Brookings: Topics - Financial Institutions

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

Authors

Douglas J. Elliott

Image Source: © Chip East / Reuters

Regulating Non-Bank Systemically Important Financial Institutions

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

Event Information

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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Regulating Non-Bank Systemically Important Financial Institutions

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Complex Funds Need Better Risk Disclosure

Robert C. Pozen and Theresa Hamacher — Sun, 05 May 2013 00:00:00 -0400

Risk matters as much as return in any mutual fund investment, but assessing the risk of a specific mutual fund can be a challenge. Even though mutual funds have become increasingly complex, their risk disclosure was designed for a simpler era, when funds used only traditional investment strategies.

Funds continue to inform investors about risks primarily by using words. In the prospectus sent to fund buyers, funds describe the types of investments they may own, along with discussions of the factors that may affect the value of those investments.

Verbal risk disclosure worked well when funds held publicly traded stocks and investment-grade bonds. The risks of the underlying assets – which were well understood and easily compared – equated to the risk of the fund.

However, as funds began to venture into non-traditional securities and investment techniques, this qualitative approach to describing risk created as much confusion as clarification. Funds added a paragraph of disclosure for every new asset type or strategy that they thought they might want to use.

Pulling a comprehensive view of a fund’s risk from this voluminous disclosure is no easy task. Is a blue-chip stock fund that uses short sales and derivatives extensively riskier than a high-yield bond fund that engages in the occasional credit default swap? Or is it vice versa?

To help investors better evaluate overall risk, regulators require that funds highlight the most relevant risk factors. These key risks are at the core of the summary fund descriptions sent to potential buyers (called the summary prospectus in the U.S. and the key investor information document or Kiid in Europe.)

And since regulators recognize that a picture is worth a thousand words, these summary documents must include a bar graph showing how a fund’s past performance has varied from year to year. These charts do make it easy to evaluate volatility, but only if the fund has been around long enough to experience a full market cycle using the same investment approach.

To make comparisons easier, European regulators also require that funds provide a synthetic risk and reward indicator, ranking funds on a single scale from one (least risky) to seven (most risky). While useful in concept, the SRRI may not be providing much insight to investors, since funds investing in similar assets generally all fall within the same one or two SRRI categories. In addition, the SRRI is calculated from past returns, giving it the same limitations as the performance bar chart.

What fund investors need are standardized risk measures that are objective, quantifiable and forward-looking. Here are two such measures that regulators might consider.

Leverage limit: Leverage is directly correlated with risk. It is also a tool that more and more funds are using, most often through derivative securities.

Funds might be required to publish a limit on leverage, so that investors can understand how much market exposure they will have relative to their investment. This limit might range from one times assets – for a traditional fund – to three times for an aggressive fund using derivatives extensively.

The published leverage limit would help ensure that investors find the fund that is right for them. For example, a retirement plan sponsor may limit fund choices to those with lower leverage limits, while an aggressive investor may seek out funds with higher limits.

Non-traditional investments: Funds have long moved beyond blue-chips stocks and bonds and now offer investors access to a wide range of asset classes. Investments in derivatives, commodities or real estate are readily available to fund investors these days.

While these alternative asset classes provide investors with increased diversification, they are subject to special risks. They may be more difficult to price – and more likely to experience wide swings in valuation during market turmoil. Derivatives and other structured securities are subject to counterparty risk, meaning that their value depends on the solvency of the financial institution guaranteeing payment.

To give investors a sense of their exposure to these risks, as with the leverage limit, funds might be required to disclose their maximum percentage in alternative assets that are less liquid or hard to value. This disclosure would only be needed if the name of the fund did not indicate that it focuses on alternative investments.

But to ensure that product innovation is consistent with investor protection, the fund industry needs better disclosures. Greater use of standardized, quantitative risk measures would help investors choose among new types of funds.

Authors

Robert C. Pozen
Theresa Hamacher

Publication: Financial Times

Image Source: Toru Hanai / Reuters

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

What the Stockton Municipal Bankruptcy Means, And Doesn't

Tracy Gordon — Tue, 02 Apr 2013 11:20:00 -0400

A few years ago, it was fashionable to compare California, Illinois, or whatever U.S. state was struggling financially to the troubled island nation of Greece. Now, with Stockton, California the largest U.S. municipality to enter bankruptcy, it may be tempting to make another Mediterranean comparison - this time to the troubled island nation of Cyprus.

In Cyprus as well as Stockton (plus San Bernardino, California and Jefferson County, Alabama), the question is: Who will be left holding the bag? A common theme is "haircuts," or possible losses for investors (bank depositors in Cyprus; bondholders in California) to spare wider pain to taxpayers, pensioners, public employees, and other local stakeholders.

One problem with haircuts is that they can impair future market access: the government in question may have to pay higher borrowing costs to regain investor confidence. A wider concern is contagion: If investors fear they won't get their money back, they might demand higher interest rates from the sector as a whole. Moody's Investors Service publicly worried about such contagion last summer, in a report critical of U.S. municipalities and what the organization viewed as changing norms toward bankruptcy.

But there are a few reasons to be skeptical about the contagion scenario applied to munis. First, although broad (worth about $3.7 trillion in 2012), the municipal bond market is not very deep. On the supply side, a few large issuers like California, New York, and Texas dominate. On the demand side, most investors are households or institutions representing households such as money market mutual funds.

Because of its traditional mom-and-pop structure, muni bonds don't transact very often. When they do, different buyers may pay different prices for the same bond, and prices can rise faster than they fall (the "rockets and feathers" phenomenon). Economists have rightly criticized these features as inefficient. However, some market participants counter that proposed cures might be worse than the disease.

A silver lining of less-than-perfect information and higher transaction costs in muni markets may be that shocks are transmitted slowly through the system. More educated institutional investors are probably able to sort good apples from bad; other investors simply "buy and hold." A recent IMF working paper confirms these predictions: after a bad credit event, investors apparently shift their money from places like California and the City of New York to safer issuers.

Rather than suffering from Stockton's misfortune, other states and municipalities will probably benefit, much like U.S. Treasuries after the 2008 financial crisis. Interestingly, the IMF authors did detect some evidence of contagion, or bad news spreading, but in an unexpected direction from munis to U.S. Treasuries. One explanation is that investors looked at a Illinois or California and worried about prospects for a federal bailout, analogous to Cyprus and the rest of the Eurozone.

Still, measured effects were small and took time to surface. The U.S. also has a long history of steadfastly refusing requests for local aid.

In any event, it will take some time to parse through yesterday's Stockton ruling. Its most significant effects may be felt within California—where many municipalities pay into the state's CalPERS pension fund. The judge ruled that CalPERS was just another creditor, but we still don't know who will be left holding the bag.

Authors

Tracy Gordon

Publication: Real Clear Markets

Image Source: © Lucy Nicholson / Reuters

Cyprus II: Considerable Improvement, but Serious Risks Remain

Douglas J. Elliott — Mon, 25 Mar 2013 10:55:00 -0400

We can heave a sigh of relief about the revised Cyprus deal. Early this morning, Cyprus, the various European authorities, and the IMF found common ground on the outline of a deal that is much better than the very flawed agreement of the previous weekend. At the same time, the earlier botched proposal will carry some long-term costs and the actions taken now, while necessary, create real risks of their own.

The best news is simply that an agreement of any kind was reached, allowing European support to flow to Cyprus and preventing, for now anyway, the possibility of an exit from the eurozone. It is also very good news that insured bank depositors in Cyprus will be protected after all, eliminating a terrible precedent with repercussions across Europe. Further, there are real advantages to inflicting large losses on the uninsured depositors and the bondholders of the two largest Cypriot banks. This is by far the strongest message Europe has ever sent that people must pay attention to the strength of the banks with which they deal. It brings the hope that market discipline will finally be a significant aid to outright regulation in ensuring that European banks act prudently at all times.

The first risk is the flip side of passing losses on to those who put their money in banks. In practice, Europe has a long tradition of protecting all depositors, not just the insured ones, and, in most cases, the bondholders as well. For example, the much vaunted, and highly successful, Swedish bank rescues included guarantees for all liabilities. Over time, in reaction to this, there may be major flows of deposits from the weak banking systems in Europe to the stronger ones, further exacerbating credit crunches in the periphery. The ECB and national central banks can offset these flows, but only with further distortions that carry costs of their own. Weaker banks, and those in weaker countries, will find their borrowing costs rising on bonds as well, as investors take heed of the lessons of Cyprus. Even banks in strong countries are likely to see costs increase over time, as depositors and investors react to this major change in regulatory regime. These costs will generally be passed on to customers, potentially slowing economies down at least modestly further. (The ECB can partially counteract this effective tightening of credit conditions, but it is already close to “pushing on a string”, hitting conditions where it is difficult to ease further and have any effect.)

The second problem is that we cannot “unring the bell” of potential hits to insured depositors. The first Cyprus deal raised the real possibility that insured depositors across Europe could lose money if their banking systems and national governments became too weak. The strong reactions to this, and its complete elimination from the final deal, reduce this damage considerably, but it will remain in people’s minds. If there is another serious banking crisis in a weak eurozone nation, depositors may be more prone to move their funds to safer banks and safer countries, in a classic bank run.

The remaining risks are about Cyprus itself. The economy will be severely damaged by the deal and the turmoil around it. A severe recession will be exacerbated by the losses taken by businesses and others with large, and therefore uninsured, bank deposits, and by the restrictions on banking transactions that may remain for some time. Confidence, of course, has been badly shot. Further, nearly a fifth of the Cypriot economy consists of financial services, a sector that will shrink very sharply now. There will also be other conditions imposed on Cyprus as part of the larger agreement with the eurozone and the IMF that will likely hurt in the short run even if they may be for the best in the long term.

It is going to be extremely difficult for a fast-sinking Cypriot economy to produce the results necessary to hold the country’s debt down to a sustainable level. Thus, we are being set up for a future round of tense negotiations to either bring in more eurozone support or take drastic actions such as a bond default, similar to Greece’s. Such a default would carry at least some contagion risk for the rest of the eurozone, unless the larger crisis is essentially resolved by then.

In short, there is no cause for real celebration, but there is reason to feel relieved that disaster was avoided and some of the ill effects of last week’s debacle have been erased. The initial market reactions seem about right; they are up after the weekend’s news, but not soaring.

Authors

Douglas J. Elliott

A Fresh Take Needed For Risky Funds

Robert C. Pozen and Theresa Hamacher — Sun, 24 Mar 2013 00:00:00 -0400

The investment management world used to be simple. Mutual fund managers sold stock and bond investments to the general public subject to stringent regulation, while unregulated hedge fund managers served only the very wealthy with much riskier investment strategies.

But this once-clear distinction is melting away as mutual funds have started to look more like hedge funds, and vice versa. The blurring of the lines has created more choice for retail investors – along with significant challenges for regulators.

The convergence of mutual funds and hedge funds has its roots in consumer demand. In an environment of low returns on traditional asset classes, investors have been willing to consider alternatives to stocks and bonds if they offer the prospect of greater gains.

In response, mutual fund sponsors have developed funds incorporating strategies that, until now, have been used almost exclusively by hedge funds. These strategies often involve leverage, either through borrowing or the extensive use of derivatives, and they frequently emphasize alternative investments such as commodities, real estate and privately placed securities.

At the same time, the sponsors of these “alternative mutual funds,” as they are known, are increasingly likely to be hedge fund managers. Legislation passed in the wake of the financial crisis has subjected these managers to some of the regulations that previously applied only to firms catering to retail investors.

As a result, more hedge funds are willing to consider managing regulated mutual funds that can be sold to the general public. They calculate that the additional regulatory burden will be modest compared with the potential pay-off.

Recent sales of funds with a hedge fund approach give them cause for optimism. Morningstar reports that US investors have moved almost $40bn into alternative and commodity mutual funds over the past two years – while pulling $185bn out of traditional stock funds. Growth in “alternative Ucits”, the European equivalent, has been similarly strong.

Though investors may have embraced these new funds with enthusiasm, regulators have been decidedly more sceptical. In the US, that is partly because existing regulations – which were largely developed in the pre-derivatives era – are a poor fit for the new strategies. For example, the limitations on a fund’s use of leverage never refer to derivatives, by default giving fund managers considerable leeway in their use.

By contrast, regulation in the European Union addresses derivatives explicitly. Funds may use these instruments to create leverage synthetically, provided that their managers have established a process to monitor and manage risk.

But the high level of leverage permitted under these rules – up to three times assets – has raised regulatory eyebrows in prominent EU member states and in some jurisdictions outside Europe, such as Hong Kong, which allow sales of European funds within their borders. These regulators question whether the more aggressive funds are appropriate for the majority of individual investors.

These questions highlight the deficiencies of the current regulatory regime when applied to hedge fund-like mutual funds. This regime is based on two key principles: disclosure of risks to prospective investors and ensuring that funds have the ability to redeem investors upon request. Fund investments have generally been restricted to those consistent with the redemption principle.

As funds have grown more complex, regulators have become keenly aware of the limitations of the disclosure approach. They have tried to make it easier for investors to compare funds by standardizing the information presented in the US “summary prospectus” and the EU’s “key investor information document”, better known as the Kiid.

European regulators have recently gone a step further, by requiring that funds provide a Synthetic Risk and Reward Indicator, ranking funds on a single scale from one (least risky) to seven (most risky). The SRRI is computed from past volatility using a defined formula.

While a laudable effort, the SRRI may be too reductive to provide much insight to investors. An analysis by Lipper found that funds investing in the same segment of the market tended to fall within the same one or two SRRI categories, making it difficult to distinguish funds on the basis of this tool alone.

Therefore, regulators should carefully consider other approaches to mutual funds that are run like hedge funds. These alternative funds might be labelled so that they can be clearly differentiated from traditional mutual funds. And they should be subject to more marketing restrictions if offered to retail investors.

A new model for fund regulation is needed to ensure that product innovation is consistent with investor protection.

Authors

Robert C. Pozen
Theresa Hamacher

Publication: Financial Times

What's the Big Deal about Cyprus?

Michael W. Klein — Wed, 20 Mar 2013 00:00:00 -0400

Editor's Note: In an interview with the GlobalPost, Michael Klein explains what made the terms of Cyprus's rejected bailout controversial and this situation might mean for the rest of the eurozone.

Why did the Cyprus bailout package cause such uproar?

With insured deposits, there is a guarantee that there will be no confiscation of depositors’ money. Even just the fear of a bank run can lead to a bank run. In the 1930s, none of the deposits were guaranteed by the government and that led to bank runs, which in turn deepened the Great Depression. Government guarantees on insured deposits took away most of those fears.

[The Cyprus bailout] is a little bit of crossing the Rubicon to start charging depositors a tax on what they perceived to be insured deposits.

The real concern is not so much what’s going on in Cyprus, but if this becomes a method by which bailouts are funded. Then, there is concern that this could lead to bank runs all over Europe, as other countries’ banks are imperiled.

If the same kind of thing happens there, it could be really problematic.

What are the potential risks of a bailout that includes taxes on depositors’ accounts? Is it a bad precedent to set?

I think it is a bad precedent. It doesn’t distinguish between bad banks and good banks. And it means that deposit insurance might not mean what they say it means.

The bank run is an infrastructure thing because then banks start to shut down and it starves the economy of credit. Historically, we've seen that in situations where banks fail, the depressions that ensued were deeper, more severe and more protracted than recessions that arose for other reasons.

Even though concessions were made to let small depositors off the hook for the tax, the bailout was vetoed by the Cyprus government. What does this mean for Cyprus and for the rest of the Eurozone?

There’s a problem with letting small depositors off the hook logistically, because what could happen is people could split up their deposits and all of a sudden big depositors could look like small depositors. Presumably they have information beforehand, so people couldn’t do that. If you had a deposit in excess of a 100,000 euros before, you can’t hide it.

For Cyprus [a veto] means they have to go back to the negotiating table. Either they get cut off from the bailout funds or there’s a realization on all parts that this was a problematic solution and they go back to the table.

The problem is though – people have been talking about this for a while now – if one country exits the Euro area, it could cause a cascade. People have not been focusing on Cyprus so far. People have been focusing on Greece, of course. If Greece were to exit, the concern is, ‘who’s next?’

If Cyprus exits… if they don’t get the bailout and they drop out of the euro, then the question arises again of who’s next. That question has always been one of the big issues in Europe. As market psychology moves against countries, the most immediate problem is that sovereigns have to pay, and everybody else has to pay, much higher interest costs.

These interest costs had been coming down and it seemed like things were settling down as compared to a year or two ago, but now the question arises about whether this will cause interest rates to spike up again.

The Dutch finance minister and Deutsche Bank’s Chief executive have said this is unlikely to be a model for other countries. Why was Cyprus a special case? How would this affect other vulnerable countries like Spain and Italy?

Cyprus is seen as a financial center where the banks are outsized given the size of the economy. There’s also an issue with a lot of foreigners parking their money in Cyprus. But, nonetheless, people might not necessarily perceive it as a special case.

On Monday morning when banks opened in Spain and Italy, there were no bank runs. Some people cite that as evidence that Cyprus is a special case. On the other hand, it could be the case that the tinder has gotten a lot drier and a spark can do a lot more damage.

The fact that it hasn’t happened yet doesn’t mean it’s not going to happen.

Greece is still a real problem. Greece doesn’t show signs of recovery. There has been some shift in other countries, but they’re operating in an environment of very weak growth for Europe as a whole. In the last week or so, Germany has talked about not providing for the stimulus to its economy, which means that Germany’s not going to be an instrument of growth for Europe.

The three problems in Europe are the sovereign debt crisis, the banking crisis and slow growth. They’re all interconnected with each other. You can’t solve one without solving another.

The banking crisis, part of it has to do with non-performing loans, so slow growth affects the banking crisis. The banking crisis means that credit is less available, and that contributes to slow growth. Slow growth makes tax receipts lower for the sovereigns, so their debt crisis is worse because the cyclical part of their deficit is large. And then banks hold sovereign debt, and when that looks more imperiled, the banks are more imperiled. All these three things are very interconnected. You can’t really solve one without solving the other two.

So far they seem to have pushed austerity measures as a way of dealing with the Eurozone crisis. Do you think that’s the wrong approach?

In a lot of countries, ultimately there has to be a scaling back of government spending and a way to raise taxes. However, in the midst of a deep, deep downturn, austerity just makes the situation worse.

It’s sort of an extreme example of what’s happening in the United States. In the United States, we seem to be coming out of a recession, and the government’s deficit has been bigger because of the recession. If we started cutting the deficit right now, we would provide very strong headwinds to the recovery.

In Europe, it’s like that but much more severe. They’re in a much worse situation. These countries are just stuck in a deep cycle of austerity and slow growth, which means further deficit problems, which raises more demands for austerity, and so on.

It seemed like things were getting a bit better but this is raising concerns so the Eurozone crisis may be back in the headlines. There may be second round effects around what’s going on in Cyprus, especially that they’re willing to cross the Rubicon now.

Once you start not distinguishing between banks that are better off and banks that are worse off, once you say insured deposits are not really insured and are open for taxation, that leads to a lot of concern about the banking system. It might start to show up in other countries as well.

Authors

Michael W. Klein

Publication: GlobalPost

Image Source: © Yannis Behrakis / Reuters

Lifting the Veil: Book Review of China’s Superbank

Erica S. Downs — Wed, 20 Mar 2013 16:27:00 -0400

What do the Three Gorges Dam, local-government investment companies (LICs), the China-Africa Development Fund, Huawei’s transformation into a global player, China’s world-beating solar technology companies, and the issuance of tens of billions of dollars in energy-backed loans all have in common? They were financed by China Development Bank (CDB), one of China’s most powerful institutions and an increasingly important player on the world stage.

Despite CDB’s central role in developing China’s economy and bankrolling the international expansion of Chinese companies, China’s biggest policy lender rarely makes an appearance in most English-language chronicles of the country’s economic rise. All the more reason then to praise a superbly researched new book, written by two Beijing-based reporters for Bloomberg, in which CDB finally makes a star turn. In China’s Superbank: Debt, Oil and Influence—How China Development Bank is Rewriting the Rules of Finance, Henry Sanderson and Michael Forsythe chart CDB’s transformation from an ATM for officials financing pet investment projects into “the world’s most powerful bank.” Lifting the veil on one of global finance’s least understood institutions, the book is essential reading for anyone seeking insight into the workings of Chinese state capitalism.

Read the full review »

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Authors

Erica S. Downs

Publication: China Economic Quarterly

Image Source: © Mohamed Nureldin Abdallah / Reuters

If Europe Doesn't Stand Up After Cyprus

Carlo Bastasin — Wed, 20 Mar 2013 00:00:00 -0400

Editor's note: This article was originally published in Italian by Il Sole 24 Ore.

Like what happens to less intelligent creatures, there was also a sudden disavowel of paternityin the Cypriot mess. No one in Europe admits responsibility for the project of forced confiscation on all bank deposits, also the more modest ones. A proposal that, while necessary, will not survive to its temerity and is putting in danger the stability of the Euro area. On the other hand, the confusion about responsibilities is due to the unbalanced decision-making mechanism that has characterized the last years of the European crisis.

Facing an emergency, Berlin sets the political priorities; the Eurogroup decides the least tricky technical solution for the governments; the heads of state communicate the decisions to their citizens, attributing the responsibility to Brussels; finally the EU commission and the European Central Bank execute orders, at times sanctioning countries and almost always taking the blame.

The anti-European short circuit is assured because the level at which decisions are made is never at the level where democratic choice happens. In fact, the problems arise when a National Parliament meets, as happened yesterday in Cyprus. The citizens circle the Parliament and the parties accuse Brussels or Berlin, also hiding the national responsibilities.

Contrary to what is said, for example, the confiscation of Cypriot deposits is a national fiscal measure. It does not violate the insurance of balanced bank accounts in the EU, that spring into action when a bank fails. It is a tax that will be discussed at the European level and that is conditional on European support, but will be done at the national level. However, in a certain confusion of roles and in a certain mess of solutions it was easy for the government and the Cypriot Parliament to turn it down like an error committed entirely by others.

Clarifying to citizens the allocation of responsibilities between Cyprus and countries in the Euro area is difficult because the transparency of the European decision-making process is really poor: there exist no memos of the Eurogroup meetings, whose last leader was chosen because he was not very garrulous; the heads of government then agreed bilaterally over telephone; above all a true public confrontation does not exist, but there are 17 members and 17 borders.

The only common thing is the confusion of blame that, if it was not tragic, would be funny. Try to follow the thread: on Sunday, all accused the German minister Wolfgang Schaublre for the proposal of forced withdrawal. Schauble however claims that he is opposed, with the IMF, to withdraw on small Cypriot money savers. Berlin, in fact, unloads the responsibility on the government of Nicosia, that (for fear of a bank run) did not want high withdrawal on the rich. But it accuses also the EU Commission and the German member of the ECB, Joerg Asmussen, who had observed that a bank run was already happening and that they needed to freeze accounts. Cypriot president Anastasiades retorts that he was blackmailed by Berlin and by the ECB, which would have cut funds that keep the country's banks alive. The Commision denies having defined the proposal and finally the ECB denies directly and categorically: the blame is on the political negotiations held in Brussels. All the institutions, however - IMF, EU, ECB - are together on having had to put a limit of 10 billion on the assistance to Nicosia. Officially to not bring Cypriot public debt to over 140% of the GDP, but in reality to appease crediting governments and to limit their expenditure. Are you lost? You have reason to be.

But we are still far from having unraveled the tangle. Behind the negotiation with Cyprus, there are in fact others that are more complex. The most important regards relations with Russia which leads with around 20-25 billion Euros deposited in Cyprus, one of the most obscure financial markets in Europe. To not touch the small Cypriot depositors, there is a need to withdraw 15-16% of big deposits. But Moscow had just loaned 2.6 billion to Nicosia, which now, pushed by European partners, they have to withhold like a tax on Russian deposits.

The European relationship with Russia is based on big interests and huge suspicions. Berlin first wants to impose on Cyprus the closure of financial channels with Moscow. It is a negotation of such implications from having to be leader of leaders of government or of ministers abroad rather than financial ones. But Europe has no real common foreign policy, least of all in the Euro area. The result is that Cyprus will end up asking Moscow for help. Hypothetically, it could end by depending on Russia so much that it detaches from the Euro area, opening the gate to the first devastating exit of a country from the Euro. Yet a European political initiative was possible: a battle against off-shore finance would collect the consensus of the vast majority of European citizens and would be difficult for Cypriots, facing European support, defending the abuses of their banks. As is seen, whether in foreign policy or in institutional assets, denouncing the lack of European political unity is anything other than an appeal to abstract principles of a dated Europeanism. However the Cypriot crisis shows also that the will of Europeans to help themselves in exchange for common policy (for example the fight against money laundering) is exhausted and weak bringing into doubt also the solidarity that will be indispensable to constitute a bank union. That is the project with which is necessary to avoid, like in Cyprus, a banking crisis sinking a country. A project on which depends the survival of the Euro.

It is estimated that Cyprus has until June to choose to form a tie with Moscow or fail. A somewhat long time that may keep the Euro area in check and may also coerce it brutally to change its strategy one more time.

Authors

Carlo Bastasin

Publication: Il Sole 24 Ore

Image Source: © John Kolesidis / Reuters

Eurozone's Risky Strategy in Cyprus

Douglas J. Elliott — Tue, 19 Mar 2013 10:58:00 -0400

Sometimes the eurozone reminds me of someone addicted to Russian Roulette.

They take out a revolver, load a bullet into one chamber, spin it, aim for their head, and pull the trigger. It doesn't fire, so they celebrate for a while, and then decide to try it again ... with the same result.

After repeating this a few times, they become convinced that it will never fire.

(This is not intended as an assertion of American superiority, since our politicians seem prone to similar behavior with our budget problems.)

The eurozone's latest gamble is on Cyprus.

They have chosen to call into question the security of bank deposits in the eurozone, including insured deposits, rather than take a more politically difficult, but safer, step.

European leaders hope to minimize the damage by convincing depositors in other troubled nations that actions taken in Cyprus would never be applied elsewhere.

Cyprus truly is unique in important ways, but depositors and citizens elsewhere will note that the eurozone's leaders have now shown a legally easy way to destroy the value of deposit guaranty insurance, along with a willingness to use that approach under at least some circumstances.

This is a foolish thing to do, because there are more bank deposits in the eurozone than government debt, meaning that the potential problems of contagion are very large. There may not be any bank runs in other nations in the near term, but I fear this action will have a large effect in any future bank crisis.

The eurozone's leaders believed, perhaps accurately, that there were no politically feasible alternatives.

The best solution would have been a eurozone rescue on fairly lenient terms, as at least an interim solution. The country is very small; its economy is only about 0.5% of the total eurozone. A pragmatic rescue would have paid dividends in increasing the euro area's stability at a critical time when problems in Greece, Italy, Spain and elsewhere are worsened by political constraints created by the run-up to Germany's September federal elections.

Unfortunately, the Cypriot banking system is too closely associated in the minds of Germans and others with Russian oligarchs and mobsters using the island for tax evasion and money laundering.

So, it appears the eurozone's leaders believed there could be no rescue without sharing the pain with Cyprus or Russia. The Russians appear likely to help, but not in a big enough and public enough way to solve the eurozone's political problem.

Imposing losses on the holders of Cypriot government bonds would have achieved the political purpose, but doing this earlier in Greece was disastrous and the eurozone's leaders have rightly sworn that this will not happen again during the current crisis. For their part, holders of bank bonds will almost certainly take losses, but there happen to not be a lot of Cypriot bank bonds, so more money was needed.

That left the depositors to make sacrifices.

Eurozone leaders were well aware that forcing losses on depositors of struggling banks would increase the risk of bank runs in other troubled countries if the public started to lose confidence in their finances.

Yet they saw no other politically feasible solution, so they tried to be clever. They chose to impose a uniform tax on depositors of all banks, rather than a haircut related to the size of each bank's losses.

Presumably, that was to avoid the precedent of depositor losses by framing the action as a one-off wealth tax, but it is hard to believe anyone but lawyers will make the distinction in applying the lesson to other situations.

There is a grave risk that this action will eventually lead to serious bank runs in other parts of the eurozone.

A depositor in a weak country with a troubled banking system would have to seriously consider moving their funds to a stronger country, which is easy to do within the eurozone, or out of bank deposits altogether, which is even easier.

European leaders can repeat until they are blue in the face that the unique circumstances of Cyprus are the only reason they went this way, but many depositors will focus on the fact that even insured deposits are being hit. Nor is the relative health of one's bank relevant to the loss, so it will not necessarily be better to hold deposits in a safe bank.

The eurozone keeps gambling on risky, politically expedient solutions to deal with the problems that are directly in front of it.

Sometimes this has worked and sometimes, as with the Greek bond haircut, the longer-term consequences are disastrous. The eurozone may get lucky this time, either because the euro crisis is near its end or because there will be no further bank panics.

However, I fear neither of those fortunate situations will prove to be true.

Authors

Douglas J. Elliott

Publication: CNN

Image Source: © Stringer . / Reuters

The Fed's Trying To Get the Party Started, So Why All the Criticism?

George L. Perry — Mon, 18 Mar 2013 15:02:00 -0400

Fed bashing has a long history. The Fed has a dual mandate of achieving both high employment and low inflation, and pursues those aims by raising short term interest rates when aggregate demand threatens to become excessive and lowering rates when aggregate demand needs a boost. But while the mandate is symmetric, the popularity of raising and lowering rates is not. Politicians and Wall Street pundits have often criticized the Fed when it tightened policy because higher interest rates were seen as bad for jobs, profits and the stock market, and disliked by borrowers. As Bill Martin, Fed chairman in the ‘50s and 60s, observed, the Fed is unpopular because its job is to take away the punch bowl just when the party is getting good.

So why are some politicians and financial observers criticizing the Fed today when it is just trying to get the party started? In the typical postwar business cycle, high interest rates brought on recessions and then low short term interest rates helped start expansions that restored high levels of employment. This time the recession was brought on by a financial crisis that made it deep and stubborn, and conventional monetary easing-reducing short term rates by buying short term Treasury securities-was not sufficient. Short term rates have been zero for an extended period, yet the expansion has been slower than everyone wanted.

To its great credit, the Fed has innovated its policy by buying sizable amounts of long term treasury securities and government backed mortgage securities in order to reduce long term borrowing costs more directly. And it has committed to continue this policy of quantitative easing until specific targets for the expansion are met. But precisely because these steps are unprecedented, the consequences are less predictable than they would be with conventional policies, and critics can speculate more freely.

Are today's critics on to something? One of their complaints is that the great liquidity the policy has produced will lead to inflation. Someday, inflation could become an issue, but not soon. Along with the rest of the advanced economies, the U.S. problem today is how to boost aggregate demand to expand employment, not how to contain it to resist inflation. Wage costs—a key element of any sustained inflation—are rising so slowly that they are impeding the growth of consumption, a key element of demand growth in the economy. This situation will change only very gradually, giving the Fed plenty of time to respond if it needs to.

Other skeptics suggest the Fed will have trouble unwinding its positions in government and agency bonds in an orderly way. Bond prices may well fall sharply once market participants believe the Fed is starting to reverse course. And that could cause stock prices to drop, too. But markets often adjust abruptly, and these changes would be consistent with the Fed's changed policy aims. If market movements achieve the desired change in rates without much selling by the Fed, the Fed is under no compulsion to continue selling.

Finally, some critics believe the Fed's easy monetary policy-both quantitative easing and ultra low short term borrowing rates-is creating bubbles in stocks and possibly other assets. Stocks have had a long rise since the market bottom in 2009, and a sharp rise over just the past several weeks. But profits have risen sharply over the long period and price to earnings ratios are generally near the middle of their historical range, not the top.

A correction in stocks can happen with no apparent reason and the Fed's aggressive easing will not be responsible when the next one comes. The present easing will benefit the stock market in the longer run by continuing to promote economic expansion. Just compare stocks in Europe, where economic expansions have faltered, with stocks in the U.S.

Authors

George L. Perry

Publication: Real Clear Markets

The Eurozone's Gambling Problem: Rolling the Dice on Cyprus

Douglas J. Elliott — Mon, 18 Mar 2013 09:35:00 -0400

In Cyprus, the eurozone’s leaders are yet again gambling the future of the currency zone through an excessively risky move. As is too frequent in the euro crisis, cruelly binding political constraints blocked the most sensible approach. Instead, they have chosen a path that may get them through the next period while laying the seeds of a worse trouble down the line. They may get lucky, but they are increasing the vulnerability of the currency zone to a future wave of crisis. (In due humility, we must note that U.S. politicians are not strikingly better at these types of decisions.)

The Cypriot government was about to run out of money and the banking system needs a bailout that is too large for the state to support in the long run, even if it could borrow the cash now. The best solution would have been a eurozone rescue on fairly lenient terms, as an interim solution if not a longer-term one. The country is very small; its economy is only about one half a percent of the total in the eurozone. A pragmatic rescue would have paid dividends in increasing the zone’s stability at a critical time when problems in Greece, Italy, Spain and elsewhere are worsened by political constraints created by the run-up to Germany’s September federal elections.

Those same German political constraints, echoed in other of the stronger eurozone nations, rendered the straightforward approach infeasible. German voters already start out skeptical about committing their financial support to an ever-increasing list of eurozone recipients. Cyprus is indeed small, but there were fears that too much generosity would set precedents that might be applied to much larger countries in the future, such as Spain or Italy. These concerns might have been overcome by the modest size of the needed support and the argument that Cyprus and its banks have suffered heavily from the eurozone’s treatment of Greece, with which Cyprus has close ties. This includes the drastic haircut on the value of Greek government bonds owned in substantial amounts by Cypriot banks.

However, Cyprus has an oversized banking system bloated by very large inflows of deposits from Russia and Ukraine that are perceived to be from dubious characters using the nation for money-laundering and tax evasion. German and other national leaders felt they could not ask their people to support a bailout of Russian oligarchs without corresponding sacrifices from the beneficiaries.

Imposing losses on the holders of Cypriot government bonds would have achieved the political purpose, but doing so in Greece was disastrous and the zone’s leaders have rightly sworn that this will not happen again during the current crisis. Bondholders of the banks needing rescue could have been hit with large losses, and probably will be, but Cypriot banks were awash in deposit money and therefore borrowed relatively little through the more expensive bond market, rendering the savings from writing off those bonds fairly small. Russia was approached to join the rescue, and probably will provide support in low-key ways, but was unwilling to provide the volume and visibility of aid that would have served the political need.

That left the depositors to make sacrifices. eurozone leaders were well aware that forcing losses on depositors of struggling banks would increase the risk of bank runs in other troubled countries if the public started to lose confidence in their finances. Yet they saw no other politically feasible solution, so they tried to be clever. They chose to impose a uniform tax on depositors of all banks, rather than a haircut related to the size of each bank’s losses. Presumably this is to avoid the precedent of depositor losses by framing the action as a one-off wealth tax, but it is hard to believe anyone but lawyers will make the distinction.

There is a grave risk that this action will eventually lead to serious bank runs in other parts of the eurozone. A depositor in a weak country with a troubled banking system would have to seriously consider moving their funds to a stronger country, which is easy to do within the eurozone, or out of bank deposits altogether, which is even easier. European leaders can repeat until they are blue in the face that the unique circumstances of Cyprus are the only reason they went this way, but many depositors will focus on the fact that even insured deposits are being hit. Nor is the relative health of one’s bank relevant to the loss, so it will not necessarily be better to hold deposits in a safe bank.

The eurozone keeps gambling on risky, politically expedient solutions to deal with the problems that are directly in front of it. Sometimes this has worked and sometimes, as with the Greek bond haircut, the longer-term consequences are disastrous. The eurozone may get lucky this time, either because the euro crisis is near its end or because there will be no further bank panics. However, I fear neither of those fortunate situations will prove to be true.

Authors

Douglas J. Elliott

Is Housing Finance Reform Coming at Last?

Michael Barr — Wed, 06 Mar 2013 00:00:00 -0500

With the nation’s focus on the latest fiscal crisis in Washington, Congress has paid scant attention to necessary reforms to Fannie Mae and Freddie Mac. The Bipartisan Policy Center’s Housing Commission just released its report on housing finance reform, and it should help refocus attention to this crucial issue.

As we move to overhaul housing finance, let us remember how we got to this point. Private risk-taking led to a race to the bottom unconstrained by either market discipline or government oversight. Weak regulation was a recipe for a vicious cycle of deteriorating standards in practices on all levels of the mortgage market: lenders and brokers; Wall Street firms that packaged and securitized these mortgages; and the credit rating agencies that rated them.

Fannie Mae and Freddie Mac were eventually caught up in this destructive race. They had lost market share as standards deteriorated around them, and they made poor strategic choices to try to gain some of that market share back. They took on too much risk in order to grow their retained portfolios, increase returns, and inflate bonuses. The market did not discipline management's decisions because the market assumed Fannie and Freddie had a government backstop. And their regulator lacked standing and authority to substitute the discipline that was missing.

Passage of the Dodd-Frank Act in 2010 now gives regulators the necessary tools to clean up bad practices in the origination, servicing and securitization of mortgage loans. The Act should help end races to the bottom. And Fannie Mae and Freddie Mac are now under strict conservatorship. But unfortunately, legislative reform of Fannie Mae and Freddie Mac has remained stalled since their collapse in Fall 2008.

Perhaps broad bipartisan agreement on a path forward can help to jumpstart the process. Here’s what the unanimous panel of leading Republicans and Democrats agreed:

Fannie Mae and Freddie Mac, still under conservatorship, need to be gradually wound down and eliminated.
We need to get the private sector, through first-loss securitization, private mortgage insurance, and other means, to bear all but the catastrophic losses in housing, not taxpayers.
The 30-year fixed rate mortgage is an important option for American families. American homeowners are not the best bearers of interest-rate risk in our economy. To have a robust and liquid market for such mortgages for most households, there needs to be a government guarantee.
Public insurance, in the form of an explicit, fully funded guarantee of mortgage-backed securities meeting safe guidelines, should be provided. No more unfunded “implicit” backstops for private, shareholder owned entities playing “head’s I win, tails you lose.” Public insurance would only step in if the mortgages defaulted and the private sector first-loss provider went broke.
Access to affordable and sustainable mortgage credit and affordable rental housing is a critical value, and should be funded in part by guarantee fees. A balanced approach to housing requires not only ownership but also rental options. Affordable rental housing also requires governmental support, a government guarantee for certain financing, and tax incentives.

These are important areas of agreement on the path forward.

There are, to be sure, details to be worked out. The insurance entity or “public guarantor” would need to be strong and independent, like the Federal Reserve or FDIC, funded through a portion of the guarantee fee. It would need to have sufficient supervisory and regulatory powers to make sure that the private sector played by the rules—on origination, servicing, securitization, and modifications. Capital requirements on the private-sector first-loss providers would need to be robust and strictly supervised by the public guarantor. We need to be sure that the new system is set up to serve the entire market fairly and efficiently. And the system needs to work well in times of stress, unlike the system we have had.

In the meanwhile, there are a number of steps that can and should be taken under existing law. Regulators need to put in place well-aligned rules for risk retention in securitization, ability-to-pay requirements for originations, and standards for loans to be guaranteed by Fannie Mae, Freddie Mac, and the Federal Housing Administration. New servicing standards, including rules regarding loan modifications, need to be strongly enforced, with careful attention paid to incentives in the system. The size limits for loans guaranteed by these entities need to be gradually reduced, so that fully private securitization predominates in a broader “jumbo” mortgage market. Guarantee fees need to match risks and costs, and not be siphoned off by the Congress for other purposes. The retained portfolios of Fannie Mae and Freddie Mac need to continue to be reduced.

The Senate also needs to confirm permanent Directors for the Federal Housing Finance Administration (the regulator of Fannie Mae and Freddie Mac) and for the Consumer Financial Protection Bureau (responsible for overseeing consumer protection in the mortgage markets).

Now Congress needs to come together around long-needed housing finance reform.

Authors

Michael Barr

Publication: Yahoo! Finance

Italy’s Post-Election Chaos Isn’t What You Think

Carlo Bastasin — Fri, 01 Mar 2013 00:00:00 -0500

No parliament, no government, no president of the republic. And now not even a pope. The situation in Italy resembles a house of cards in a perfect storm.

It’s not just a matter of politicians, scenarios and furniture flying all over the place until the storm subsides. The problem is deeper than that. The new Italian Parliament has three minorities that are unable to form a majority. It is a power game in which Pier Luigi Bersani, the electoral winner, is the political loser, and the electoral losers, former Prime Minister Silvio Berlusconi and ex-comic Beppe Grillo, are the political winners.

Consider this. Almost half of those Italians who cast their ballots for one of the traditional parties switched their vote this time. You think Americans are fed up with Congress? In Italy, trust in the government stands at 5 percent, and trust in Parliament at 8 percent. The rate of abstentions is high. The party holding the majority of seats in the Chamber of Deputies -- 54 percent, as required by law -- won the support of just 20 percent of the electorate.

On top of all this, the timeline to form a new government is tight. The Parliament convenes for the first time March 15. Amid all the confusion, the parties must agree within 10 days on the leaders of the Chamber of Deputies and the Senate. Then they have to nominate a prime minister, who must form a government and take an oath in front of the president of the republic. All this before April 15, when the Parliament meets to elect a new president of the republic.

Against Everything

So I can sympathize with those who despair and say Italy has chosen nihilism, or who say, in effect, that Italians voted against everything -- including Europe and austerity, which they had come to believe in before the debt crisis. I understand why people are saying Italy could bring down the whole euro project. But I disagree with them.

Italians remain pro-European, and fewer people than you would suppose are seriously thinking of relinquishing either the euro or the economic-policy commitments that come with it.

Discontent is focused, above all, on taxes. They are among the highest in the euro area. Taxes on business are the highest of any euro member, and they are severely hurting a weakened economy. Italians see excessive taxes mainly as the consequence of bad political management. It’s not that they object to Europe and austerity. Rather, they are angry about the tax increases introduced under the banner of Europe and austerity.

If austerity means fiscal discipline, Italians actually want more of it. This is why New York Times columnist Paul Krugman is wrong to say Italians shunned an intelligent and credible man such as Prime Minister Mario Monti because he was “the proconsul installed by Germany to enforce fiscal austerity on an already ailing economy.”

In Italy’s case, however, the argument about fiscal stimulus just misses the point. A bigger budget deficit wouldn’t do much to stimulate demand, because the real problem is the breakdown in Italy’s supply of credit. From the beginning of the euro crisis three years ago, Italy has seen a faster shrinkage in total credit supply than most euro-area countries, as foreign banks have repatriated their loans. This widespread lack of credit has crushed the private economy. Businesses and households can’t get loans and are cutting investments and consumption at an unprecedented rate.

Effective Answers

Reviving the market for credit is the first job. This would be far more effective than delivering a new fiscal stimulus. In fact, continued budget discipline is vital in ending the credit crunch. The new government must negotiate a deal with the European Union and with the European Central Bank, so that the ECB can support the Italian banks. But this can’t happen unless the ECB is sure that it has a reliable partner in the Italian state and that Italy will remain as fiscally stable as possible.

Italians understand this, and so the political crisis may be a little easier to resolve than many think. Under the pressure of markets, Italian parties are likely to close ranks behind another technical prime minister, just as they did in November 2011 behind Monti. They will nominate someone familiar with financial issues -- some high official at the Bank of Italy, or maybe even Monti himself. They will call it an “institutional government” and ask it to make the political system more honest and functional, reining in the anger and recrimination of the citizens.

It’s a strange way to run a country -- but don’t write off Italy.

Authors

Carlo Bastasin

Publication: Bloomberg

Higher Bank Capital Requirements Would Come at a Price

Douglas J. Elliott — Wed, 20 Feb 2013 10:26:00 -0500

A dangerous misconception appears to be taking root in the public debate about bank safety. A belief is growing that banks could be made much safer, at essentially no economic cost, by requiring shareholders to supply far more of the funding for banks with correspondingly less coming from debtholders and depositors. In fact, there would be significant economic costs, so there needs to be a debate centered on an examination of the trade-offs. Personally, I agree with the majority of analysts and policymakers that the costs would outweigh the benefits, but my key point here is that we need a debate on the trade-offs, wherever we come out on them.

The arguments start with a sound theoretical base, but important caveats and practical problems are dropped from the discussion somewhere in the transmission chain from the more careful academic studies to the popular discourse. This matters, because many of the simplistic proposals being aired would reduce lending and make what remains substantially more expensive. The recent severe recession is a reminder of how much damage a credit crunch can do, so we ought not to inflict one on ourselves voluntarily.

The proposals call for much greater levels of bank capital, mostly in the form of “shareholder equity”, which comes from the sale of common shares to investors in combination with bank profits that accumulate over time. Currently, common shareholders supply roughly 5% of the funding for most banks, while the proposals often call for increasing this up to 30%. A key attraction is that proponents frequently argue that this increase in capital is costless or nearly so, when measured properly.

I will argue that this is untrue, unless one assumes some major changes to law and public policy that are very unlikely to occur. Even if they do, there would remain quite difficult transition issues and a more permanent problem that the change would likely cause a massive shift of lending to less regulated sectors, reducing the benefits of the change, potentially to the point of making the financial system less stable in the aggregate, not more.

Once one accepts that there will be significant economic costs to sharply higher capital requirements, then a useful debate can take place about the right level of capital, given the trade-offs, and how best to achieve it. In fact, this is the debate that much of the policymaking and academic community has been involved in for some years, and to which I have contributed. My central point is that it is important not to be sidetracked by arguments that there is no real cost to the added capital.

The remainder of this paper will discuss the issues at a fairly high level, both because of space limitations and to ensure the key points are understandable for a non-specialist. For those wishing more explanation, I have included a list of my more detailed papers on this topic under References in the back. This includes a primer on bank capital, for those new to the topic.

Before beginning the substantive explanation, let me explain my background. I was a financial institutions investment banker for almost two decades, (until 2008), primarily at J.P. Morgan, which might appear to some to potentially bias me in favor of the banks. However, I have been a strong supporter of the core of the Dodd-Frank reforms and of the Basel III global agreement on bank capital and liquidity requirements, as well as other reforms, which many in my former industry lobbied against quite strongly. I have done very extensive analyses of the economic costs and benefits of higher capital requirements, including as the co-author of a year-long study for the IMF on this topic and as sole author of an earlier series of papers for a task force put together by the Pew Charitable Trusts and additional papers since.

The core of agreement

As noted, there is a sound theoretical basis for the argument that, under certain conditions, high levels of capital at a firm do not raise financing costs. Modigliani and Miller demonstrated this more than 50 years ago and both went on to win Nobel Prizes in Economics, in part for this critical insight. They found that, under idealized conditions, moving to higher levels of funding in the form of common stock, and therefore lower levels of debt, would leave the total cost of funding unchanged. Common stock (also referred to as “common equity” or sometimes “equity”) should always be more expensive than debt, because debt has greater legal protections, particularly the right to be paid off in bankruptcy prior to shareholders receiving payments. So, it might seem at first blush that more equity and less debt should raise the total cost. However, Modigliani and Miller showed that the cost of each unit of equity and each unit of debt would drop by an amount that exactly offset the additional cost from having more units of equity and fewer of debt. The price per unit drops because both equity and debt become safer, and therefore more attractive, when a firm has more equity to protect it from financial shocks and thereby avoid bankruptcy.

No one of note seriously argues with this overall point anymore, under the idealized conditions assumed in the analysis. The issue becomes the extent to which these idealized conditions hold true in the real world and what the implications are of divergences from it.

The first area of disagreement: tax effects

In the U.S. and most of the advanced economies, interest payments on debt are tax-deductible while dividend payments on common stock are not. This is partially offset by lower tax rates for capital gains on the sale of stock by investors, but the net tax effect remains substantially more favorable to debt than to equity. Adding tax effects based on U.S. law to the Modigliani-Miller framework results in an altered finding – the total after-tax cost of financing a company is lower with higher levels of debt and lower levels of equity. This is a major reason that banks fund with much more debt and deposits than equity.

Proponents of much higher bank capital requirements generally argue that this differential tax treatment is a policy distortion that should be eliminated. My impression is that most economists agree with this position, although the issue seems to me more complicated than it is often presented, even from a theoretical point of view. (Does it really make sense for a bank to have no tax benefit related to its main expense, funding itself, while being taxed on the interest it receives from making loans and owning bonds?)

Regardless of the theoretical conclusions, it behooves advocates of sharply higher bank capital to make clear what their policy conclusions would be if the tax law were not changed, since this outcome is highly unlikely. This question is too often sidestepped or downplayed.

Advocates do make the sound argument that higher tax bills for banks would not represent money being burned, but would be available for other public uses and therefore represents a private cost and not a public one. However, this would still have the effect of pushing banks to raise credit pricing and/or reduce credit availability, unless the higher tax revenue is returned to the banks or used to subsidize borrowing. That is, the tax regime for banks could be altered to lower their tax rate or in some other manner offset the higher tax bill resulting from holding more equity and less debt. (Belgium gives a tax advantage to bank issuance of common stock in order to achieve this objective.) Alternatively, borrowers could be granted a government subsidy to offset the higher costs banks would charge.

Absent these changes, we should acknowledge that credit would become pricier and potentially less available. This represents an economic cost that then has to be weighed against the societal benefits of greater financial stability and the gains from whatever is done with the additional tax revenue. The trade-off might be worth it, but it is a trade-off and needs to be analyzed as such.

The second area of disagreement: government guarantees

Another factor not present in the Modigliani-Miller model is that bank debt and deposits often receive explicit or implicit government guarantees that are not fully offset by insurance premiums. The most obvious example is the FDIC’s guarantee of a large portion of bank deposits. The FDIC charges premium rates set by Congress, which partially offset the economic advantage. However, the aggregate premiums do not fully offset the benefits and, equally importantly, the degree of risk-sensitivity of the premiums is fairly low. Put simply, many bank depositors treat their deposits as if they were government-guaranteed and completely safe. Therefore, they do not charge more for deposits with riskier banks and less for safer ones, as Modigliani-Miller assumes for debt. The FDIC premiums do vary modestly with risk, but not enough to substitute for the market pricing that would occur without government guarantees.

Similarly, most observers believe that investors in bank debt assume that their risk is lowered by the potential for a government rescue if the financial markets start to fall apart. They do not necessarily believe that an idiosyncratic problem at a single bank, no matter how large, will cause a rescue. However, their biggest risk is that we have a repeat of the recent financial crisis, when wide swathes of the financial system were put at risk. In such circumstance, there remains a belief that government help would be available to at least some extent. This, too, reduces the responsiveness of interest rates on bank debt to differing levels of risk. The level of risk of bank equity is much less influenced by guarantees, since it is observable that governments are willing for shareholders to lose a high percentage of their investments in banks, sometimes all.

Taken together, these explicit and implicit guarantees make bank debt and deposits cheaper and less responsive to changes in risk, thereby incentivizing banks to fund less with equity and more with these other sources.

Advocates of higher capital correctly point out that these subsidies represent policy distortions and ought to be done away with, or their price passed through to banks to eliminate the economic distortion. Dodd-Frank does go some ways to accomplish this, but it clearly does not eliminate the issue. Therefore, forcing banks to move away from cheap debt towards expensive equity would raise their costs, with some or all of that passed through to borrowers. Higher capital levels would make banks intrinsically safer, which would itself reduce the benefit of any remaining guarantees, but the advantage would not be eliminated.

It might be worth forcing higher capital levels and either accepting higher credit costs and lower availability or providing subsidies to offset the effect. My point is simply that there are actual trade-offs at play here, a fact often ignored or denied by advocates of very high capital ratios.

Third area of disagreement: efficiency of capital-raising

Modigliani-Miller assumes a frictionless financial system, in which there is effectively no transaction cost for raising funds and in which equity and debt markets price securities perfectly. In reality, there are transaction costs, although these tend not to be major in the grand scheme of things for stocks that are already publicly traded. (Initial public offerings have quite significant transaction costs, but additional sales after that are considerably cheaper. Banks are generally publicly traded already and therefore IPO costs will seldom arise.)

The bigger issue is that stock offerings normally come at a discount. This is observable in the market and there are also theoretical reasons to expect it. The key theoretical explanation is probably the one related to what economists refer to “asymmetric information.” Put simply, company managements know their firm’s situation better than anyone on the outside. If they are willing for their company to sell shares, then it is unlikely that they view the shares as underpriced by the market and they may even think the stock price is currently higher than warranted. This is particularly concerning, since managements tend to have an excessively optimistic view of the prospects of the businesses they run. So, if they think the stock price is reasonable or even too high, then the shares are unlikely to be a bargain. Recognizing this problem, investors normally demand a discount to protect them from the real possibility that they would otherwise be overpaying for the shares. (The same issue theoretically applies with debt issuance, but the practical effect is far smaller, for a variety of reasons[1].)

In addition, markets are not always fully efficient, with money ready to shift at a moment’s notice to the investment with the best risk/return tradeoff available. For example, a key market for bank stocks consists of dedicated funds that have developed the expertise to invest in that specialized area. There is a limit to the funds they have available for investment at any given time. Therefore, stock offerings also come at a discount out of the need to lure sufficient money in the limited time in which the offering is operational.

Some of the factors that create a need for a discount are of less significance when small amounts are raised than when larger offerings are undertaken. The informational asymmetry problem is also lessened in circumstances where managements are not given a choice, such as when operating under a government mandate.

Advocates of sharply higher capital requirements generally argue that each of the above issues are of minor importance, especially when spread out over the many years in which the bank will use the equity raised. They also sometimes argue that the informational asymmetry problem can be effectively eliminated by simply requiring banks to raise the capital, so that investors will see that it does not reflect managements’ views on stock prices. However, unless the government is willing to require that certain absolute amounts are raised, the more likely approach is to set minimum capital levels in relation to the size of the bank. In that case, bank managements could choose to shrink, in order to lower or eliminate their need to sell stock or hold back on dividend payments or share repurchases. Thus, investors would still see the choice as essentially voluntary.

Forcing an absolute level of capital may be a viable choice for regulators in the short-term, but it would become micromanagement of the banks in the medium- to long-term, by foreclosing the ability to modify business plans in a way that would reduce capital requirements.

The fourth area of disagreement: market perceptions of the safety benefits of capital

Modigliani-Miller relies on markets to correctly perceive the change in relative safety that results from adding more equity to the funding mix. However, there is a chance that markets will be too skeptical in this regard, in which case equity and debt costs will not fall as they should and total funding costs will go up more than would be required by the other factors described above. Higher funding costs would then be passed on to borrowers in whole or part.

Why might markets be too skeptical? First, markets may assume that banks will be able to “game” the system. If managements would prefer to target a lower ratio of capital to risk, they may be able to find ways to take on additional risk that are not reflected in the formulas used to determine required capital levels. At the extreme, they might be able to hold the effective capital to risk ratio constant, producing no net gain in safety. Second, and related, markets may fear that managements will take stupid risks in an attempt to keep profits up in the face of the cost pressures produced by the factors described earlier.

The “black box” nature of banks is a related problem. Investors must rely on the quality of lending, securities, and derivatives transactions that are difficult to understand from the outside. There is likely to be a limit as to how safe investors are willing to assume banks will be, at least in the proposed range of capital requirements. This may change in the long-term, if banks end up proving themselves to be very safe.

It also must be recognized that much of the empirical work in this area shows a weaker relationship between capital ratios and overall risk levels than theory suggests. There are many reasons for the inability to prove the stronger case, including real difficulties in measuring the true level of risk being taken. Nonetheless, one can understand why markets may be somewhat skeptical of something on which academics assure them of the truth, but have not conclusively proven with empirical evidence.

Assuming, as I do, that the academics are fundamentally right on this, the markets should adjust appropriately in the long run. However, the transitional problems discussed next could be considerably exacerbated for some years by the market’s need to see proof of the increased safety. In addition, problems from gaming the risk levels would not go away over time, unless regulators find better methods to catch such actions, which may not be possible. On the positive side, to the extent that banks find intelligent ways to increase expected profits while taking higher risk the result may be equivalent to regulators imposing a lower than anticipated capital ratio, which would also mean lesser effects on credit.

The fifth area of disagreement: transitional effects

Proponents of sharply higher bank capital often downplay the difficulty of the transition from our current rules to the proposed new standards. However, there are real dangers that would need to be addressed. If the transition is too short, a substantial number of banks may have to sell a considerable amount of stock to maintain their current lending levels, much less to accommodate increasing credit demand. However, raising bank equity is unlikely to look very attractive for some years, because of a combination of: the continuing effects of the financial crisis, including major litigation and regulatory risks; the ever-increasing capital requirements as a result of adopting the proposed changes; and the problems that markets can have in absorbing large offerings in a sector in a limited time period. If there is any room for discretion, many banks are likely to cut back on credit provision to avoid having to raise some or all of the new capital. If there is not room for discretion, it will mean that the government has essentially imposed credit quotas on individual banks, which seems unlikely and probably economically damaging.

If banks do cut back on credit provision, then either the economy is likely to be slowed down, or less regulated entities will pick up the lending slack, bringing up other risks that will be covered in the next section.

Previous sections mentioned some other issues that would be harder in the near and medium-term than in the long run and there are likely to be others as well.

The sixth area of disagreement: the growth of “shadow banking”

There is a danger in focusing solely on the highly regulated financial sector. Extremely high capital requirements may drive banking activity into institutions or financial arrangements that are not regulated as strongly, often referred to somewhat pejoratively as “shadow banks.” There are many ways in which “shadow banking” can occur, and different authors have different definitions. A quite incomplete list of the mechanisms and institutions includes: Structured Investment Vehicles (SIVs), repurchase agreements (repos), money market funds, finance companies, and some forms of securitizations and derivatives.

There is near universal agreement after the financial crisis that the shadow banking sector is potentially capable of creating massive problems and triggering a future crisis. Therefore, there is much discussion of how to control those institutions and types of transactions. However, the truth is that we are far from completely figuring out how to make this happen and it is unlikely that there will be an approach clever enough to provide the same level of systemic protection in regard to shadow banks as there will be for highly regulated entities. There are some types of institutions that are so much like banks that it is conceivable that they will end up with capital requirements quite similar to banks, such as finance companies, but there will always be room for activity to move still further away from arrangements that look like traditional banks.

Let me give just one example of the type of difficulty that could arise in trying to regulate shadow banking on a basis similar to standard banking. If banks, and everything that looks bank-like, have very high capital requirements, then there will be a strong incentive for major industrial and retail firms to provide credit directly to their customers and suppliers. They could simply provide credit directly, to the extent this is allowed by the new regulations without triggering treatment as a bank. Beyond that, it is well known that there are many different ways to provide supplier and customer financing without making a formal loan. For example, one could pay a supplier up-front for a shipment of goods that will not be provided for some time in the future. If that is regulated away by treating it as a loan, then it will likely still be possible in many cases to buy a year’s worth of goods in advance, with a refund mechanism if the buyer ends up wanting to take less than the agreed level. This would economically be equivalent to an informal intent to purchase goods, combined with a loan to the supplier. Regulators would have to dive deep into the regulation of the business practices of non-banks in order to avoid all the potential permutations and it is impossible to imagine that happening in the U.S.

On the other side of the ledger, these companies would find themselves borrowing large sums in order to fund the supplier and customer loans. There will be a strong temptation to do this primarily in the short-term money markets, such as the commercial paper market, since this is almost always the cheapest source of funding on average over time. Policymakers and analysts generally are concerned about the funding side as the primary source of risk to the financial system from shadow banks. After all, if an industrial company wants to loan out funds that it has obtained from shareholders or long-term bond investors, why should regulators worry? On the other hand, a “bank run” could result if short-term money markets freeze, resulting in contagion effects across the financial system. There is a great deal of truth to this, although I would suggest that a future financial system with a much larger role for lending from huge businesses to small ones could produce its own form of crisis and resulting credit crunch, if large losses started to result from making big volumes of bad loans over some future period of extended prosperity.

Current market conditions would limit how much leverage could be taken on by big industrial firms and how much of that could be short-term in nature, since wholesale markets are skittish after the debacle of the financial crisis. However, feasible risk levels could rise very substantially as memories fade.

There are many disadvantages to allowing shadow banking to supplant traditional banking as the main source of lending to small and medium-sized enterprises and, perhaps even families. (Lending to big corporations in the U.S. has already largely moved out of the hands of the banks, except for contingent lending, such as letters of credit or revolving loans or lines of credit.) The lenders would be subject to much less supervision and regulation and their activities would be less well understood by the monetary authorities and by regulators. They might also undertake lending activity with less knowledge and experience of how to do so safely. This would be a particular problem in the near to medium term, as the expertise is being acquired.

How big might the trade-offs be?

The primary intent of this paper is to underline the fact that there are trade-offs between higher capital and goals such as economic growth. It would require a much longer paper to quantify the trade-offs, as I have done in part in the papers listed below.

However, it is easy to demonstrate that the level of costs is significant enough to require serious investigation. The first-order effect of increasing the ratio of common equity to total assets for banks from 5% to 30% would clearly be very high. Assume that the annual cost of bank equity is 5 percentage points higher than the after-tax cost of bank deposits and debt. (There are arguments for a higher figure or for a lower one. This is just an example in the middle of the range.)

If one quarter of the funding for their assets (30% minus 5%) shifts to the more expensive funding source, then, all else equal, banks would have to earn about 1.25 percentage points more, after-tax, on their total assets. This would translate into a need to collect nearly two percentage points more on their loans and other assets, all else equal, since the interest collected would be taxable. A two percentage point increase in credit pricing would have huge economic effects.

The good news is that this first-order effect would be offset by increased tax revenues, greater financial safety, a squeeze on bank cost, shifts of business away from the banks, and other factors. The debate needs to be about this set of trade-offs, rather than the false debate about why a seemingly costless approach to bank safety is being stifled by the power of the banks and those who do their bidding.

References

Elliott, Douglas, “A Primer on Bank Capital,” The Brookings Institution, (Washington: The Brookings Institution), January 2010, http://www.brookings.edu/~/media/Files/rc/papers/2010/0129_capital_elliott/0129_capital_primer_elliott.pdf

Elliott, Douglas, Suzanne Salloy, and Andre Oliviera Santos, “Assessing the Cost of Financial Regulation,” IMF Working Paper 233, September 2012, available at http://www.imf.org/external/pubs/ft/wp/2012/wp12233.pdf

Elliott, Douglas, “Quantifying the effects of lending increased capital requirements,” (Washington: The Brookings Institution), September 2009, http://www.brookings.edu/papers/2009/0924_capital_elliott.aspx

Elliott, Douglas, “A Further Exploration of Bank Capital Requirements: Effects of Competition from Other Financial Sectors and Effects of Size of Bank or Borrower and of Loan Type,” (Washington: The Brookings Institution), January 2010, http://www.brookings.edu/~/media/Files/rc/papers/2010/0129_capital_elliott/0129_capital_requirements_elliott.pdf

[1] The deposit portion of “debt” is often guaranteed and therefore insensitive to the future prospects of the bank. The rest of the debt is insensitive to all variations in future performance in the range of outcomes that avoid bankruptcy. Stockholders, on the other hand, care greatly about whether they earn a zero or negative return or a strongly positive one. Knowing a bank is “safe” may effectively be enough for a bondholder, but is not nearly enough information for a stock investor.

Authors

Douglas J. Elliott

Obama's SOTU Should Promote a Continued Path to Financial Reform

Michael Barr — Tue, 12 Feb 2013 11:10:00 -0500

In tonight's State of the Union, President Obama should take the opportunity to remind the country of the need to stay on the path of financial reform. A collective amnesia appears to be descending on Washington-and on major financial capitals around the world-about the causes and consequences of the financial crisis. The financial crisis of 2008 crushed the American economy, cost millions of Americans their jobs and their homes, shuttered American businesses, and wiped out family savings. We're still suffering from those effects.

The President's financial reform law, enacted in 2010 against massive opposition from Wall Street and most Republicans, laid a firm foundation for a more resilient financial sector, one that works for American families, instead of exposing us all to needless risk and cost.

A new Consumer Financial Protection Bureau has been built from scratch. New rules governing derivatives transactions have largely been proposed. A resolution authority and improvements to supervision have been put in place. The largest firms have to hold a lot more equity capital. The U.S. financial system is more resilient than it was four years ago.

But nearly three years later, there's still much work to do to turn that law into reality.

And the financial sector did not leave the battlefield after their defeats in 2010. Far from it. The brutal fight over financial reform wages on, and there is a serious risk that financial sector lobbying and lawsuits will further weaken the resolve for reform. Aggressive lawsuits are being used to try to unseat the consumer bureau director, block shareholder rights, roll back protections against abuse in the derivatives market, and slow down reform. Many Republicans in Congress have blocked nominees to key posts or used the appropriations process to undermine enforcement of financial laws.

To be clear: the financial system is safer, consumers and investors better protected, and taxpayers more insulated, than they were four years ago-by a lot. But that is not enough.

In the next four years, it will be critical to stay on the path of reform.

Authors

Michael Barr

Publication: Real Clear Markets

Silence Is Golden: The Financial Markets and the State of the Union

Douglas J. Elliott — Thu, 07 Feb 2013 14:13:00 -0500

The president will probably not say very much about the financial system in this year’s State of the Union address. This is a tribute both to our recovery from the financial crisis and the extensive work that has been done on revamping our system to avoid a fiasco of this magnitude in the future.

I wish that he would highlight a comprehensive plan to restore the housing finance system by replacing Fannie Mae and Freddie Mac or very substantially altering their roles and removing them from effective government ownership. However, this is not politically attractive and he will probably not choose to use his limited bargaining chips to achieve this. We may well be stuck with the unsatisfactory status quo for many years. Politicians are caught in a bind. They recognize that Fannie and Freddie cannot be restored to their former, very dangerous roles and they want to reduce the government’s current bloated role in housing and the attendant risk to taxpayers. On the other hand, middle class voters determine elections and they highly value subsidies that make mortgages cheaper. Any solution that truly cuts back on government guarantees will also make mortgages more expensive and harder to obtain. It is easier politically to keep kicking the can down the road.

I hope that the president avoids populist rhetoric attacking Wall Street, but it may be difficult to resist including some swipes at a group hated by voters. The Administration has actually supported quite balanced approaches to restoring our financial system, embracing comprehensive changes to make the existing structures safer while avoiding radical “solutions” that could do real damage to the economy. However, inflaming popular passions could inadvertently fuel some of the damaging proposals out there that are based on the mistaken belief that little has been done to make the financial system truly safer. In reality, the total impact of the legal and regulatory changes that are in process will be quite large and should substantially reduce the danger from future financial crises. (It will never eliminate them as long as humans are in charge of markets and of their regulation. Herd behavior inevitably produces bubbles from time to time.)

In the end, the best we can hope for on the topic of financial regulation in this State of the Union address is probably silence.

Authors

Douglas J. Elliott