Brookings: Topics - Financial Markets and Services

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.

Video

Audio

Dealing with “Too Important to Fail” Banks

Event Materials

14 dealing with too important to fail banks baily presentation

Participants

Panelists

Ted Gayer

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

Douglas J. Elliott

Fellow, Economic Studies, Initiative on Business and Public Policy

Martin Neil Baily

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

H. Rodgin Cohen

Senior Chairman

Thomas Hoenig

Vice Chairman

Fed Policy, Stock Markets and Japan

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

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

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

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

Authors

Douglas J. Elliott

Image Source: © Toru Hanai / Reuters

Quantitative Easing Withdrawal: How Bad Will it Hurt?

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

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

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QE Withdrawal: How Bad Will it Hurt?

Authors

Douglas J. Elliott

Image Source: © Brendan McDermid / Reuters

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

China’s Foreign Reserves and Overseas Investment

Thu, 30 May 2013 03:00:00 -0400

Event Information

May 30, 2013
3:00 PM - 4:30 PM CST

School of Public Policy and Management Auditorium
Brookings-Tsinghua Center

Beijing, China

An outstanding feature of the current world economy is the internal imbalance of the economic structure in the developed entities, which is persisted and expanded due to the global trade imbalance. After the global financial crisis, China’s foreign exchange reserves accounted for 1/3 of world’s total, and 1/2 of China’s GDP. Huge risk exists, when such amount of foreign reserves is exposed to turbulent international financial market.

On May 30th, 2013, the Brookings-Tsinghua Center for Public policy hosted a public event, featuring Dr. Yu Qiao, nonresident senior fellow of the Brookings-Tsinghua Center, to address the aforementioned issues of China’s foreign currency reserves and its overseas investment. To mitigate the huge risk, as Yu Qiao suggested, a diversified investment portfolio is needed, and the investment demand of China’s aging population should be taken into serious consideration. Dr. Yu’s monograph A Study on the External Environment of Chinese Investments in the United States and his newly-released book China’s Foreign Reserves and Overseas Investment were also presented at the event.

After the talk, Jing Xuecheng, director of China International Economic Relations Association, and Chen Xiaowen, deputy editor-in-chief of the Commercial Press made comments to Yu Qiao’s presentation and book.

Transcript

Chinese Event Transcript (.pdf)

Event Materials

China overseas investment Yu Qiao Chinese transcript edited

Participants

Panelists

Feng Wang

Director, Brookings-Tsinghua Center
Senior Fellow, Foreign Policy, Global Economy and Development, John L. Thornton China Center

Qiao Yu

Nonresident Senior Fellow, Brookings-Tsinghua Center

JING Xuecheng

Director

CHEN Xiaowen

Deputy Editor-in-Chief

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

Balancing Technocrats with Democratic Politics

Kemal Derviş — Fri, 10 May 2013 10:16:00 -0400

A simplistic (actually, naive) view of markets is that they exist almost in a “state of nature,” and that the best of all worlds is one where they are free to operate without government interference. An equally simplistic view of democracy is that it is a political system in which periodic competitive elections give the winner the right to govern without constraint.

The reality is far more complex, of course. Markets can function only within an institutional and legal framework that includes property rights, enforcement of contracts, quality and information controls, and many other rules to govern transactions.

Similarly, while competitive elections are essential to any democratic system, a “winner-take-all” attitude to electoral outcomes, with the victor concentrating power, is incompatible with democracy in the long term. Well-functioning democracies are embedded in complex constitutional and other laws that separate executive, legislative, and judicial power, and that protect freedom of speech, assembly, and peaceful dissent by those who lose elections.

Regulatory institutions – such as bank supervisory agencies and bodies that oversee the telecommunications, food, and energy industries – play a vital role by maintaining the always-delicate balance between “free” markets and the actions of elected governments and legislatures. The central bank is perhaps the most important of these institutions, for it conducts monetary policy (and sometimes serves as the financial-sector regulator).

The policy and regulatory mistakes that contributed to the subprime mortgage crisis – and thus to the US financial system’s near-meltdown and the eurozone’s travails – have brought the issue of optimal economic regulation and its relation to democracy to the fore once again. In the US, a significant share of the Republican Party favor abolishing not only the Department of Energy and the Environmental Protection Agency, but also the Federal Reserve! In their view, markets and private initiative require no significant regulation. The role of politics is to elect majorities that can abolish regulations and regulatory bodies.

Others around the world similarly oppose regulatory institutions, but for very different reasons. They argue that politicians can regulate and supervise without intermediate bodies that have some degree of autonomy. In their minds, these bodies merely impede and constrain realization of the people’s will.

If an elected government wants a bank to offer cheap credit to a group of enterprises so that they can hire more people, why should a supervisor be able to obstruct this democratic will? If these enterprises are told to hire the governing party’s supporters as an implicit condition of obtaining subsidized credit, that, too, is the expression of electorally legitimized popular will.

Management of the economy should be entrusted to competent and independent experts, a group of "Platonic Guardians" empowered to act in the state's higher interests, regardless of electoral outcomes or public opinion.

At the other end of the spectrum are technocratic super-defenders of regulatory bodies who believe that politicians and electorates are hopelessly confused, uneducated, and often corrupt. Management of the economy should be entrusted to competent and independent experts, a group of “Platonic Guardians” empowered to act in the state’s higher interests, regardless of electoral outcomes or public opinion.

The International Monetary Fund, the European Commission, and the European Central Bank are often viewed as such technocratic institutions – and as supporting the technocratic element within states and societies around the world. At the height of the eurozone crisis, the IMF, the EC, and the ECB (not to mention financial markets) warmly welcomed the economists Mario Monti and Lucas Papademos as highly respected “technocratic” prime ministers for Italy and Greece, respectively.

Experience in recent decades has shown that a balanced and “moderate” approach is needed on these matters. Electoral cycles (and the accompanying political pressures) are such that monetary policy, banking, and many other areas of policy and economic activity must be overseen by those with professional competence and a much longer time horizon than that of politicians.

Day-to-day politics cannot dominate the regulation that markets need. The single most important institutional reform underlying price stability throughout the world has been the stronger independence of central banks.

But, if independent technocrats are allowed to determine long-term policy and set objectives that cannot be influenced by democratic majorities, democracy itself is in serious jeopardy. I find it undemocratic, for example, that the ECB can set the eurozone-wide inflation target unilaterally. How much inflation a society finds desirable or tolerable (taking into account other important variables, such as employment, GDP growth, or poverty) is an inherently political question that should be debated in parliament. The central bank should be consulted, but its role should be to implement the objective without political interference: independence in terms of policy tools, not goals.

Globalization and the increasing complexity of financial and other markets make it imperative that the domains of private activity, political decision-making, and regulation be clarified. The challenge is even greater because some regulatory agencies must be multilateral, or at least intergovernmental, given the global nature of much economic activity. The difference and the distance between markets and politics must be clear – and, for the sake of both effectiveness and legitimacy, it must be based on rules that are well understood and on popular consent.

Authors

Kemal Derviş

Publication: Project Syndicate

Image Source: © Lisi Niesner / 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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Uncorrected Transcript (.pdf)

Event Materials

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

Banking Has to Become Boring Again

Lex Rieffel — Mon, 29 Apr 2013 17:39:00 -0400

Editor's Note: Lex Rieffel responds to John Dizard's opinion piece, "Tobin tax will only benefit shady fixers,” in a Letter to the Editor.

Sir, John Dizard makes the classic argument against the European financial transaction tax (Tobin tax) due to go into effect at the beginning of 2014, cleverly linking it to the fresh warning from the Institute of International Finance about the “Balkanisation” of the global economy (“Tobin tax will reinforce position of banks it seeks to challenge”, April 20). But Mr Dizard focuses on the short-term impact and misses the larger context.

While US banks are likely to benefit in the short term, past experience suggests that their eager financial engineers and clever lawyers will invent a new set of instruments that in due course trigger another financial crisis.

The point is that ordinary citizens around the world will not be able to sleep soundly until banking once again becomes boring. Given the choice between Balkanisation and more taxpayer-funded bailouts, isn’t Balkanisation the more rational option?

The argument that financial sector freedom is necessary for economic growth rests on an assumption that gross domestic product growth is the solution for all problems. Surely we have seen enough in the past few decades to question this assumption.

If the solution instead is smart investment, both by the public sector and the private sector, then bankers are among the last we would want deciding which investments to finance.

Banks are backward-looking intermediaries, inclined to invest in the last good idea. That is actually a more useful function than the alternative, which is rushing like lemmings over a cliff.

Authors

Lex Rieffel

Publication: Financial Times

Economic Policy’s Narrative Imperative

Kemal Derviş — Mon, 15 Apr 2013 10:40:00 -0400

The best advice I received when taking up policymaking responsibilities in Turkey more than a decade ago was to take “a lot of time and care to develop and communicate the ‘narrative’ to support the policy program that you want to succeed.” The more that economic policy is subject to public debate – that is, the more democracy there is – the more important such policy narratives are.

The crisis faced by the European Union and the eurozone is a telling example of the need for a narrative that explains public policy and generates political support for it. A successful narrative can be neither too complicated nor simplistic. It must capture the imagination, address the public’s anxieties, and generate realistic hope. Voters often sense cheap populism.

European Central Bank President Mario Draghi provided such a narrative to the financial markets last July. He said that the ECB would do everything necessary to prevent the disintegration of the euro, adding simply: “Believe me, it will be enough.”

With that sentence, Draghi eliminated the perceived re-denomination tail risk that was highest in the case of Greece, but that was driving up borrowing costs in Spain, Italy, and Portugal as well. It was not a populist message, because the ECB does indeed have the firepower to buy enough sovereign bonds on the secondary market to put a ceiling on interest rates, at least for many months.

Central bankers, more generally, are typically able to provide short- or medium-term narratives to financial markets.

Central bankers, more generally, are typically able to provide short- or medium-term narratives to financial markets. US Federal Reserve Board Chairman Ben Bernanke provided his own by pledging that US short-term interest rates would remain very low, and the Bank of Japan’s new chairman, Haruhiko Kuroda, has just provided another by saying that he will double the money supply so that inflation reaches 2%.

While central bankers can provide such narratives to financial markets, it is political leaders who must provide the overall socioeconomic messages that encourage long-term real investment, electoral support for reform, and hope for the future. Central bank alchemy, to borrow a term from the US journalist Neil Irwin’s new book, has its limits.

Europe, in particular, needs a narrative of long-term hope that will trigger a real recovery. France is coming closer to the danger zone, and even Germany’s annual GDP growth is falling well below 1% per year. In the meantime, the easing of sovereign interest-rate spreads provides little comfort to the growing army of unemployed in southern Europe, where youth unemployment has reached dramatic heights – close to 60% in Greece and Spain, and almost 40% in Italy.

The narrative should address three essential questions. How can the European model of strong social solidarity and security be reformed, but endure? How can economic growth be revived and sustained throughout the EU? And how can Europe’s institutions function with enhanced legitimacy to accommodate countries that share the euro and others that retain their national currencies?

For starters, a revolution is required in the organization of work, learning, and leisure. Social solidarity, essential to European identity, can and must include longer work lives, but also more work-sharing, adult learning, and shorter average work weeks (particularly close to retirement).

Such flexibility requires the consent of all: employees must adjust to changing requirements; employers must re-organize their enterprises to allow more work-sharing, work from home, and learning intervals; and governments must overhaul taxes, income support, and regulation to promote a “flex-solidarity revolution” that encourages personal choice and responsibility, while remaining committed to social cohesion. This can lead to a better future for all, with citizens gaining better access to adult education, having more free time to pursue personal interests, and remaining productive and occupationally engaged far longer into their healthy lives.

Europe does not need Asia’s rates of economic growth. It can secure decent jobs and prosperity, with a sustained annual growth rate of around 2%.

Europe does not need Asia’s rates of economic growth. It can secure decent jobs and prosperity, with a sustained annual growth rate of around 2%. To achieve that, German voters should be told not that their country’s resources will forever flow to Spain, but that their wages can rise at twice the rate of the recent past without risking inflation or a current-account deficit, because Germany has the world’s largest external surplus.

Service-sector industries throughout the EU must be opened up. The countries with stronger fiscal positions should take the lead in a major pan-European skill-upgrading program. The number of pan-European scholarships should be doubled. School programs everywhere should aim to educate trilingual citizens.

Moreover, a full European banking union with shared resources for resolution should be created without further delay. The European Investment Bank, which received a significant capital increase in 2012, should add a large investment-support program for medium-size enterprises to its current operations, with a subsidy financed from the European budget to encourage first-time job takers for a limited period. Jobs and training for young people must be the centerpiece for the new growth pact, and projects must move ahead in “crisis mode,” rather than according to business as usual.

Finally, while monetary union obviously requires greater sharing of sovereignty, there should also be a “greater Europe” that includes the United Kingdom and others. This implies two-tier institutions that can accommodate both types of countries: the “euro-ins” and those that prefer to preserve their monetary sovereignty in a larger Europe built around a vibrant single market and common democratic values.

These interconnected visions can and must be realized if Europe is to thrive again. Together, they form a compelling narrative that European leaders must begin to articulate.

Authors

Kemal Derviş

Publication: Project Syndicate

What the Stockton Municipal Bankruptcy Means, And Doesn't

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

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

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

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

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

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

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

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

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

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

Authors

Tracy Gordon

Publication: Real Clear Markets

How African Governments Should Respond to the Impact of the U.S. Sequester

Julius Agbor and Brandon Routman — Wed, 27 Mar 2013 14:02:00 -0400

Based on the 2011 Budget Control Act, and due to the failure of the “supercommittee” to agree upon discretionary budget cuts in 2012, across-the-board cuts to all discretionary spending accounts in the U.S. federal budget (now known as the sequester) went into effect in March of this year. At the G-20 finance ministers and central bank governors meeting held in Moscow last February, Christine Lagarde, the managing director of the International Monetary Fund (IMF) insinuated that the sequester might not be the optimal path to medium-term fiscal consolidation in the U.S., and its impact could be wide-ranging on the global economy. The sequester would potentially affect African economies directly through reduced foreign aid and indirectly through lower export receipts, remittances and foreign investment should there be an accompanying significant slow down in the U.S. economy.

According to Secretary of State John Kerry, the effects of the sequester will be fairly dramatic. For instance, they will initiate some $1.7 billion worth of cuts in foreign assistance, which will negatively affect Africa in a number of key ways.

According to the State Department’s estimations, foreign aid to the health sector may be cut by about $400 million. The highly successful President’s Emergency Plan for AIDS Relief (PEPFAR) will loose some $280 million, which will mean that more than a quarter million fewer patients will receive HIV/AIDS medication. Other cuts in the sector will translate into 2.5 million women being denied family planning service, 3 million fewer treatments for malaria and 60,000 fewer treatments of tuberculosis. If these cuts only affected health outcomes, they would be tragic enough; however, they are compounded by budgetary slashes in other areas. There will be cuts of approximately $200 million in humanitarian assistance, cuts in international peacekeeping operations by almost $20 million and significant cuts to agricultural programs like Feed the Future. The Millennium Challenge Corporation (MCC)—another tremendously successful program and one which incentivizes good governance on a national scale throughout Africa—will also likely sustain a hit. As a consequence, cuts to this program could set back the agenda of governance reforms on the continent.

It also should be noted that the funding cuts induced by the sequester are really only a small part of the story; the larger part is the dwindling levels of funding for international assistance in the current cash-strapped climate.

It should be noted that the above figures are estimates from the State Department and the House Appropriations Committee. While we know for sure that the sequestration cuts will be in effect through 2013, the specifics of how and where these shortfalls occur will be ironed out via a budgetary process over the next few months. It also should be noted that the funding cuts induced by the sequester are really only a small part of the story; the larger part is the dwindling levels of funding for international assistance in the current cash-strapped climate. It should be noted that since 2010, there has been a systematic reduction of about 20 percent in U.S. international aid funding, which is occuring despite the fact that it is less than 1 percent of the total federal budget. Furthermore, in an era where most donors are dealing with fiscal problems of their own, finding alternative funding might be difficult. Thus, continuity of some of those programs that are jointly financed with African governments will critically depend on a greater budgetary participation by African governments themselves.

In formulating policy responses to these economic shocks, it is critical that Africa’s governments preserve the sound macroeconomic framework that has undergirded its remarkable economic growth during the last two decades. The optimal policy response of African governments to the sequester will depend on whether the sequester is percieved as temporary or permanent (the fate of these cuts is uncertain in 2014 and beyond) and on country-specific percularities. The country-specific percularities refer to the exchange regime in place (fixed or flexible) and to the availability of policy space – fiscal, monetary and external buffers. Fiscal buffers refer to the ability of governments to run larger fiscal deficits without creating unfavorable debt dynamics and undue pressures in domestic financial markets, while monetary buffers refer to the ability to ease monetary policy in support of economic activity without triggering significant inflation and exchange rate pressures. External buffers simply refers to the availability of a pile of foreign exchange reserves that can be run down in times of need. Generally, countries with flexible exchange regimes have a greater advantage over fixed exchange regime countries (notably, the African Financial Community, franc zone, member countries) in maneuvering support for affected programs as monetary and exchange rate policies can be fine tuned to support fiscal policy.

If the sequester is perceived as temporary, the optimal response would be to scale up budgetary support for similar, African-groomed programs. Countries with enough buffers could temporarily decrease their stock of foreign exchange reserves and run large fiscal deficits supported, where available, by an expansionary monetary policy stance. For countries with limited buffers, budgetary support could come from borrowing from domestic financial markets (where available) or from the International Monetary Fund and other multilateral funding agencies.

The efforts to mitigate the impact of the sequester on African economies should also be complimented by the continents’ bilateral as well as multilateral development partners.

However, if the sequester is percieved as permanent a different set of policy responses, contingent on each countries’ percularities, can be envisaged:

For countries with limited fiscal buffers (that is, those facing both high budget deficits and high debt-to-GDP ratios), the optimal response depends on the depth of countries’ domestic financial markets as well as on the extent of the pressure imposed by financial markets. Where fiscal buffers are limited, domestic financial markets are well developed but governments are under intense pressure from financial markets. For instance, in South Africa, the optimal response will be to allow a full blown impact of the sequester, which would entail a sharp increase in the price of anti-retroviral drugs in a country where 10 percent of the population is currently living with HIV/AIDS. It should be noted that under the Global Health Initiative, in fiscal year 2012, $469 million was allocated towards South Africa’s fight against HIV/AIDS, which currently tops the list of beneficiary nations. There are other African countries where limited fiscal buffers exist, domestic financial markets are developed, but the government is not under intense pressure from financial markets. For instance, in Botswana, the optimal response might be to borrow from domestic financial markets to partially offset the full blown impact of the sequester. Some sub-Saharan African countries have limited fiscal buffers, thin domestic financial markets, but do have some credibility in international markets, including Kenya, Ghana, Zambia, Angola and Mozambique. These countries could attempt to raise funds internationally through sovereign and diaspora bonds.
Some natural resource-exporting countries in sub-Saharan Africa have accumulated savings in the form of a sovereign wealth fund or in foreign currency denominated assets (for instance, the franc zone countries). They could draw down on those resources to finance the additional cost of maintaining the affected programs.

The efforts to mitigate the impact of the sequester on African economies should also be complimented by the continents’ bilateral as well as multilateral development partners. On its part, the Obama administration and the black congressional caucus should strive to minimize the cuts on some of the highly successful programs like PEPFAR and MCC, and if African governments demonstrate greater commitment to good governance, economic freedom and citizen empowerment, they will be more motivated to do so. The responsibility for ensuring that African citizens continue to receive critical services delivered through U.S. foreign assistance ultimately rests with African governments themselves, notably, their willingness to step up budgetary support to similar African-groomed programs.

Authors

Julius Agbor
Brandon Routman

Cyprus II: Considerable Improvement, but Serious Risks Remain

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

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

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

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

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

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

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

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

Authors

Douglas J. Elliott

A Fresh Take Needed For Risky Funds

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Authors

Robert C. Pozen
Theresa Hamacher

Publication: Financial Times

What's the Big Deal about Cyprus?

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

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

Why did the Cyprus bailout package cause such uproar?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Authors

Michael W. Klein

Publication: GlobalPost