s net worth required to do the same volume of business as prior to this agreement. In particular, the largest banks, such as Morgan, will have to raise their levels of common equity by 2.5% of their risk-weighted assets purely as a function of their importance to the financial system, over and above the requirements common to all banks. In Morgan’s case, this stipulation adds almost $30 billion to their required net worth, enough to absorb perhaps twenty losses the size of the one just announced, after taking account of the reduction in income taxes.

At first glance, these measures of the small relative size of Morgan’s loss seem at odds with the drop in Morgan’s share price of over 9% as a result of the announcement of the $2 billion loss. However, the stock market was reacting to considerably more than just the direct loss. First, investors tend to be conservative and to pull back after any negative surprise, in part because there could be more surprises coming. Second, Morgan has been viewed by many in the market as the best-managed of the large U.S. banks, which was reflected in a premium market price relative to many other banks. Investors are doubtless less confident now of the degree to which Morgan is really better and therefore have reduced that premium. Indeed that same perception of excellence was helpful with customers and in the recruitment and retention of employees, so any diminishment of reputation creates harm. Third, there will be investigations and possibly lawsuits related to the loss, which will do further damage to Morgan. Fourth, rating agencies and creditors are likely to take a less positive view of Morgan going forward, increasing its funding costs and hampering its operations at least modestly. Fifth, Morgan under Jamie Dimon was viewed as the best placed of the large banks to make the industry’s case on regulatory reforms related to a bank’s trading activities, since the firm came out of the financial crisis in much better shape than many other banks. This level of credibility will take considerable time to recover, if it is ever fully recovered. The perceived scandal of the loss, combined with Morgan’s direct reduction in lobbying clout, significantly increases the chance of regulatory reforms that harm industry profitability.

Would the Volcker Rule have affected these trades, if the rule had been in force? Should it?

The Volcker Rule is the portion of Dodd-Frank that requires regulators to forbid banks from engaging in “proprietary trading.” The classic example of proprietary trading is when a bank has set up an in-house hedge fund that operates separately from its other trading operations with the intent purely to use the bank’s money to make profitable trading bets. However, the exact limits of proprietary trading are very ill-defined and overlap with a great deal of activity that is conducted as part of servicing clients, conducting hedging operations, ensuring an adequate liquidity reserve of high-quality securities in case of cash needs, and other activities that Congress did not intend to discourage. This inherent ambiguity and subjectivity is a major reason why I have personally opposed the Volcker Rule, since it is likely to considerably restrain desirable activities, unintentionally, raising the price of credit and other financial services. (See http://www.brookings.edu/research/testimony/2012/01/18-volcker-rule-elliott for testimony I gave on this topic. I prefer other approaches that deal directly with the risk of investment positions.)

The practical difficulties of operationalizing the Volcker Rule necessitated serious delays in implementation and a proposed rule of great length that included hundreds of questions for comment by interested parties. It is likely that the rule will be reworked very substantially based on the extensive comments that were received.

We cannot know whether the Volcker Rule would have applied to these transactions in any way, had it been already in force. First, we do not know what the rule will say in the end. Second, we do not know the details of the transactions by Morgan. Some of this will come out over time, but much of the detail may remain confidential between Morgan and its regulators, for competitive reasons.

The key conceptual point is probably whether the transactions would have been viewed as true hedges under the final version of the Volcker Rule. The rule is not intended to prevent banks from taking actions to mitigate their risk. Morgan has indicated that a flare-up of the Euro Crisis could have cost it a substantial amount of money in credit losses and that the money-losing positions were taken to offset that. In theory, this was an intelligent risk-reducing activity, if executed sensibly, as was apparently not the case here. Incompetence of execution would presumably not trigger the Volcker Rule, if the intent were truly to hedge.

However, the final version of the Volcker Rule might limit the ability of banks to act as Morgan did in one of two ways. First, there is the possibility that “portfolio hedges” will be forbidden. These are hedges which attempt to offset the aggregate risks of a whole portfolio of investment positions, as opposed to taking a series of specific hedges related to each position within those portfolios. Portfolio hedges can be substantially less expensive, but can run more risk of imperfectly offsetting the risks. Senators Merkley and Levin, two of the early proponents of what became the Volcker Rule, have proposed not allowing an exemption from the proprietary trading rules for portfolio hedges because they believe they would create major loopholes in the Volcker Rule, since any definition of them would be necessarily broad.

Second, the rules might be set to allow hedges only if there is a high probability that they will be very effective. For example, it might make economic sense to enter a hedging transaction that might not fully offset the potential losses or that has some probability of failing to work. This kind of partial protection may be substantially cheaper than paying up for a higher level of insurance. Banks do not, and should not, try to eliminate all the risks they take. They conduct a cost-benefit analysis to decide what risks can be cost-effectively offset, so price is always an issue. The final Volcker Rule might set standards that would fail to exempt such incomplete hedges, perhaps out of a fear of allowing loopholes in the trading rules if excessive flexibility is allowed.

It is still too early to judge what actually happened at Morgan, but there is the possibility that some of those doing the actual trading tried to use the excuse of hedging to take positions that would profit from expected market movements related to the Euro Crisis. This would be an example of the type of activity by traders or their managers that opponents of portfolio hedging fear would be used to circumvent the Volcker Rule. (Of course, the Volcker Rule would not have been the motivation in this instance, but rather working around internal management guidelines or constraints.)

The last several paragraphs of speculation assume that the relevant trades would not have fallen outside the Volcker Rule for some other reason. Certain types of proprietary trading are excluded from the Volcker Rule, such as those involving U.S. government bonds, and medium- and long-term transactions are also exempted. Some of these exemptions may be expanded, such as to include transactions involving highly creditworthy foreign government securities, which might conceivably have been used as part of the hedging against developments in the Euro Crisis.

In my view, it would be undesirable to have the Volcker Rule implemented in a way that made it excessively difficult to offset firmwide risks, such as those from the Euro Crisis. We would not want U.S. banks to be stuck with excessive exposures to certain major events simply because implementing the hedges became too difficult for regulatory reasons. At the same time, if we are serious about the Volcker Rule, despite concerns by myself and many others about its flaws, it will likely be necessary to put rules around hedging activities to avoid creating loopholes that allow large amounts of proprietary trading.

How is this relevant to other proposed structural changes to banks?

The Morgan debacle has given further life to other proposals to reduce the trading activities of banks, such as the proposal by Thomas Hoenig, former President of the Federal Reserve Bank of Kansas City and current FDIC director. That proposal would force banks almost entirely out of the business of trading financial instruments, producing a split something like the original Glass-Steagall Act did. The trading losses are also being used as ammunition by those who would like to break up the largest U.S. banks to reduce their size. A similar dynamic will occur in Europe’s debate as well, giving increased importance to the Liikanen commission that is studying potential structural changes to the banking industry there.

The $2 billion of trading losses are argued to show that (a) big banks can lose very large sums of money and (b) they do not understand the risks they are taking. The first point is self-evidently true, but is not necessarily important and should certainly not be news after the financial crisis. As described earlier for Morgan, sheer size means that it is not difficult for the largest banks to generate multi-billion dollar losses, although these more usually come from the loan book in a recession than from hedging operations. The real key is the level of difficulty in generating losses that are large enough to threaten the capital base of these immense organizations, which the $2 billion loss at Morgan did not remotely do. It is to defend against that possibility that the banking system, and big banks in particular, are being required to have much more net worth than they used to have. As noted for Morgan, one key regulatory provision alone will require that firm to increase its common equity by about $30 billion. Many other regulatory changes are embedded in Dodd-Frank and other measures in order to further bolster the banking system.

It is harder to measure the increased concern that we should have about whether the big banks know what they are doing and what level of risk they are carrying at any given point in time. The ability for a generally well-run bank to mess up by $2 billion does not necessarily mean that banks are vulnerable to a level of losses that would have systemic significance. However, it is certainly concerning to see these kind of losses result from misunderstandings and mistakes at a good bank. This leaves an unquantifiable, although likely low, probability that systemically threatening mistakes are being made at firms that are generally less well run. At a minimum, this debacle will doubtless lead to a useful review by banks and their regulators of trading and hedging activity across the board.

Were policymakers or politicians to conclude that the large banks do not understand the risks they take, it would certainly add impetus to consideration of structural measures to reduce bank complexity and/or size. I, personally, believe that there is no need for such more radical remedies and that the costs to the wider economy would be large, in terms of decreased credit availability and increased costs. In addition, the transition to such new arrangements would be difficult and painful, with a high probability of a period of reduced credit availability while things sorted out. That would be particularly painful if undertaken while our economy remains in a vulnerable state.

What does this tell us about communications and transparency issues?

In addition to the losses themselves, the Morgan debacle raises issues of communications and transparency. News stories began focusing on trading activities associated with the botched hedging operations roughly a month prior to the announcement of the $2 billion in losses. Morgan initially downplayed the stories and there is now reportedly an informal SEC investigation into whether Morgan failed to properly disclose what it knew in a timely manner. There may not be any policy implications about the communications pattern, since there are well-established laws and rules that require firms to disclose material information to shareholders about losses and risks. If there were violations, they can presumably be dealt with under current law.

The more interesting policy questions may be about transparency. As we learn more of the facts, it may become clear that the accounting and reporting for certain types of trading and hedging activities need to be done more effectively. However, it is difficult to draw any conclusions at this early stage.

In sum, if the facts were clear to Morgan, or should have been clear save for negligence, and should have been reported earlier, current law and regulation presumably provide the necessary remedies. If, however, the facts were unclear even to management because current accounting or reporting is insufficient, then we need to find better ways for both internal and external parties to track what is actually happening.

Authors

Douglas J. Elliott

Image Source: Brendan McDermid / Reuters

Europe's Rising Risks from Greece

Douglas J. Elliott — Fri, 11 May 2012 14:26:00 -0400

The rest of the eurozone was really hoping that Greece would stay out of the spotlight for at least a few more months, and ideally longer.

Eurozone leaders recognize the great difficulties in solving Greece's terrible problems, worsened by serious deficiencies in Greek administrative capabilities and even worse problems with its political culture.

To their credit, they have been willing to provide large amounts of financial and administrative assistance to help things along. But they have also been fervently hoping to buy time for the rest of the eurozone to become stable enough to handle the problems that could arise if Greece explodes.

For this reason, they were strongly rooting for the traditional mainstream parties to win a majority in parliament, since those parties have each promised to honor their previous commitments to European and global institutions.

But, that did not happen. The two parties that traditionally dominated Greek politics fell just short of a majority, despite a 50-seat bonus that went to one of them for winning the largest number of popular votes.

Parties that oppose the international agreements won about 70% of the popular vote, as the public revolted against the political elites that got Greece into such a mess and the Germans and other Europeans who are seen as having imposed excessive pain. One cannot blame the anger: Greece is now in its fifth year of recession and the damage is very severe.

There are so many uncertainties surrounding Greece that satellite photos probably show a giant question mark where the peninsula used to be. The one thing that seems fairly clear is that another election will have to be held shortly, since there does not appear to be any combination of the parties that can command a stable majority.

There is a real chance that the leftist party that came in second this time will come in first next time, gaining that critical 50-seat bonus, and perhaps creating a solid majority with other parties that share its rejection of the international agreements.

Greece is a small country which does not directly affect America much, even though our hearts go out to the Greeks in their struggles. The real issue for us is whether Greek contagion will again infect the rest of the eurozone and, this time, produce a catastrophe.

I continue to believe that Europe will muddle through, avoiding the worst outcomes, which would be national debt defaults beyond Greece or withdrawals from the Euro. If they succeed in that modest goal, they will likely avoid the kind of sharp recession that would trigger a recession here as well.

The eurozone as a whole has the economic strength to get through its problems, since it has an economy roughly the same size as the United States, with significantly lower annual budget deficits, and accumulated debt modestly below ours. As with the United States, the real issues are about political will and the ability to forge the necessary consensus.

My continued cautious optimism is based on the strong desire of all key European leaders to avoid a recession severe enough to get them fired, combined with long commitments by those leaders to the "European Project," the kind of commitments that carry major political costs when they are broken.

In other words, the economics make a compelling case for sticking together, and the broader political structure pushes the leaders in the same direction, despite less Euro-enthusiasm among the public in some countries.

The risk, though, is that many things need to go right to work through the Greek mess without knocking the eurozone economy over and to avoid the problems that lurk in many other eurozone countries. Will Greece pull back from the brink of a confrontation with its key financial supporters?

Will the European leaders find yet another clever way to finesse their differences with Greece and with each other? Are the financial "firewalls" built up by the Europeans sufficient to reassure the markets if the Greek situation falls apart?

Will the European Central Bank and national governments step in with the necessary massive financial commitments if worse comes to worst? The list of questions goes on, especially once we look outside of Greece to other potential trouble spots.

Don't count Europe out; they have been proving doubters wrong for several decades and my money is on them to do it again. But don't bet too heavily on success either, there are simply too many risks. Cautious optimism should be the watchwords.

Authors

Douglas J. Elliott

Publication: CNNMoney

Image Source: John Kolesidis / Reuters