Brookings: Topics - Financial Market Regulation

The SEC Gets Money-Fund Reform Half Right

Robert C. Pozen and Theresa Hamacher — Tue, 18 Jun 2013 11:33:00 -0400

The Securities and Exchange Commission recently proposed two new rules to help prevent sudden redemptions of money-market shares by investors from wreaking havoc on the financial system. The first proposal, requiring a "floating NAV" (net asset value), deserves support because it is limited to the most risky type of money-market funds: those held mainly by fast-moving institutions and invested largely in prime commercial paper.

By contrast, the second proposal would apply to both institutional and retail money-market funds that invest mainly in commercial paper (so-called prime funds). Such funds would generally be required to impose "fees" and "gates" to slow down redemptions once a fund's liquid assets drop below 15% of total assets. This proposal could be counterproductive. To avoid these barriers to redemptions, investors would likely flee en masse as soon as their fund approached the 15% trigger.

Under current rules, money-market funds maintain a constant NAV of $1 per share unless its fair market value drops below 99.5 cents per share. During the financial crisis in 2008, the Reserve Primary Fund—an institutional prime fund—"broke the buck" when its position in the commercial paper of Lehman Brothers went sour. Then some investors, especially large institutions, rushed to redeem shares in other prime money-market funds, leading to distressed sales of commercial paper.

In response, the first SEC proposal would force institutional prime funds to move from a constant NAV of $1 per share to a fluctuating NAV—reflecting the actual market value of its assets every day. Since the fund's NAV per share would gradually reflect any deterioration in the market value of its assets, there would be no dramatic and sudden event of "breaking the buck." Without such an event, institutional investors would be less inclined to flee from a money-market fund to avoid a sharp drop in its NAV from $1 to 99 cents per share.

Sensibly, the SEC's first proposal would not apply to money-market funds holding mainly U.S. government-guaranteed securities. Such securities are effectively immune from default and unlikely to cause a permanent decline in a fund's value. The funds that have broken the buck in the past have invested primarily in commercial paper issued by large corporations. Nor would this proposal apply to retail funds. The money-market fund holdings of any individual retail investor are relatively small and these investors have historically been much slower to redeem than large institutions. Institutional investors follow closely their holdings of money-market funds and make large redemptions as soon as they sniff the possibility of a serious problem.

Unfortunately, the second SEC proposal would apply to prime money-market funds owned mainly by retail investors (although it would not apply to money-market funds that invest primarily in U.S. government-guaranteed securities.) The proposal would generally require funds to impose a 2% charge on all shareholder redemptions once a fund's liquid assets dropped below 15% of total assets. This 2% redemption fee is huge for retail investors in money-market funds, whose total annual returns are often less than 2%.

The second proposal also allows a retail money-market fund to suspend all shareholder redemptions for a period of up to 30 days. The threat of being locked into a money-market fund would terrify most retail investors.

While retail investors have been relatively slow to move in the past, the new rules will require prompt disclosure of the liquidity level of a money-market fund. When a fund's liquid assets dip below 20%, this will be widely noted by the financial press, so retail investors would be put on notice of impending barriers to redemptions.

In response, some retail investors might shift their savings from money-market funds to bank deposits. Such a sharp rise in deposits would be challenging for many banks that are already struggling to meet higher capital standards. More fundamentally, short-term borrowers would receive much less financing from money-market funds.

Other retail investors might keep their savings in a money-market fund, but redeem as soon as it reported liquid assets below 20%. At that point, the risk of redemption fees and suspension would be uncomfortably high, so retail investors would rush to redeem—causing the very "run" that the SEC is trying to prevent.

In short, the SEC should adopt its first proposal to require a floating NAV for institutional prime money-market funds. The agency should rethink its second proposal because it could inadvertently increase—not decrease—redemption waves from retail money-market funds in times of financial stress.

Authors

Robert C. Pozen
Theresa Hamacher

Image Source: © Jonathan Ernst / Reuters

Dealing with “Too Important to Fail” Banks

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

Event Information

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

Falk Auditorium

1775 Massachusetts Ave., NW
Washington, DC

Webcast Archive:
Introduction

Full Event

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

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

Join the discussion on Twitter using hashtag #TooBigToFail.

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Dealing with “Too Important to Fail” Banks

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14 dealing with too important to fail banks baily presentation

Participants

Panelists

Ted Gayer

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

Douglas J. Elliott

Fellow, Economic Studies, Initiative on Business and Public Policy

Martin Neil Baily

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

H. Rodgin Cohen

Senior Chairman

Thomas Hoenig

Vice Chairman

Time to Start Experimenting with Macroprudential Regulatory Policy

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

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

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

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

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

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

Authors

Douglas J. Elliott

Publication: The Economist

Image Source: © Brendan McDermid / Reuters

The Fed Will Soon Be Regulating Some Major Life Insurers

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

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

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

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

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

Authors

Douglas J. Elliott

Image Source: © Brendan McDermid / Reuters

The Coming Wave

G. Andrew Karolyi, David Ng and Eswar Prasad — Fri, 31 May 2013 11:13:00 -0400

Editor's Note: This piece is part of the June issue of Finance & Development.

As emerging market economies become increasingly important players in the global economy, their share of the global cross-border flows of financial assets is also rising. Because of their strong growth prospects, emerging market economies have attracted foreign investors in search of higher returns, especially at a time of very low interest rates in advanced economies. And flows have also gone in the other direction, as the governments of emerging market economies have built up their foreign exchange reserves by investing heavily in advanced economies.

Recently, another phenomenon has gradually gained momentum: the outflow of private capital from emerging market economies as their investors seek overseas opportunities.

Understanding the volumes and patterns of the various outflows—sovereign and private—and analyzing what influences them will shed light on how the landscape of international capital flows is likely to change as emerging market economies become more integrated into global financial markets. We look at the types of capital outflows from emerging markets and describe some preliminary results from our ongoing research, which shows that the direction of portfolio outflows—relatively small now, but with a large potential to expand—is heavily influenced by proximity and familiarity.

Exporting capital

Led by China, emerging markets added about $6 trillion to their foreign exchange reserves between 2000 and 2012—with nearly all of it invested in securities issued by the major reserve currency economies, mainly the United States. It is likely that these emerging market economies will accumulate foreign exchange reserves at a much slower pace in coming years because most have put away sufficient stocks of foreign reserves to help buffer any future capital flow volatility.

Read the full piece on Finance & Development »

Authors

G. Andrew Karolyi
David Ng
Eswar Prasad

Publication: Finance and Development

Act of Congress: How America's Essential Institution Works, and How It Doesn't

Tue, 28 May 2013 14:00:00 -0400

Event Information

May 28, 2013
2:00 PM - 3:30 PM EDT

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

This event was streamed live by C-SPAN2 Book TV.

In his new book, Act of Congress: How America's Essential Institution Works, and How It Doesn't (Knopf, 2013), author Robert G. Kaiser chronicles the dramatic story of Congress’ struggle to pass financial reform overhaul in the wake of the financial collapse in 2008. As a reporter with the Washington Post, Kaiser was a first-hand observer of the legislative process that resulted in The Dodd–Frank Wall Street Reform and Consumer Protection Act, one of the most significant pieces of legislation regulating Wall Street in recent memory. In this book, Kaiser pulls back the curtain and shows us the inner machinery—the politics and players, the successes and the failures—of the U.S. Congress.

On May 28, as part of the Management and Leadership Initiative, Governance Studies at Brookings hosted a book event for Act of Congress, which discusses lessons from the process of passing Dodd-Frank and the impact of partisanship, lobbyists, and staffers on the legislative and policymaking process. Moderated by Senior Fellow E.J. Dionne, author Robert G. Kaiser presented his findings, followed by the reflections of Senator Chris Dodd, one of the two legislators who worked to move these reforms through Congress, and for whom the act is named, and Brookings scholar Tom Mann.

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Act of Congress: How America's Essential Institution Works, and How It Doesn't

The History of Cyclical Macroprudential Policy in the United States

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

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

Downloads

The History of Cyclical Macroprudential Policy in the United States

Authors

Douglas J. Elliott
Greg Feldberg
Andreas Lehnert

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

Image Source: © Larry Downing / Reuters

Regulating Systemically Important Financial Institutions That Are Not Banks

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Systemic Risk

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

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

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

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

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

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

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

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

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

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

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

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

Types of non-bank SIFIs

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Regulating SIFIs

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

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

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

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

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

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

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

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

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

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

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

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

Principles for regulating non-bank SIFIs

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

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

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

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

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

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

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

Regulating Life Insurers as SIFIs

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Capital Requirements

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What might the Fed do beyond capital standards?

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

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

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

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

Conclusions

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

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

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

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

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

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

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

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

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

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

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Regulating Systemically Important Financial Institutions That Are Not Banks

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

China’s Global Currency: Lever for Financial Reform

Arthur R. Kroeber — Thu, 11 Apr 2013 12:09:00 -0400

Following the global financial crisis of 2008, China’s authorities took a number of steps to internationalize the use of the Chinese currency, the renminbi. These included the establishment of currency swap lines with foreign central banks, encouragement of Chinese importers and exporters to settle their trade transactions in renminbi, and rapid expansion in the ability of corporations to hold renminbi deposits and issue renminbi bonds in the offshore renminbi market in Hong Kong.

These moves, combined with public statements of concern by Chinese officials about the long-term value of the central bank’s large holdings of US Treasury securities, and the role of the US dollar’s global dominance in contributing to the financial crisis, gave rise to widespread speculation that China hoped to position the renminbi as an alternative to the dollar, initially as a trading currency and eventually as a reserve currency.

This paper contends that, on the contrary, the purposes of the renminbi internationalization program are mainly tied to domestic development objectives, namely the gradual opening of the capital account and liberalization of the domestic financial system. Secondary considerations include reducing costs and exchange-rate risks for Chinese exporters, and facilitating outward direct and portfolio investment flows. The potential for the currency to be used as a vehicle for international finance, or as a reserve asset, is severely constrained by Chinese government’s reluctance to accept the fundamental changes in its economic growth model that such uses would entail, notably the loss of control over domestic capital allocation, the exchange rate, capital flows and its own
borrowing costs.

This paper attempts to understand the renminbi internationalization program by addressing the following issues:

Definition of currency internationalization;
Specific steps taken since 2008 to internationalize the renminbi;
General rationale for renminbi internationalization;
Comparison with prior instances of currency internationalization, notably the US dollar after 1913, the development of the Eurodollar market in the 1960s and 70s; and the deutsche mark and yen in 1970-90;
Understanding the linkage between currency internationalization and domestic financial liberalization;
Prospects for and constraints on the renminbi as an international trading currency and reserve currency.

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Authors

Arthur R. Kroeber

Image Source: © Bobby Yip / 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

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

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

Image Source: © Brendan McDermid / Reuters

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

It’s Time for Sensible Regulation of Derivatives

Martin Neil Baily and Aaron Klein — Wed, 23 Jan 2013 14:51:00 -0500

The beauty of a pendulum is that once set in motion it can swing predictably forever. The difficulty is getting it to return to the middle. This seems to be the problem with regulation of derivatives.

In the 1990s, derivatives were widely heralded as new instruments that could improve the transference of risk. In 1999, then Federal Reserve Chairman Alan Greenspan stated: “By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives.” He went on to argue that they “enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it. This unbundling improves the ability of the market to engender a set of product and asset prices far more calibrated to the value preferences of consumers than was possible before derivative markets were developed. The product and asset price signals enable entrepreneurs to finely allocate real capital facilities to produce those goods and services most valued by consumers, a process that has undoubtedly improved national productivity growth and standards of living.”

A Harmless Tool?

With general (although not universal) agreement in Washington that deregulation of financial services would benefit the economy, the Administration and Congress decided that the derivatives market should be largely unregulated. This position was codified in the Commodities Futures Modernization Act of 2000 and the Gramm-Leach-Bliley Act of 1999. Here is when the pendulum was set in motion.

Not all policymakers or investors were convinced that derivatives were harmless. Brooksley E. Born, Chair of the Commodity Futures Trading Commission, argued for tighter regulation of derivatives.In 2003, Warren Buffett famously stated that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Lessons of the Financial Crisis

When the financial crisis began in 2007, derivatives played a central role. AIG among others had sold a form of derivatives, credit default swaps (essentially default insurance), on billions of dollars of complex securities ultimately backed by shaky mortgages (collateralized debt obligationsor CDOs). AIG believed it was taking on little risk by selling these derivatives because a widespread housing price collapse was not seen as a possibility. Little capital had been set aside to cover potential losses on the swaps, largely because the buyers of the swaps relied on AIG’s stellar credit rating. When CDOs began dropping in value, AIG’s large derivative exposurecaused its bankruptcy and required a large government bailout to prevent its counterparties from taking losses and triggering additional financial instability.

It is no surprise then that the pendulum began to swing the other way.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 devoted an entire title (Title VII) to re-regulating derivatives. Dodd-Frank set in place a multitude of new rules, each designed to address a different aspect of derivative regulation. Some of the more prominent ones are the Lincoln Amendment, single counterparty credit limits, clearing requirements, business conduct requirements on dealers, and varying specific rules, which apply to some, but not all, derivative contracts. The Volcker rule, which stipulates that banks cannot conduct “proprietary trading,” also affects the institutions that issue and trade derivatives.

Toward Regulation That Actually Works

One of the authors of this op-ed served in the Clinton Administration that approved financial deregulation, while the other served the Obama Administration that worked with Congress on Dodd-Frank. We want to make it clear that we both support derivatives regulation, but we also want to get that regulation right.

The bulk of derivatives are interest rate swaps, credit default swaps on corporate bonds and municipal and state bonds, commodity price derivatives, and currency swaps. These markets did not break down in the crisis and did not contribute to it. Many, many institutions took risky bets on mortgage-backed assets without any help from the derivatives markets.

Derivatives have value. Many families rely on 401(k) investments to fund their retirement, and the financial institutions that manage their money use derivatives. American companies use derivatives to lower their borrowing costs, manage their balance sheets, and hedge against risks. Airlines hedge against fuel price spikes, and exporters hedge against swings in exchange rates. Even Warren Buffett’s investment fund, Berkshire Hathaway, uses derivatives.

Dodd-Frank gave leeway to regulators to implement its rules. For derivatives trading, it gave varying responsibilities to both the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) to write and enforce rules. Rather than merge these two regulators into a single body, Dodd-Frank maintained the multiple regulator approach, while requiring varying levels of regulatory coordination and consultation in rule writing. The Federal Reserve was given regulatory authority over the large financial institutions that issued most derivatives contracts in the past, and its proposed rules would greatly impact the derivatives market in the future.

It is worth asking if the myriad of rules put into place in Dodd-Frank to regulate derivatives can work together effectively and coherently. Congress, and the Financial Stability Oversight Council, should ensure that the different regulatory bodies work together to craft consistent rules of the game. Tackle the problems that emerged in the derivatives market and improve the economy’s stability, while still reaping the economic benefits derivatives can and do provide.

Let’s try and stop the pendulum in the right spot and avoid the wild swings.

Authors

Martin Neil Baily
Aaron Klein

Publication: Yahoo! Finance

National Suspicions Undermine Global Financial Cooperation

Douglas J. Elliott — Tue, 22 Jan 2013 15:45:00 -0500

Mistrust and narrow conceptions of short-term national interests are undermining the global cooperation necessary to repair the damage of the financial crisis and build the safe and efficient financial sector that we need going forward. Increasingly interconnected national economies need financial institutions and markets that efficiently cross borders as well. Further, the many links that already exist in global finance require cooperation on financial regulations to avoid a race to the bottom or dangerous gaps that encourage risky behavior.

The terrible global financial crisis of 2007-9, and the ensuing "Great Recession," concentrated the minds of national leaders on the need for cooperation. Several G-20 summits of the leaders of the world's big economic powers focused on setting global rules, in particular by mandating that the Basel Committee on Banking Supervision and the Financial Stability Board build new and improved global rulebooks. Recognizing the need for reform, and knowing that the most powerful leaders in the world were watching, these international organizations moved swiftly to reach agreement, despite the daunting complexity of the task. In particular, the Basel Committee designed the "Basel III" rules to ensure that major banks have enough capital and liquidity to operate safely. These rules are big improvements on the earlier Basel and Basel II accords that had governed banks in the run-up to the financial crisis.

Unfortunately, mistrust and narrow national fears are eroding cooperation. The Basel Committee is increasingly divided into two camps, each suspicious of the other. The US, the UK, and some others are pushing hard to ensure that short-term concerns do not lead the standards to be whittled down too far. Germany, France, Japan and their allies appear more concerned about avoiding any actions that will make life much harder for their banks in the midst of the Euro Crisis and Japan's continuing stagnation. Within these camps, most countries are also maneuvering to protect their own particular national interests, often conceived in a narrow and short-term way. No country has a monopoly of virtue here and there are genuine issues about how to balance long-term and short-term goals while also accommodating true differences in national economic and financial structures. It's time to step back from the antagonism and mistrust and work harder to find a common ground that will get us through the short-term while building a better global financial system that will aid all of us.

The same problems of creeping mistrust are evident in Europe as well. Back in the summer, European leaders took a bold and necessary step forward by agreeing to build a true "banking union" across Europe, or at least the Eurozone. They did this in part because integrated supervision and support for banks was long overdue, given the amount of cross-border banking that already occurs in Europe. Mostly, though, they did it because the financial markets had concluded that using national guarantees for national banking systems in Europe was pouring fuel on the fire of the Euro Crisis. Spain was the example du jour. The need for the Spanish government to rescue its banking system made the government's debt load higher and more burdensome. Meanwhile, the plummeting value of existing Spanish debt, and the rising interest rates on new borrowings, were inflicting severe damage on the banks, leading to a vicious circle. Bringing banks together across Europe into a system with Europe-wide safety nets would break this link. Keeping the new system safe also calls for Europe-wide oversight of the banks, to ensure that lax supervision in a troubled country does not unfairly cost taxpayers across Europe.

So far, so good. However, fear about the Euro Crisis has diminished. As a result, true banking union is being delayed, watered down, and splintered, at least in comparison with the original grand statements. The bold, high-level promises were always going to be constrained by the realities of implementation, but this has gone further than I had hoped. In particular, Germany and the other fiscally strong Eurozone nations are dragging their feet about anything that might cost money, especially in the run-up to this fall's German elections.

At this point, a pessimistic reading is that the part of the banking union proposal that was supposed to break the link between the safety of governments and the safety of their banks will not happen for at least a couple of years and may not truly ever be implemented fully. Even the "easy" part, agreeing on overall supervision of Eurozone banks by the European Central Bank, is at risk of meaning considerably less than it should, at least for a few more years. Giving the ECB the ultimate supervisory power can mean a lot of different things and Germany and some others are pushing to weaken the ECB's mandate, at least in practice. Germany wants to protect its politically connected system of savings banks and cooperative banks from real European oversight.

In Europe, and in the wider world, it is critical that leaders recognize that the gains from cross-border cooperation in finance are large and the risks from playing games to protect narrow national interests are also big. It's time to get serious again, across the board. Complacency is dangerous with the job of reform still so far from finished.

Authors

Douglas J. Elliott

Publication: Real Clear Markets

Structuring Finance to Enhance Economic Growth and Stability

Douglas J. Elliott — Thu, 17 Jan 2013 12:14:00 -0500

Editor's Note: The following summarizes the ideas discussed at a December 4, 2012 Brookings event on structural reform of the finance industry. Additional resources, including panelist presentations, are available on the event page.

Governments around the globe are making major strides in transforming the regulation of the financial sector, in response to the financial crisis of 2007-9 that did such damage to the world economy. However, for all its virtues, that reform has focused too much on fighting fires – focusing on specific problems that arose in this crisis – and too little on why we have a financial system, what we want it to do, and how it should best be structured to accomplish those goals. We are in a uniquely good period to restructure the financial system, since there is a clear recognition that the old system had to change.

This is not to say that structural issues, particularly the problem of Too Big to Fail institutions, have been completely ignored. For example, there have been some proposals to force major changes in the way in which our core financial institutions are structured, rather than just how they operate. These include:

Proposals to “restore Glass-Steagall”, re-splitting investment and commercial banking
The Hoenig proposals for a kind of modernized and more limited Glass Steagall
The Volcker Rule to abolish proprietary trading by banks and their affiliates
The Vickers Commission proposals to “ringfence” traditional banking services
The Liikanen Group proposals, including a different approach to ring-fencing
Various proposals to break up the big banks

The Economic Studies Department of the Brookings Institution convened a conference on December 4, 2012 in Brookings’ Washington offices. We brought together leading experts in finance to discuss the structure of the financial industry and proposals for its transformation. The keynote address was given by Daniel Tarullo, the member of the Board of Governors of the Federal Reserve System (Fed) who has been the lead there on financial regulatory reform. Speeches were also given by Martin Baily, a Senior Fellow at Brookings and a former Chair of the President’s Council of Economic Advisers, and by Donald Kohn, a Senior Fellow at Brookings and a former Vice-Chair of the Federal Reserve Board. In addition, two panels of experts discussed the current structure of the financial system in the US and the rest of the world and proposals to transform finance and its regulation going forward. These experts were:

Sujit “Bob” Chakravorti, Chief Economist of the Clearing House Association
John Lester, Partner, Oliver Wyman & Co.
Nicolas Veron, a Senior Fellow at Bruegel and at the Peterson Institute for International Economics
Charles Calomiris, Professor of Finance at Columbia University
Marcus Stanley, Chief Economist, Americans for Financial Reform
Douglas Elliott, Fellow in Economic Studies, the Brookings Institution

This paper explores the key themes of structural reform by presenting the range of views expressed by the speakers and panelists in their formal remarks and in their answers to questions from the panel moderators and the audience. The reader will note that there is far from a complete consensus among these experts, although there are some important areas of common agreement.

This paper presents my own interpretation of the views expressed at the event and I am solely responsible for any errors in my understanding or presentation of those views. A complete transcript and presentation slides are available for those who wish more detail or who want to form their own impressions of the statements of the experts.

The Importance of Considering the Industrial Organization of Finance

The conference was driven by a belief that the structure of the financial industry has critical implications for how effectively it operates to achieve its societal purposes. There has long been a discipline of management science and economics, known as “Industrial Organization,” (or “IO”), which focuses on how industries are structured to achieve their purposes. Sadly, traditional industrial organization theory has fallen out of vogue with academics, supplanted by game theory and high-powered econometrics. However, there remains a rich heritage of research on multiple industries and some current work continues.

Governor Tarullo devoted his keynote address to a strong call for researchers to bring together the principles of finance and of Industrial Organization in order to design new financial regulations that will stand the test of time by enhancing financial stability without sacrificing economic growth unnecessarily. To his credit, this is a call that he has been making since soon after he joined the Fed’s board in 2009.

There appears to have been a strong, probably even complete, consensus among the experts present at the conference that it was important to analyze the structure of the financial industry, although this underlying assumption was not always explicitly stated. Governor Tarullo addressed it most explicitly and thoroughly, so the remainder of this section will largely focus on his remarks.

He argues that much can be learned from Industrial Organization that is relevant to redesigning the financial system. As he put it, “the value of an IO research agenda for shaping a regulatory system to protect financial stability lies both in ascertaining costs that may result from specific regulatory measures and in revealing industry dynamics that may suggest how regulatory measures may be more effective.” For example, an understanding of the extent to which there are economies of scale and scope in finance has implications for regulation. If these are economically significant, then there would be societal costs to actions which go too far in pushing banks to shrink or to step away from securities or other activities that extend beyond their traditional activities. If, however, the advantages of size and scope only result from excess market power or from the perception of a government guarantee, then there would be a stronger case for structural reforms.

Governor Tarullo went on to say that IO research could “inform financial stability regulation by illuminating industry dynamics that may not be intuitively apparent,” such as the patterns of competition and cooperation among financial institutions that are central to the functioning of the financial markets. It may be that findings from other industries can suggest better ways to limit contagion in financial markets while preserving the virtues of cooperation.

At the same time, there are clear differences between finance and most other industries, particularly the very high prevalence of what economists call “externalities”, indirect effects of the financial system on the rest of the economy. This was very evident in the recent crisis, when the troubles of the financial system spilled over to send the economy as a whole into a deep recession, so widespread and deep that it is often called “The Great Recession” as an analogy to “The Great Depression” of the 1930’s. These externalities are exacerbated by aspects of the industrial structure of finance that lead to “contagion,” such as: the interconnectedness of competing firms, strongly correlated asset holdings across the industry, the centrality of maturity transformation, with its resulting liquidity risks, and mark-to-market accounting that spreads the effects of fire sales quickly throughout the system.

Much of Governor Tarullo’s speech focused on the key questions of the existence and extent of economies of scale and scope. Despite the critical importance of this issue in any discussion of potential structural limitations, there is too little good research and no consensus on these related topics. He outlined some of the ways in which such economies could exist, going on to say that “the paucity of empirical work means we can only hypothesize these scale and scope economies, though intuition and observation may make some hypotheses stronger than others. Even assuming, as I think reasonable, that most or all of the economies that I have identified would hold up to empirical assessment, the crucial questions would remain as to how big or how integrated financial firms need to be in order to attain these economies.” He then proceeded to describe some of the challenges in doing sound empirical work in this area, but went on to urge further research in this area nonetheless, given its importance.

Governor Tarullo illustrated the value of IO theory, when appropriately adjusted for the peculiarities of finance, by addressing three particular issues under debate. First, the idea of breaking firms up by business line, such as through the restoration of the former Glass-Steagall non-affiliation provisions, is difficult to consider without a good IO analysis. For example, there are theoretically significant diversification advantages of combining lending and securities activities. The Governor considered it informative that the firms that suffered most in the crisis were generally firms that specialized in securities markets or specialized in lending, although he acknowledged this might not be true in a future crisis. Further, there are non-trivial economies of scope from combining commercial banking and securities activities, which would be lost in a break-up. As he stated, “with the present state of research, it is virtually impossible to quantify the social benefits of these economies. However, what seems the likelihood of non-trivial benefits from current affiliations is a good reason to be cautious about adopting this proposal.”

Second, he focused on proposals to cap the level of non-deposit liabilities that banking groups are allowed to gather. He noted that “many studies of the financial crisis demonstrate that the reliance of large financial firms on nondeposit funding made them, and the financial system as a whole, susceptible to the dramatic runs that peaked in the fall of 2008.” In addition to the potential reduction in systemic risk, “another attraction of this form of proposal is that, even as it places constraints on the potential size and composition of a firm’s balance sheet, it allows relative flexibility to the firm in meeting that constraint, particularly when compared with proposals for prohibitions on commercial banking affiliations with other financial firms.”

Governor Tarullo pointed out that a combined IO-finance perspective would be needed to help answer three key questions raised by this proposal. “First, of course, is the key issue of how the functioning of funding markets is affected by the participation of very large counterparties using very large amounts of short-term wholesale funding, particularly under conditions of financial stress.” “Second, is the question of scale and scope economies associated with nondeposit funding, the answer to which would help determine the limit at which significant social benefits might be lost, to be balanced against the avoidance of social costs arising from systemic events.” ”A third question is how second- and third-tier institutions might respond as the largest firms reposition, and perhaps shed, parts of their balance sheets.” After elaborating on each of these points, he concluded that “the IO-finance perspective could contribute significantly to an elaboration and evaluation of this policy proposal. In the process, it could advance what I regard as the most important task of financial regulatory reform – determining the most effective and efficient ways to deal with short-term funding markets, often characterized as the shadow banking system, that are inherently subject to runs.”

His final example related to proposals for requiring minimum levels of long-term debt at large financial firms as “a way to facilitate the orderly resolution of such firms.” As he put it, “the basic idea is that the maintenance of minimum levels of long-term debt at the top holding company level will allow a resolving authority to transfer operating subsidiaries of the failed firm to a functioning bridge entity, while leaving behind in receivership the equity and sufficient long-term debt to absorb the original firm’s losses.” After reviewing the benefits and likely effects, he concludes that the IO-finance perspective “did not immediately suggest any unfavorable unintended consequences, thereby strengthening its appeal as a near-term policy priority.”

Purpose of the Financial Sector

There was clear agreement among the experts that the purpose of the financial sector is to serve the “real economy.” In fact, the agreement was so universal that it was implied rather than explicitly stated by most of the experts. The belief was most explicit in reply to a question from the audience that touched directly on the social purposes of finance. This came in the first panel, moderated by me, with participation from Bob Chakravorti, John Lester, and Nicolas Veron. All of them agreed that there was little reason for public policy to support the financial sector for its own sake, but that its proper working was critical for overall economic activity and growth.

I, and other of the experts, have written elsewhere about the social purposes of finance. There is general agreement that the provision of credit to businesses and households is a crucial role as is, more generally, the allocation of funds within the economy, whether through debt, equity, or a hybrid or more novel form of finance. As the other side of the coin, savers and investors need to be given the opportunity for reasonable returns on their excess funds through participating in financial transactions, directly or through intermediaries. Finance is also important for providing risk management products that allow businesses or households to protect themselves from volatility in interest rates, exchange rates, prices of commodities and other assets. In furtherance of these higher-order objectives, finance also needs to provide for liquid markets in which to trade a wide variety of financial instruments.

Marcus Stanley and some of the audience members raised questions about the extent to which the financial sector had lost its focus on these societal objectives and instead generated a large number of transactions and instruments whose only real objective was to enrich the participants in the financial sector. This is a very difficult and subjective topic. Everyone accepts that there are specific transactions that served no particular social purpose and may have done harm. However, it requires a great deal of judgment to conclude whether these are isolated anecdotes or whether there were large volumes of transactions in categories that clearly did not need to exist. One of the reasons for this subjectivity is that virtually all speculative transactions have at least the theoretical advantage of increasing liquidity in markets by raising the volume and frequency of activity. In some cases it is difficult to argue that the modest increase in liquidity could be worth the risks caused by the speculation, but in most cases it is a more difficult judgment call.

It is important in this regard to keep a focus on the potential for market failures that distort market signals that would otherwise tend to optimize economic activity. The pursuit of individual profit objectives, no matter how seemingly venal, can come together to produce overall good for society, a concept that goes back at least as far as Adam Smith. The key question is therefore whether something about the current market structure encourages speculation to do more harm than good.

In his concluding remarks, Don Kohn appropriately emphasized the need to find the right trade-off between financial stability and economic growth. He noted that these two goals are not in inherent conflict, as the recent crisis demonstrated how badly economic growth is hit by financial crises, bringing down the long-term average of economic activity. However, it would also be possible to take such extreme actions to avoid systemic risk that the financial system would fail to adequately fulfill its role, thereby slowing the economy. Therefore, it is critical to consider the balance between costs and benefits.

The Right Size for the Financial Sector

An underlying question that affects one’s view of whether structural reforms are needed for the financial system is whether the financial sector is too big as currently constituted. This ties, of course, directly back to the question of the purpose of the sector and how well participants have fulfilled their roles. That is, if a significant portion of transactions and instruments do not provide value for the real economy, then one is much likelier to conclude that finance has grown to be too big.

I raised this question for the participants in the first panel, in my role as moderator. None of the three panelists was prepared to argue that they knew that the financial sector was too large. John Lester answered that it probably was not too large. While admitting that we simply do not know enough to definitively answer the question, his intuition is that the financial sector was not too big, in aggregate, in the US. He would not, however, expect the financial sector to usefully grow faster than the overall economy going forward, as we have a very mature financial system at this point. For his part, Bob Chakravorti gave a defense of the existence of large banks, and a large banking system in absolute size, by pointing to various advantages of economies of scale and scope, as well as diversification and innovation benefits. He also argued that once we remove the problem of some banks being Too Big to Fail, which he thinks new law and regulation is achieving, then there will be a market test for the size of banks and of the banking sector. As he stated, “credit intermediation is a market determined thing. The whole financial sector is there because there is a demand for financial products. So I do not think it is the case that the financial sector is too big.”

Nicolas Veron pointed out that whatever the concern about the size of the financial sector globally, the banking sector in the US is significantly smaller in relative terms than it is in Europe and Japan. Further, he argued that “financial intermediation is increasingly high value added if you move to a service economy,” implying that we should expect to have a substantially larger financial sector as we have moved away from manufacturing and agriculture over time. He explicitly stated that “I think finance has to be big, but profits were too large in the recent past.” That is, there are reasons to have a very large finance sector, even accepting that the recent boom was excessive.

Marcus Stanley took the opposite viewpoint, explicitly arguing that finance has indeed grown too large. In fact, the first two slides of his presentation focus specifically on the high growth rate of finance from 2000 to 2008 and some empirical studies that find that economic efficiency declines with rapid financial growth and high levels of financial activity. He pointed out that gross international banking positions rose by a factor of 3.5 times from 2000 to 2008 and that the notional value of over the counter derivatives positions grew from 3 times global gross domestic product (GDP) to 10 times over that period. There is a strong consensus, in retrospect, that financial activity grew excessively in the boom, that this helped create the conditions for the financial crisis, and that the crisis did enormous economic damage. Thus, few would argue with the desirability of avoiding bubble conditions in financial markets, although there is disagreement about how to go about this and even whether it is feasible.

More controversially, Marcus Stanley argued that there is evidence in the academic literature that the rapid growth of finance did not bring with it very much economic benefit during the upswing. He cited a recent study by Phillipon that found the efficiency of credit intermediation declined as finance grew. Further, Cechetti and Kharroubi found that rapid growth in financial intermediation is correlated with slower productivity growth in the wider economy.

I believe the question of the right size is a subjective one, given our current knowledge. We do not have enough data points to be able to do a statistical comparison of different financial sectors that are similar enough in most dimensions but differ in size. Nor, given the many other factors that vary over time is it definitive to compare financial sectors in one country over time. Marcus Stanley and, as will be discussed later, Charles Calomiris, are on the right track in trying to identify structural problems that create market failures which distort incentives and cause the financial system to be too big. However, I do not think we know enough to draw definitive conclusions.

That said, the answer is almost certainly that the US financial sector is either roughly the right size or is too big. I cannot think of an expert at this point who makes the argument that finance is too small, although that does not exclude the possibility that future analysts will look back and reach this conclusion. Intuitions are not always accurate. I have been struck by the fact that Confucian philosophy treated merchants as relatively unimportant, since they did not actually produce anything but merely dealt with the distribution of items. With the benefit of hindsight and more modern theories, we have come to realize just how important the business sector is. There remains the possibility that future analysts will conclude that our financial sector is still growing towards its right size. Or, of course, they may confirm the intuition of many that finance is too big.

Distribution of Tasks Within the Financial Sector

A key structural question is how financial tasks should be divvied up between commercial banks, investment banks, insurers, non-bank credit intermediaries, funds managers, markets, etc. The two biggest live questions are: (1) where to draw the line between banking activities and those that can be conducted by non-banks and (2) which activities should be allowed to be undertaken by depository institutions and their affiliates and which should be undertaken only by non-banks.

Underlying both questions is a consensus that certain banking activities are central to the economy and therefore are, and should be, protected by government-backed safety nets such as deposit insurance funds. Deposit-taking is clearly among these core activities, since households and businesses need the ability to use transactional accounts and to deposit spare cash without concern about the safety of the banks with which they deal. As the recent crisis showed, anything that creates widespread suspicions in this regard is very detrimental to the economy. Thus, the money-market funds received government guarantees, even though their shares are not legally deposits. Too many people were using these funds as if they were deposit-takers for the economy to handle a “run” on the money market funds. Similarly, deposit guarantee limits were expanded widely in order to avoid runs from spreading at the commercial banks.

The size and importance of deposits, and their federal safety net, have led many analysts to concentrate on ensuring that deposit-taking institutions do not engage, directly or through affiliates, in transactions that are either excessively risky or where the implicit subsidy for deposits might encourage too great a volume of activity. This is discussed in more detail below.

“Shadow banking” is another structural issue of great importance. This refers to bank-like activities that take place in entities that operate with little or no regulation because they are not organized as banks, insurers, or other highly regulated legal entities. Some examples include finance companies that borrow short-term money and lend it out for longer periods and money market mutual funds that take quasi-deposit money. Certain types of activities are also often considered part of shadow banking, regardless of what entity performs them, such as repurchase (“repo”) agreements where very short term borrowing occurs using securities as collateral. These activities share the characteristic that they involve very short-term borrowing, often overnight, which is then used to support longer-term lending.

Shadow banking was not a prime focus at this conference. However, a number of the experts share a concern that shadow banking is insufficiently controlled by regulation and that it could grow substantially as a result of increased regulatory burdens on the banking sector. At the same time, Don Kohn stressed that there is an appropriate role for non-bank financial activities, including securitization, so we should not throw out the baby with the bathwater by attempting to eliminate everything that might be seen as “shadow banking”.

A major structural topic at the conference was the extent to which traditional banking activities should be conducted in the same corporate groups as securities and derivatives activities. At an extreme, a re-imposition of Glass-Steagall would forbid most of these activities from being conducted by affiliates of a deposit-taking institution. Such limitations are discussed in considerably more detail below.

Too Big to Fail

Virtually all analysts believe that the largest banks benefitted from the perception that the federal government was likely to provide assistance if they got into too much trouble, usually expressed as those banks being “Too Big to Fail”. Shareholders did not rely to any great extent on this, since it was clear, and proved true in practice, that the government could and would allow them to lose close to the entirety of their investments. However, bank creditors and uninsured depositors in the aggregate almost certainly charged less and supplied more funds because of this implied safety net.

There are considerable arguments on two key points about the implicit subsidy. First, what was its size in the run-up to the financial crisis? It clearly became much larger during the height of the crisis, when many institutions could not have borrowed or would have paid far more for their funds without the knowledge that governments stood behind them. This leads to the second question, has it vanished or been very considerably reduced? Dodd-Frank and other new laws and regulations are intended to make it feasible for the government going forward to allow any bank to fail without triggering an infusion of taxpayer money.

Bob Chakravorti argued very strongly that the Too Big to Fail problem has largely been solved by Title II of the Dodd-Frank Act, which provides a new means of resolving troubled financial institutions that are systemically important, in combination with other parts of Dodd-Frank and new regulations. In addition to addressing a number of specific points, he mentioned a symposium that his organization had put together at which participants from all across the financial sector, including ex-regulators, explored how Title II might work in a hypothetical future crisis. I also attended this symposium and would concur with his assessment that the results were encouraging, although I certainly did not view them as definitive.

Marcus Stanley, on the other hand, indicated serious doubts about whether Dodd-Frank had gone far enough to truly remove the potential of a government rescue of one or more large financial institutions. Charles Calomiris concurred, although coming at this from a different angle. His overall view of the regulatory reforms is that they largely fail to get at the heart of the problem, which is the capture by financial interests of the politicians and regulators, leading to “reforms” that purport to reduce government support and require prudent operation of financial institutions, without actually creating the necessary changes in constraints and behaviors. Truly effective changes would reduce profits and executive compensation by draining away economic rents that are currently captured by the sector. In his presentation, he focused on a series of proposed reforms that he believes would be truly effective, which I will not summarize here because they generally do not involve changes to the overall structure of the financial sector, but rather aspects of the specific operations of the players. The most relevant aspect of his remarks for the structural reforms discussed at the conference is the idea that the system can be made safe without such changes, if the reforms he suggests are put into place. After that, he believes, the structure of the industry will adjust sensibly over time based on the underlying economics, but he is effectively agnostic about the optimal structures, since the safety of the system depends instead, in his view, on these other actions.

Concern about the implicit subsidy has led many to suggest that the largest banks be broken up or forced to shrink or given strong incentives to choose on their own to be smaller. The major counter-argument to this is that there are true economic benefits to having banks of this large a size and scope of activity. A number of the experts tackled this question.

Governor Tarullo made a strong argument, as noted earlier, for more research on this area, since he believes the question of the scale of economic benefits created by the largest institutions remains open. There are clearly some benefits, but he is unsure how much they are offset, or even more than offset, by harm done by the size of these organizations.

Bob Chakravorti referred to an extensive study by the Clearing House Association, an industry body, which concluded that large banks in the US provide a series of important economic benefits that would not be achievable to the same extent by smaller banks. The study found that the existence of big banks created $20 to $45 billion a year in benefits from economies of scale, figures they reached by looking in detail at various areas of banking where one would expect scale to matter. Similarly, benefits of a wide scope of product offerings at these banks and their affiliates produced another $15 to $35 billion a year of economic benefits. Finally, benefits that big banks provide through encouragement of financial innovation came to another $15 to $30 billion, bringing the total to $50 to $110 billion a year. He argued that these findings were relatively conservative, pointing to a finding by Wheelock and Wilson of the Federal Reserve Bank of St. Louis that even capping banks at $1 trillion in size, a relatively high limit compared to some proposals, would result in a loss of $79 billion in benefits.

Nicolas Veron, a public policy expert, did not express a strong position on the Too Big to Fail issue, but did show in a series of data tables that European banks are quite substantially larger in relation to the size of their national economies than is true for US banks. He believes that the Too Big to Fail problem, to the extent it exists, is distinctly worse in Europe. This, of course, would change if the Europe achieves a true banking union in which the relative comparison becomes the size of each bank relative to Europe as a whole.

John Lester, a consultant to financial firms, came down on the same side of the question, for similar reasons to Bob and also in light of the relatively lower concentration of banking in the US, as pointed out by Nicolas.

For my part, I argued strongly that there are indeed very substantial economies of scale and scope at the largest banks. Some of this has been shown by studies using more modern analytical tools that have been done recently at the Federal Reserve Bank of Philadelphia and the Federal Reserve Bank of Saint Louis. Further, work by Ronald Anderson, a professor at the London School of Economics, and colleagues have demonstrated that economies of scale and scope at the banks are likely to be much larger when one takes into account that some of the

benefits have been captured as “economic rents” by bank employees. This matters because we need to know the full extent of the economic benefits, whether they are retained by shareholders, passed along to customers in lower prices or better products, or captured as higher compensation. We might wish to take other actions to squeeze out the rents captured by employees or shareholders, but this may be preferable to reducing the size or scope of activities and losing the genuine economic benefits altogether.

I find these economic studies convincing in part because they mesh with my experience of almost twenty years as an investment banker, primarily focusing on financial institutions as clients. During that period, I saw many mergers put together by very smart industry leaders who believed that there genuinely were substantial synergies that would yield economic benefits of scale and scope. Further, these promises largely appear to me to have been borne out afterwards, although I did no formal study. These instances are not definitive, of course. They may not have represented the universe of transactions and it is possible that accounting or other factors confused what was actually going on. However, I tend to place weight on the opinions of industry leaders who are committing their own money and/or careers when they make decisions of this nature.

In my talk, I also emphasized that the benefits of breaking up the big banks may be much less than is sometimes argued. For example, if in the run-up to the financial crisis the major banks had each been broken up into 20 pieces, I maintain that the great bulk of the problems of the crisis would still have occurred. There would still have been excessive investments in both residential and commercial real estate, financial institutions would still have operated with far too little capital and liquidity, opaque and excessively complicated securitizations and derivatives would still have been in vogue, compensation structures would still have encouraged excessive risk-taking, markets would have much too cavalier about the risks that were taken, etc. In fact, it is difficult to find many significant ways in which the crisis would have been different. The best argument is that creditors would have been more careful about the risks the banks were taking if they did not perceive a government safety net. However, it seems unlikely that this would have happened to a significant extent, since most market participants were making bets across the spectrum of investments that indicated that the types of risks the banks faced were not of concern to investors. Another argument would be that individual troubled banks could have been allowed to fail, given their smaller size, however I find this unconvincing in the context of a crisis this wide. The S&L crisis, for example, demonstrated that taxpayers can end up paying large sums when a herd of smaller institutions all encounter the same problems, even though each could theoretically have been allowed to fail were there not the larger crisis.

Don Kohn, in his concluding remarks, emphasized the importance of increasing competition within the financial sector. He noted that dealing with Too Big to Fail is of critical importance in this regard, since implicit subsidies otherwise give the major firms too great an advantage over smaller competitors. He noted that considerable progress has been made in tackling these implicit subsidies, but did not indicate whether he thought enough was being done to contain the problem.

Limitations on Interconnections Between Financial Entities

One way of limiting the Too Big to Fail phenomenon is to reduce the connections among large financial institutions and between them and other parts of the financial sector. At the extreme, if a very large financial institution could exist without being crucial to any other financial institution or market, then its size would largely cease to be a concern. It could be allowed to fail without serious harm to the economy. In a less extreme version, reducing the importance of interlinkages in the financial system would reduce the direct effects of the failure of a single institution on the rest of the system and might reduce contagion effects resulting from fears of the indirect effects of such a failure. (It would not eliminate the “common shock” problem, where contagion occurs because the failure of an institution makes the market aware of a problem shared by many other institutions. Many argue that the Lehman failure revealed that government support was not necessarily available to troubled financial institutions, despite the seeming lesson from the Bear Stearns rescue, as well as emphasizing just how bad the problems of toxic assets were.)

One important move in this direction is the set of regulations mandated by Dodd-Frank and proposed by the Fed on Single Counterparty Credit Limits (SCCLs). These limits are intended to ensure that no large banking group has too much exposure to any other party, with the proposed limits particularly binding in regard to the very largest banks, those with $500 billion of assets or more.

The key question in dealing with interlinkages within the financial system is how to reduce the contagion risks without stifling useful market activities. Imposing the equivalent of a plague quarantine would certainly limit financial contagion, but it would also sharply limit all financial activities.

The subject of interconnections was touched on only fairly lightly at the conference, except in Governor Tarullo’s opening remarks. For my part, I expressed a concern that the combination of the Volcker Rule, discussed below, and the proposed SCCL rules could make it particularly difficult for securities and derivatives markets to fulfill their important economic roles effectively.

Functional Limitations for Banks

As noted, there are strong advocates of placing stronger functional limitations on banks, particularly to prevent deposit-taking institutions and their affiliates from engaging in certain securities and derivatives activities. The Volcker Rule is a prime example of this, since it forbids “proprietary trading” by any commercial bank or affiliate of a commercial bank. The next section deals with a related issue, the series of proposals to prevent deposit-taking institutions and their affiliates from undertaking securities activities or forcing those activities to be kept more separate than they currently are.

There was surprisingly little said about the Volcker Rule during the conference, given that it is the prime structural restriction that we know will occur in the US. Several speakers mentioned it, but in little detail. Marcus Stanley did argue in favor of activity limitations and for the Volcker Rule in particular, while expressing a concern that regulatory discretion would weaken its effectiveness substantially.

Charles Calomiris had an interesting take, arguing that the Volcker Rule would be unnecessary if there were instead a requirement for margin to be put up on any transactions between banks and their affiliates, thereby protecting banks from losses on the securities transactions in all cases except where there is an extreme movement in a very short period of time. He indicated that several prominent supporters of the Volcker Rule have told him in private that they would be quite comfortable with that alternative approach to the problem.

I only touched briefly myself on the Volcker Rule, but have written and testified about my serious concerns about the damage it could do by making useful market activities substantially more expensive. It is also not clear to me that there is any particular safety benefit to be gained. For that matter, the overall rationale for the Volcker Rule has always seemed quite unclear to me and the explanations of its benefits rather strained.

Ring-fencing and Bank Affiliations with Securities Dealers

One of the more common proposals for dramatically restructuring the financial sector is to remove deposit-taking institutions from securities market activities or to substantially reduce their scope and level of activity. Glass-Steagall, for example, had forbidden commercial banks from undertaking much of this type of activity either directly or through affiliates. (There were always exceptions, such as the ability of banks to engage in activities involving US government securities and those of states and localities. It is noteworthy that the US government almost never produces regulations that limit the ability of banks to buy its own products and to sell them on to others. This continues to be true with Dodd-Frank and, for example, the SCCL rules.)

There was a very lively discussion in the Q&A period after the last panel between Charles Calomiris, Marcus Stanley, and a member of the audience who strongly advocated the reimposition of Glass-Steagall. (It should be noted that Glass-Steagall has actually never been repealed. It was only the crucial anti-affiliation provisions that were repealed. Many other important aspects of the law remain, including those that prevent commercial banks from engaging directly in forbidden securities transactions, even though affiliates are now allowed to do so.)

Professor Calomiris, who is a financial historian as well as an expert on regulation, strongly asserted that the arguments of the Pecora Commission that conflicts of interest harmed bank depositors and therefore required a separation of banking and securities activities are now completely discredited. He further argued that much of Senator Carter Glass’ thinking that led to Glass-Steagall was based on an economic theory known as the “real bills” doctrine, which is also now discredited. Overall, he believes that Glass-Steagall was established for unsound reasons and he further asserted that the common conception that it did no harm for 50 years is wrong. He stated, for example, that prior to Glass-Steagall, the financial system was developing ways for smaller corporations to borrow through the securities markets, but that Glass-Steagall abruptly ended these experiments, leading to hearings in the 1950’s and later about the difficulty of borrowing for small businesses.

Marcus Stanley argued that Professor Calomiris’ assertions were much overstated and sometimes wrong, although he did not go into great specifics during the Q&A period. Nor did the questioner from the audience back away from his own beliefs.

Whatever the historical basis of Glass-Steagall and its efficacy in the past, there was strong skepticism from a number of the experts about the benefits of restoring such a simple division now.

Governor Tarullo was very careful in his wording not to take a definitive position, but it does not seem a strain to read his speech as indicating a strong preference for approaches other than this kind of simple structural division. He indicated that “what seems the likelihood of nontrivial benefits from current affiliations is a good reason to be cautious about adopting this proposal.” Further, he lauds the concept of capping non-deposit liabilities at banks, saying “another attraction of this form of proposal is that, even as it places constrains on the potential size and composition of a firm’s balance sheet, it allows relative flexibility to the firm in meeting that constraint, particularly when compared with proposals for prohibitions on commercial bank affiliations with other financial firms.” (Emphasis added by me).

Similarly, Don Kohn explicitly argued against reimposing Glass-Steagall, although he does support the Vickers Commission recommendations in the UK for ring-fencing. However, he noted in that regard that his support was influenced by conditions in the UK that do not apply to the same extent in the US, such as the considerably higher degree of market concentration in the UK.

With the exception of Marcus Stanley, who explicitly endorsed activity limitations and argued for some of the historical advantages perceived to arise from Glass-Steagall, the other experts appeared to disagree fairly unanimously with returning to Glass-Steagall.

There was less of a consensus about the degree to which securities and derivatives activities should be conducted in bank affiliates and how that should be governed. In this regard, it is worth noting two European efforts that are underway to use “ring fencing” to reduce the economic risks of combining these activities in a group that also takes deposits. The first to be proposed was that of the Independent Commission on Banking, in the UK, known as the “Vickers Commission”. The Commission called for core activities, such as deposit taking, to be conducted by a bank that would then be protected by a “ring fence” which would hold it separate from most securities and derivatives activities that would be undertaken in separate affiliates. The core economic activities could then be protected by deposit insurance and other safety nets without fear that the bank would be compromised in a serious way by failures in these other businesses. Some activities could only be undertaken within the ring-fenced entity, others would be forbidden to that entity, and others could be undertaken either inside or outside the ring fence, at the discretion of the management.

The second proposal is from a “High Level Expert Group” formed by the European Commission, known as the Liikanen Group after its Chair. Among other policies, the group recommended that all securities trading must be undertaken outside of a ring-fenced deposit-taking entity. This choice is an attempt to get around a problem affecting the Volcker Rule and the Vickers Commission recommendations, which is that allowing market-making activities to remain inside the ring fence means that there must be a reasonable way to differentiate between trading undertaken for its own sake and trading undertaken as part of market-making. As even proponents of these approaches generally concede, this is quite difficult to operationalize.

A number of the experts at the conference explicitly placed a high value on the economic benefits of bank-centered groups engaging in securities and derivatives activities, including Martin Baily, Bob Chakravorti, John Lester, and me. For us, there are serious dangers in the Volcker Rule and the ring-fencing proposals, although the latter could potentially be implemented in ways that would not be that harmful. For example, the US already has a ring fence around commercial banking entities, in that they are forbidden to directly undertake many securities activities and have fairly strict rules about how they undertake transactions with their affiliates that do engage in such transactions. (Credit arrangements must be on terms that approximate an arms-length transaction and the banking group cannot approach a client with a proposal where the bank provides concessionary terms in exchange for non-credit transactions that benefit the affiliates.)

I and the others expressed several concerns about the Volcker Rule and the strong form of ring-fencing. First, there are significant synergies between credit activities undertaken as loans and credit activities undertaken as securities underwriting or market-making. These economies of scale and scope would be reduced or eliminated by the regulatory proposals, with real cost to customers and the economy. Second, there are very significant operational problems inherent in these proposals that are likely to do damage to economically useful activities. This is clearest in the case of the Volcker Rule, where it is extremely difficult to tell “proprietary trading”, a term of art, from market-making. This matters, because market-making is essential to liquid markets and liquidity is essential if markets are to provide well-priced credit and equity to companies in the real economy. If the Volcker Rule forbids activities too easily or is so complicated that it pushes banks to forego those activities, then markets are likely to suffer in a significant way.

Third, even if such changes were desirable in the long run, groups centered on large commercial banks are at the very core of the current system of markets. At a minimum, there would need to be a very long and careful transition period to allow small players and new entrants to expand their activities without jumping in before they are ready. It takes time to develop the appropriate risk-management systems, to develop the right culture, and to develop the relationships with counterparties to operate safely and efficiently.

Martin Baily, in particular, went beyond discussions of securities activities to plead for a careful approach to derivatives regulation, which is central to the financial risk management of many firms in the real economy, as well as of the financial institutions and markets. I touched on this as well, as I am concerned that too little value is being placed on these risk management activities, thereby encouraging regulators to take actions that they believe increase the safety of various activities, without fully considering the economic cost of placing excessive burdens on risk management. Forcing many derivatives activities to take place outside the ring fence or, in the case of the Volcker Rule, potentially forbidding them, raises such risks.

Others among the experts at the conference support the Volcker Rule and are interested in the ring fencing ideas. Marcus Stanley was most vocal in this regard. In addition, Governor Tarullo discussed the benefits of such ideas, although in the context of the need to carefully balance the benefits and costs.

Conclusions

Our conference is only one step among many that must be taken to fill in the gaps of theory and fact to allow us to evaluate structural reform proposals in a way that truly reflects their benefits and costs to society. It was gratifying that Governor Tarullo gave such a strong endorsement of the need for further research and discussion of this area and that the remainder of the day produced further examples of the issues that need to be resolved and some early thoughts on their implications.

Authors

Douglas J. Elliott

Finish the Job of Financial Reform

Michael Barr — Thu, 27 Dec 2012 11:20:00 -0500

When President Obama came into office four years ago, the financial crisis had just thrown the U.S. economy over a cliff. The financial stability plan that the President and Treasury Secretary Geithner launched worked: the financial panic ended and the economy began to grow again. With the announcement earlier this month of AIG’s repayment of taxpayer funds, TARP and other federal investments are 90 percent repaid, and net costs of the federal intervention in the financial sector overall are expected to approximate zero. That is a remarkable achievement.

At the same time, the Administration put forward a financial reform plan, eventually enacted as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, to make the financial system more resilient, and to protect taxpayers and the broader economy in the future. The Act brings shadow banking into the daylight; regulates the largest firms regardless of their corporate form; establishes a resolution authority to wind down financial firms in a financial panic; sets new rules of the road for financial derivatives; puts in place the tools to reduce systemic risk across the market; sets out important investor protections; and establishes a new Consumer Financial Protection Bureau to look out for the interests of households.

Regulators have been working hard over the last two and a half years to implement these reforms. A new Consumer Financial Protection Bureau has been built from scratch. New rules governing derivatives transactions have largely been proposed. The resolution authority and many new approaches to supervision have been put in place. The U.S. financial system is more resilient than it was four years ago.

While much progress has been made, a combination of financial sector lobbying and aggressive lawsuits, congressional appropriations cuts and moves to delay or block nominees, and interagency wrangling, has slowed rule making.

Now is the time to finish the job of financial reform.

The Financial Stability Oversight Council needs to bite the bullet and designate systemically important firms for heightened supervision. The Fed needs to finalize its rules for tough new oversight, including limits on counterparty credit exposures and on the relative size of liabilities held by the largest firms; and it must also urgently speed up reforms to repo markets. The CFTC and the SEC need to finalize derivatives rules, and push for LIBOR reform. Regulators need to put in place a firm Volcker rule on proprietary trading. And markets need clarity and a coordinated approach to the risk retention rule for securitizations (“qualified residential mortgages”), ability-to-pay rule (“qualified mortgages”), and the practices of Fannie Mae and Freddie Mac for loans they will guarantee (let alone legislation to determine the ultimate fate of the government-sponsored enterprises).

At the SEC, a Commission deadlock has blocked the outgoing Chairman’s proposed reform of Money Market Funds, which faced a devastating run in the financial crisis, stemmed only by a massive taxpayer guarantee of the entire sector. If the SEC is unable to reach a consensus on how to proceed, the FSOC and the banking regulators will need to step in with an admittedly second-best set of steps to make MMFs less susceptible to runs, and the rest of the financial system less vulnerable to contagion from such runs.

Beyond MMFs and derivatives, the SEC faces critical regulatory policy challenges on investor protection, market structure, high frequency trading, exchange-traded funds, JOBS Act implementation, and a host of other issues. And its embattled enforcement division still has a long way to go, working with the Department of Justice, in rebuilding the public’s trust that our financial markets are being adequately policed for unlawful conduct.

Globally, new capital and liquidity rules have been proposed; the Europeans are making progress on derivatives reforms, supervision and new resolution authorities; and U.S. and global regulators have made progress on mechanisms to coordinate action on all these topics. Yet much still remains in flux, and there remains the danger that the next financial crisis, like the last, will occur when there are still no globally coordinated mechanisms for regulation or crisis management.

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