Brookings: Topics - Regulation

The SEC Gets Money-Fund Reform Half Right

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

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

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

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

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

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

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

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

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

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

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

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

Authors

Robert C. Pozen
Theresa Hamacher

Image Source: © Jonathan Ernst / Reuters

Dealing with “Too Important to Fail” Banks

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

Event Information

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

Falk Auditorium

1775 Massachusetts Ave., NW
Washington, DC

Webcast Archive:
Introduction

Full Event

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

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

Join the discussion on Twitter using hashtag #TooBigToFail.

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

Can Smartphones Help Improve Access To Medications?

Gregory W. Daniel — Fri, 07 Jun 2013 14:00:00 -0400

Undertreatment of common diseases and conditions contributes to critical gaps in the public health of the United States. While undertreatment is a complex problem that can result from a range of failures along the healthcare continuum, lack of access to and low usage of health services is widely recognized as a critical barrier. Addressing the undertreatment of common diseases and conditions will require innovative thinking about existing healthcare practices, medical technologies, and a commitment to testing promising solutions by all healthcare stakeholders, including providers, payers, manufacturers, patients, and regulators.

Advances in technology have brought about promising solutions for consumer self-care. In recent years, medical technologies have been utilized in many healthcare delivery settings and have demonstrated the potential to improve outcomes and decrease costs. Applications developed for smartphones, electronic devices, and the internet can assist patients in making complex health care decisions. Portable and wireless diagnostic technologies can collect valuable health information such as cholesterol levels, blood pressure, and measures of blood glucose control and transmit the data back to the consumer or to providers via direct input into electronic health records (EHRs) to inform and optimize treatment. As these consumer-oriented medical technologies continue to evolve, patients will have better tools to facilitate the safe and effective use of medications.

In addition, an increasing number of alternative and innovative practice settings have expanded the role of many health care providers. Acute care centers and retail medical clinics (e.g., CVS MinuteClinic) provide consumers with greater access to and options for medical care, typically through the use of nurse practitioners, physician assistants, and pharmacists. Collaborative practice agreements and medication therapy management programs have also enhanced communication and clinical care between healthcare providers.

Recognizing these emerging trends and opportunities, the U.S. Food and Drug Administration (FDA) is exploring how health care providers and innovative technologies might enable a broader range of medications to be made available in the nonprescription setting. This initiative, know as Nonprescription Safe Use Regulatory Expansion (NSURE), was launched by FDA to address one issue that may contribute to the problem of medical undertreatment: lack of access to appropriate medications. Through an expansion of the nonprescription drug class, FDA may support increased access to medications for undertreated diseases and conditions, particularly for underserved populations without regular access to a physician.

Establishing creative ways to utilize technologies and health professional expertise may help to overcome existing barriers in consumer self-care. In-store kiosks, mobile applications, and other technologies may help to guide consumers to the appropriate self-selection and self-treatment of medications. Similarly, pharmacists and other healthcare providers may provide consultation services to ensure the continued safe use. These mechanisms may permit certain prescription medications to be switched to nonprescription status for increased access.

In launching the NSURE initiative, FDA has begun to address one component of undertreatment of common diseases and conditions. Further development of the NSURE initiative will require a greater understanding of the health, economic, behavioral, and technological factors involved. In an effort to explore these key considerations, the Engelberg Center for Health Care Reform has initiated a series of expert workshops which address major factors in the NSURE initiative. These meetings have served to inform the NSURE initiative through broad stakeholder input on issues related to the role of health care providers, the innovative application of technology, and integration within the existing health care delivery systems. Additional topics to be explored in upcoming workshops include issues related to cost-shifting, third-party reimbursement, and economic considerations.

Ultimately, the NSURE initiative may promote the use of essential medications, and could serve as an important mechanism to bring undertreated patients into the healthcare system. For more information on these issues, including a description of the latest expert workshop, please visit the Brookings event page “Innovative Technologies and Nonprescription Medications: Addressing Undertreated Diseases and Conditions through Technology Enabled Self-Care”.

Authors

Gregory W. Daniel

Image Source: © Steve Marcus / 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

Rethinking Responsibility in Innovation

Thu, 30 May 2013 10:00:00 -0400

Event Information

May 30, 2013
10:00 AM - 11:30 AM EDT

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

While emerging technologies—like nanotechnology, synthetic biology and advanced manufacturing—bear the promise of great benefits to society, they also pose significant risks. New sciences and technologies substantially affect society and yet it is nearly impossible to anticipate every major consequence of their advancement, development and commercialization. Who is responsible for those consequences? How is responsibility distributed among the various actors who influence and regulate innovation such as private enterprises, the government, inventors and the general public?

On May 30, the Center for Technology Innovation at Brookings hosted a public forum to discuss the role of social responsibility in each stage of the innovation process. A panel of experts discussed the kinds of institutions and incentives that govern innovation and how they shape the behavior of researchers, high-tech firms, capital investment firms, and regulatory agencies.

Audio

Rethinking Responsibility in Innovation

Why Investors Should Brush Up on Their Political Science and Economics

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

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

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

A return to the norm

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

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

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

World markets increasingly important

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

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

Government actions matter

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

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

Authors

Douglas J. Elliott

Publication: Yahoo! Finance

Image Source: © Kevin Lamarque / Reuters

The History of Cyclical Macroprudential Policy in the United States

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

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

Downloads

The History of Cyclical Macroprudential Policy in the United States

Authors

Douglas J. Elliott
Greg Feldberg
Andreas Lehnert

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

Image Source: © Larry Downing / Reuters

Regulating Systemically Important Financial Institutions That Are Not Banks

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Systemic Risk

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

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

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

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

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

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

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

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

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

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

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

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

Types of non-bank SIFIs

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Regulating SIFIs

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

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

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

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

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

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

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

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

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

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

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

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

Principles for regulating non-bank SIFIs

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

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

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

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

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

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

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

Regulating Life Insurers as SIFIs

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Capital Requirements

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What might the Fed do beyond capital standards?

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

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

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

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

Conclusions

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

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

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

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

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

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

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

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

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

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

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Regulating Systemically Important Financial Institutions That Are Not Banks

Authors

Douglas J. Elliott

Image Source: © Chip East / Reuters

How to Avoid Another FAA Fiasco

Clifford Winston — Wed, 08 May 2013 00:00:00 -0400

In the aftermath of last month’s air traffic control fiasco, many people are probably wondering how there could be a budget pinch since travelers pay for air traffic control every time they buy an airline ticket. Current fees amount to a 7.5% ticket tax per flight and $3.90 per flight segment, which generates some $10 billion in annual revenues. Assuming that user fees fund the service, it made no sense that the sequester would affect air traffic control. But that assumption is wrong.

What Americans experienced in April was a classic example of how federal transportation deficits can reduce the nation’s productivity. Millions of man-hours were wasted on planes that were delayed, and hundreds of thousands of travelers postponed or canceled trips that generate work for people at their destinations. Unfortunately, the United States will experience more costly disruptions to its transportation system unless its deficits are curbed by efficient policy reforms or by privatization.

Travelers’ user fees do not bear a close relationship to an aircraft’s contribution to the cost of air traffic control. Why? Because there is no variation in price for airspace congestion that increases traffic control’s workload. The gap between passengers’ user fees and the cost of air traffic control is even greater for unscheduled general aviation (corporate jets and other private flights). General aviation causes unpredictable peaks in demand for airspace, and their preferred altitude approaches create additional complexity and cost for controllers. Overall, revenues from user fees do not cover costs, and the difference is covered by a subsidy from the general federal fund.

The Federal Aviation Administration has been unable to figure out the real costs of air traffic control services and thus has underpriced it since its founding in 1958 as the Federal Aviation Agency. The inadequacy of the ticket tax to cover costs over time has been compounded by the intensity of airline competition that has driven down real airline fares. The costs of air traffic control also have undoubtedly been inflated by the delays and cost overruns attributable to the FAA’s inability to adopt new technology to upgrade and modernize the system. The long-anticipated next generation satellite-based air traffic control system, known as NextGen, is billions over budget and years behind schedule. It may need to be renamed PastGen at the rate of its deployment.

FAA’s involvement with public airports is also characterized by pricing and cost inefficiencies. The charge that an aircraft pays public airports to land—they are not charged to take off—is based on weight and generally does not vary by time of day. But the time at which an airplane lands clearly affects airport congestion and an airport’s capacity to reduce delays. Building new runways has turned into multiyear projects with a price tag in the billions of dollars due to various regulations that can take decades to meet, especially Environmental Protection Agency environmental impact standards.

As part of a federal agency that depends on taxpayer funds to cover a deficit caused by its inefficiencies, air traffic control is at the mercy of Congress. So when the sequester hit, the FAA’s already troubled budget was cut—including funding for air traffic control.

To be sure, the 10% cut in air traffic control was politically efficient from the White House’s perspective, because it delayed more than one-third of all flights and drew the immediate attention of the public and Congress. But FAA’s pricing and operating inefficiencies led to the deficits that rendered air traffic control operations subject to manipulation.

Air traffic control is not an isolated case. Evidence in my forthcoming Journal of Economic Literature paper indicates that the nation’s highways, ports, urban bus and rail transit systems are also characterized by prices that are below costs and by inefficiencies that inflate operating costs, which have resulted in large and growing budget deficits that make those services vulnerable to politics. Cuts in their funding could adversely affect the nation’s productivity by, among other things, increasing commuting and shipping delays.

One way to insulate the nation’s transportation system from the threat of costly political shocks is to efficiently reform its pricing policies so services are financially supported by real, cost-based user charges. Alternatively, the U.S. could follow the lead of countries such as Canada, England, Australia and New Zealand and explore privatizing its transportation services.

All of America’s transportation modes and infrastructure services were initially developed and operated by the private sector. Over the past centuries, they were brought into the public sector by financial crises—some that the government arguably helped create by interfering in the market. Now that the government’s political crises are becoming ever more disruptive, it may be time to return the transportation system back to where it started.

Authors

Clifford Winston

Image Source: © Larry Downing / Reuters

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

Simpler: The Future of Government

Fri, 05 Apr 2013 10:00:00 -0400

Event Information

April 5, 2013
10:00 AM - 11:30 AM EDT

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

In his new book, Simpler: The Future of Government (Simon & Schuster, 2013), bestselling author and academic Cass Sunstein shares his lessons as head of the “most powerful White House office you’ve never heard of.” As administrator of the Office of Information and Regulatory Affairs, Sunstein worked with others to initiate a program of simple, data-driven regulation designed to increase efficiency and flexibility of government. In Simpler, he illustrates how simplifying regulation saves money, improves health and lengthens lives—and why this is just the beginning.

On April 5, Governance Studies at Brookings, as part of the Management and Leadership Initiative, hosted a book launch for Simpler: The Future of Government to discuss the streamlining and reimagination of American regulation and rule-making. Moderated by Senior Fellow Elaine Kamarck, Sunstein offered key insights from his book and how to rethink what government can and should accomplish.

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Cass Sunstein Previews New Book, Simpler: The Future of Government

Cass Sunstein Previews New Book, Simpler: The Future of Government

Cass Sunstein — Mon, 25 Mar 2013 00:00:00 -0400

Visiting Fellow Cass Sunstein shares insights from his forthcoming book, Simpler: The Future of Government, which focuses on how government can be more “user-friendly,” simple and efficient by streamlining and reforming government regulation and rule-making. To make his case, Sunstein discusses various accomplishments and actions undertaken while he was administrator of the White House Office of Information and Regulatory Affairs.

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Cass Sunstein Previews New Book, Simpler: The Future of Government

Authors

Cass Sunstein

Quantitative “Moneyball” Needs to be Played When Reimagining U.S. Regulations

Cass Sunstein — Mon, 25 Mar 2013 14:00:00 -0400

In my new book, I argue that government should be simpler, and I suggest a number of ways to reduce complexity. In this video, I explain the importance of quantitative analysis -- a kind of Regulatory Moneyball -- and contend that it should be applied to government regulation (as indeed it has been during the Obama administration).

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Quantitative “Moneyball” Needs to be Played When Reimagining U.S. Regulations

Video

Quantitative “Moneyball” Needs to be Played When Reimagining U.S. Regulations

Authors

Cass Sunstein

To Reduce Lawyers' Drag on Growth, How about a Law PhD?

Clifford Winston and Robert W. Crandall — Thu, 14 Mar 2013 00:00:00 -0400

A crisis is a terrible thing to waste, so the saying goes. So is a mind – a keen scholarly legal mind. Fewer students seem to be interested in entering law school as can be seen by the 50% decline in applications. But the crisis in legal education may have a silver lining: as most law schools are cutting their student enrollments, Chicago, Vanderbilt, and Yale law schools are attracting students to new legal doctoral programs. Despite what one might think, PhD lawyers could be a good thing for the economy: they will be trained to produce research that could help eliminate costly inefficiencies caused by public policies—ironically, especially those that increase the demand for lawyers. Indeed, if economics research is correct that an economy’s growth slows as more lawyers comprise its workforce, then the payoff from such research could be substantial.

Last year, the University of Chicago established the Coase-Sandor Institute for Law and Economics and is currently developing a joint J.D./Ph.D. in law and economics. Vanderbilt Law School will welcome students to its new Ph.D. program in law and economics in 2014. And this fall, Yale Law School will welcome students to its new Ph.D. program in law. Other major law schools are likely to follow, offering similar doctoral programs in the coming years.

Law is at the core of public policy and indeed is the bedrock of democratic government; thus, doctoral programs in law will require graduates to apply analytical tools that produce original contributions to knowledge about the causes and effects of a vast array of public policies. As a result, these newly minted PhDs will develop powerful, empirically testable findings that could significantly benefit society by maximizing the benefits and reducing the costs of government intervention in our economics lives.

Since the late 1950s and early 1960s, when faculty at Chicago and Harvard first used quantitative methods to analyze whether economic regulations of various industries were having their intended effects of controlling monopoly pricing, scholars have assessed countless public policies. However, we have little knowledge of the quantitative—and even qualitative—effects of many important policies, especially those where lawyers may benefit at the expense of society at large. Those laws and regulations would therefore be ripe for analysis by law doctoral students due to their in-depth knowledge of the legal system and the various roles that lawyers play in it.

For example, lawyers are central to the resolution of intellectual property disputes. Indeed, lawyers are routinely called upon to write patent applications because applicant companies know that the validity of most patents will eventually be determined in a federal court. While lawyers benefit from a patent system that generates demand for their services, there is little evidence on whether the lawyer-rich patent system provides benefits that outweigh its costs.

There’s also America’s expensive liability system. Lawyers are generally paid on a contingency-fee basis, and because the cost of defending a suit is high, defendants often pay the plaintiffs (and their lawyers) to settle before trial. The cost of the U.S. tort system has been estimated by Towers Perrin to be at least two percent of GDP, but there is little evidence on whether the benefits of this system exceed its cost. Thus policymakers have little guidance on how the system should be reformed to reduce its costs without compromising any incentives it may provide for individuals and firms to behave in a socially desirable manner.

Another example: financial regulation reform in the wake of the Great Recession. Highly-paid lawyers representing various interests have engaged intensely with federal regulatory agencies to shape the implementation of the Dodd-Frank Act. Unfortunately, little scholarly knowledge is available to guide how, if at all, financial regulation should be reformed and how best to prevent a repeat of the events that led to the financial crisis. As a result, the merits of the Act are being strongly questioned and certain policymakers and industry executives are calling for its repeal even before it is fully implemented.

Finally, reform of health care has emerged as one of the most important policy issues of our time. And while research has yet to find a “magic bullet” to lower the costs of the health-care delivery system without significantly reducing the quality of care, lawyers are fully engaged in opposing any measures that would limit their fees or impose caps on damages in medical malpractice cases.

Graduates and faculty of the new doctoral programs in law have an opportunity to fill many gaps in our understanding of the effects of policies that are at the center of their expertise and to explain how the symbiotic relationship between private-sector lawyers and policymakers, who often come from legal backgrounds, have adversely affected policy outcomes.

If lawyers are truly a drag on the nation’s growth in the course of influencing and benefiting from inefficient public policies, then doctoral programs in law have come at just the right time.

Authors

Publication: Forbes

Image Source: Darren Greenwood

American Energy Security and Innovation

Ted Gayer — Tue, 26 Feb 2013 00:00:00 -0500

Chairman Whitfield, Congressman Rush, and Members of the Subcommittee, I appreciate the opportunity to appear here today. My comments will cover the market incentives for energy efficiency innovation, the most cost-effective means of reducing pollution stemming from energy use, and the limitations and problems associated with government energy-efficiency mandates.

Many of the points I will make come from a Mercatus working paper I co-authored with W. Kip Viscusi of Vanderbilt University, which I have submitted along with my testimony. A revised version of the paper is forthcoming in the Journal of Regulatory Economics.

Market prices convey information about the strength of consumer demand for a good and the scarcity of supply for that good, allowing for a balancing of buyers’ and sellers’ interests. In the market for appliances, prices reflect how consumers value features such as energy efficiency and convenience. If the price of energy increases, consumers will be willing to pay more for more efficient appliances, providing a clear incentive to suppliers to respond. The response, in turn, depends on the constraints on production, such as the state of technology. Economists agree that this flow of information between producers and consumers is better achieved through the price mechanism than through government oversight. One important benefit of the market process is that consumers with different preferences can find appliances that best suit their needs. For example, a consumer who lives in a region where energy is inexpensive may prefer appliances that emphasize convenience over energy efficiency compared to a consumer who lives in a region with expensive energy. In short, there is no uniformly “right” amount of energy efficiency in an appliance any more than there is a “right” variety of apple.

However, market prices can provide misleading signals to the extent that they do not account for the pollution costs stemming from energy use. In other words, the price that shows up on one’s electric bill accounts for the private cost of energy, but it does not include the additional environmental damages that impact others due to one’s energy use. Economists refer to these latter costs as “negative externalities.” The best approach to addressing this problem of negative externalities is for the government to price these pollution costs directly. Consumers and firms would then face the full cost of energy use, and markets would respond through some combination of new technologies, alternative fuels, and conservation.

There are a number of reasons why the market-oriented approach of setting a price on pollution is more cost-effective than regulations such as energy efficiency mandates. First, the one-size-fits-all energy efficiency mandates ignore the substantial diversity of preferences, financial resources, and personal situations that consumers and firms must align in order to make their decisions. Second, unlike a price set for pollution, energy efficiency mandates do not promote conservation. Indeed, they lower the cost of using an appliance, reversing some of the energy savings. For example, an energy efficiency standard for air conditioners increases the incentive to run the air conditioners longer. Third, energy efficiency standards apply only to new products, which can create incentives for consumers and firms to retain older (and thus less energy-efficient) products.

Kip Viscusi and I examined a number of recent government regulations that mandate energy efficiency standards for vehicles and appliances. Despite the fact that these regulations are frequently touted as pollution-reducing initiatives, the agencies’ own estimates confirm that the environmental benefits are negligible and are often dwarfed by the societal costs they impose.

In order to justify these expensive regulations, the agencies assert that consumers and firms are making irrational purchase choices and that they therefore benefit if product choices are restricted to those that meet the agencies’ mandated standards. Dismissing consumer preferences as irrational is a significant departure from well-established tenets for conducting cost-benefit analyses set forth in the economics literature and by the administration’s Office of Management and Budget.

By claiming regulatory benefits from the correction of so-called “consumer irrationality,” agencies are shifting regulatory priorities from the important goal of reducing the harm individuals impose on others (through pollution) towards the nebulous and unsupported goal of reducing harm individuals cause to themselves by purchasing purportedly uneconomic products. This shift from environmental protection to consumer protection results in a host of costly regulations that are far less effective than a government policy that simply sets a price for pollution. It also establishes a dangerous precedent: If agencies can justify regulations on the unsubstantiated premise that consumers and firms (but not regulators) are irrational, then they can justify the expansive use of regulatory powers to control and constrain virtually all choices consumers and firms make.

To summarize: I believe that markets generally work well to provide incentives for energy efficiency and to satisfy consumers’ diverse tastes. To the extent that energy prices fail to incorporate the environmental cost of energy use, the most sensible government response is to price the pollution costs directly, and then allow consumers and businesses to respond to the higher prices. Regulations and mandates are inferior policies, but still may be better than doing nothing if the benefits exceed the costs. Unfortunately, by the agencies’ own estimates, energy efficiency mandates frequently lead to minimal environmental benefits that are far less than the costs. In an effort to justify these uneconomic regulations, the agencies have deviated from well-established economic tenets by asserting that consumers and firms are “irrational” and that they therefore benefit from government mandates that restrict choice. The evidence for this view is weak, and assuming that citizens are not capable of making sensible decisions that affect their own pocketbooks is not the right way to advance the important goal of enhancing the quality of our environment.

Authors

Ted Gayer

Publication: Subcommittee on Energy and Power, Committee on Energy and Commerce

Higher Bank Capital Requirements Would Come at a Price

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

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

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

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

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

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

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

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

The core of agreement

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

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

The first area of disagreement: tax effects

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

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

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

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

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

The second area of disagreement: government guarantees

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

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

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

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

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

Third area of disagreement: efficiency of capital-raising

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

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

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

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

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

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

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

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

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

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

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

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

The fifth area of disagreement: transitional effects

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

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

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

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

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

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

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

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

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

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

How big might the trade-offs be?

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

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

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

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

References

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

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

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

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

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

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