http://www.kansascityfed.org/publicat/speeches/Restructuring-the-Banking-System-05-24-11.pdf

Restructuring the Banking System to Improve Safety and Soundness

Federal Reserve Bank of Kansas City

Prepared by

Thomas M. Hoenig

President and CEO

Charles S. Morris

Vice President and Economist

May 2011

Reforming the shadow banking system

• Restricting the activities of banking organizations alone, however, does not completely

address the stability of the financial system. In fact, it could worsen the risk of financial

instability by pushing even more activities from the regulated banking sector to large,

interconnected securities firms, which would expand the sector that was an integral part of

the financial crisis.

• As previously discussed, the source of this instability is the use of short-term funding for

longer-term investment in the shadow banking market, i.e., the maturity and liquidity

transformation conducted by a lightly regulated/unregulated sector of the financial system.

We believe this source of systemic risk can be significantly reduced by making two changes

to the money market.

• The first recommendation addresses potential disruptions coming from money market

funding of shadow banks – money market mutual and other investment funds that are

allowed to maintain a fixed net asset value of $1 should be required to have floating net asset

values.

- The primary MMIs today are MMMFs and repo (ABCP has largely disappeared as a

funding instrument for financial companies since the financial crisis). Individuals,

institutional investors, and nonfinancial companies are the primary holders of MMMF

and other MMI funds with a $1 NAV, which in turn are major investors in repo along

with other financial companies.

- Some have suggested that MMMFs should be backed by government guarantees. We see

no reason why the safety net should be extended and the taxpayer put at risk when other

solutions are feasible. In addition, providing government guarantees would require

prudential supervision to prevent excessive risk taking, but it would not be effective

because of the ability of funds to rapidly shift their risk profiles.16

- The runs during the crisis on MMMFs occurred because of concerns about the quality of

their investments and because of the promise to maintain a $1 NAV. MMMF investment

rules have been strengthened by increasing the minimum average quality and decreasing

the maximum average maturity of their investments.

• Critics of eliminating a $1 NAV for MMMFs argue that this limits cash management options

for large corporations. However, MMMFs were first introduced to evade interest rate

ceilings on deposits, and the only remaining Regulation Q deposit rate ceiling – the

prohibition of paying interest on business transactions deposits – was eliminated by the

Dodd-Frank Act. Some may be concerned that their deposits will be largely uninsured, but

they were uninsured when invested in MMMFs.

However, because of the

difficulty in calibrating these requirements, it is not clear that the vulnerability of

MMMFs to runs in a systemic event would be significantly reduced as long as the $1

NAV is maintained. We believe reliance on this source of short-term funding and the

threat of disruptive runs would be greatly reduced by eliminating the fixed $1 NAV and

requiring MMMFs to have floating NAVs.

• The second recommendation addresses potential disruptions stemming from the repo

financing of shadow banks – the bankruptcy law for repurchase agreement collateral should

be rolled back to the pre-2005 rules. This change would eliminate mortgage-related assets

from being exempt from the automatic stay in bankruptcy when a borrower defaults on its

repurchase obligation.

- One reason for the runs on repo during the crisis was because of the prevalence of repo

borrowers using subprime mortgage-related assets as collateral. Essentially, these

borrowers funded long-term assets of relatively low quality with very short-term

liabilities. The price volatility of subprime MBS rose sharply when subprime defaults

started reducing MBS income flows. As a result, haircuts on subprime repo rose sharply

or the repo was not rolled over.

- The eligibility of mortgage-related assets as collateral exempt from the automatic stay in

bankruptcy in case of default by the borrower is relatively recent. The automatic stay

exemption allows the lender to liquidate the collateral upon default as opposed to having

to wait for the bankruptcy court to determine payouts to secured creditors.

- Prior to 2005, collateral in repo transactions eligible for the automatic stay was limited to

U.S. government and agency securities, bank certificates of deposits, and bankers’

acceptances. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

expanded the definition of repurchase agreements to include mortgage loans, mortgagerelated securities, and interest from mortgage loans and mortgage-related securities. This

meant that repo collateralized by MBS, CMOs, CMBS, and CDOs backed by mortgagerelated assets were exempt from the automatic stay.

Some of the new rules for MMMFs are: 30 percent of assets must be liquid within one week, no more than 3

percent of assets can be invested in second-tier securities, the maximum weighted-average maturity of a fund’s

portfolio is 60 days, and MMMFs have to report their holdings every month.17

- We believe the threat of runs by repo lenders would be significantly reduced by rolling

back the bankruptcy law for repurchase agreement collateral to the pre-2005 rules.

• Overall, these two changes to the rules for money market funds and repo would increase the

stability of the shadow banking system because term lending would be less dependent on

“demandable” funding and more reliant on term funding. Term wholesale funding would

continue to be provided by institutional investors such as mutual funds, pension funds, and

life insurance companies. While this might increase the cost of funds and, therefore, the cost

of mortgages and other consumer loans, it would be less risky and more reflective of the true

costs.

Alternative proposals

• A variety of alternative policy reforms, which are not necessarily mutually exclusive, have

been proposed to improve the stability of the financial system. These proposals address the

structure of banking organizations (size limitations), bank regulation and supervision

(stronger resolution authority, stronger capital regulation, systemic risk fees, improved

supervision) and institutional changes (government guarantees for repo similar to deposit

insurance).

• Size limit

- Banking organizations have been prohibited from merging if the new company would

hold more than 10 percent of national deposits since 1994, and the Dodd-Frank Act

prohibits mergers of financial companies if the new company would hold more than 10

percent of financial industry liabilities. These provisions do not limit organic growth.

- We are not in favor of a strict size limit because it is not clear what the size limit should

be or how it should change over time.

• Resolution authority (would only address the too-big-to-fail problem and not systemic risk

more generally) – the Dodd-Frank Act includes a provision for resolving systemically

important companies.

- We believe resolution authority is necessary but it may not be sufficient for very large,

complex financial institutions. The resolution authority is too political because the

Treasury secretary makes the final decision to close a failing company as opposed to

independent supervisory authorities.

- But even if it were up to the supervisory authorities, it is not clear they would use it when

faced with the failure of a systemically important company. Liquidating a large and

complex financial company will always impose costs and disruptions even under ideal

circumstances, but is more likely to cause systemic problems. Given the tradeoff

between costs and economic disruption that are large, highly visible, and immediate

versus benefits that may take years to be recognized, the more likely scenario is that

regulators will choose to bail out the company. This decision is even more skewed to

avoiding the short-run costs because of pressures on regulators from politicians and the

big banks. 18

• Improve capital regulation – this is the approach taken by the Basel Committee in developing

the Basel III capital requirements. The Dodd-Frank Act also has provisions to improve

capital regulation.

– Basel III attempts to correct the problems with Basel II and is an improvement. It

increases the minimum capital requirement (capital to risk-weighted assets), introduces a

leverage ratio and capital conservation buffer, tightens restrictions on what counts as

capital so that common equity is the predominant source of capital, improves the

treatment of off-balance-sheet exposures and funding, and includes a proposal for

counter-cyclical capital requirements.

– Some countries require an even higher minimum capital requirement than the

recommended 7 percent (Tier 1 common equity base plus capital conservation buffer) in

Basel III. For example, Switzerland is requiring a 10 percent Tier 1 equity risk-based

ratio and a 19 percent total capital risk-based ratio. The preliminary report of the U.K.’s

Independent Commission on Banking, the Vickers report, also recommends a 10 percent

Tier 1 common equity risk-based capital requirement for British banks.

– Nevertheless, we do not believe Basel III capital rules will be effective largely because of

the complexity of the largest financial companies and the variety of their activities. The

complexity and variety of activities requires complex, risk-based capital rules, which

were reflected in the 1996 revision to Basel I and the 2004 Basel II requirements.

However, the requirements depend on regulators setting relative prices in the form of risk

weights for the various asset classes, or for the firms to set their own requirements based

on internal model risk calculations. Basel III is an extension of these previous standards,

and the underlying problems causing instability remain. In addition, the leverage ratio is

based on Tier 1 capital instead of common equity and is only 3 percent. Stronger

minimum leverage ratios have been recommended by economists and some regulators.

– The Dodd-Frank Act requires regulators to set more stringent capital requirements for

BHCs and FHCs with more than $50 billion in assets and nonbank financial companies

determined to be systemically important than for other banking organizations. The

capital requirements, however, are based off the Basel III requirements.

• Systemic risk fee

- These proposals are based on the traditional economic policy of taxing externalities.

Market data on financial companies and historical data on financial crises are used to

assess the expected cost of financial crises and the individual contributions of financial

institutions to these costs. Based on these estimates, a fee is charged so that financial

institutions internalize the systemic impact of their decisions.

The New York University Stern School of Business Vlab project proposes a method to assess the systemic

relevance of financial institutions.

Presumably, the fee

would also account for the increased systemic risk of being too big to fail. By charging

the appropriate fee, companies would reduce or even divest activities that are no longer

profitable.19

- Charging a fee clearly is an appropriate policy option, but we believe it would be very

hard to implement in practice for the same reasons as implementing the risk-based capital

requirements along the lines of Basel II. It is extremely hard in practice to calibrate the

risk-weights and fees in such a way that the banks are not able to arbitrage them away. In

addition, because it is impossible to always charge the right fee on a continuous basis,

some firms will still end up taking too much risk. While the likelihood of a crisis would

be reduced, the cost of a crisis may still be too large.

• Improve supervision

- The Dodd-Frank Act made the Federal Reserve the consolidated supervisor for BHCs and

FHCs with more than $50 billion in assets and nonbank financial companies determined

to be systemically important. The Act also requires the Federal Reserve to establish more

stringent prudential standards for these organizations than for other banking

organizations.

- We do not believe enhanced supervision will be effective without restricting the activities

of the largest financial companies. First, there is evidence that the largest financial

companies did not fully understand the extent of their risk exposures for a variety of

reasons.

- Second, many of the activities that pose the greatest risks to the organization and to the

broader financial system and economy are not conducive to prudential supervision

because of the short-term nature of the risks. As noted earlier, activities that have high

short-term risks cannot be effectively monitored because supervision and regulation

occurs periodically at potentially irregular intervals.

If the organization does not fully understand the risks, it is infeasible for the

regulatory authority to understand the risks and effectively supervise the organization.

- Essentially, the overall regulatory system for the largest financial companies broke down

by not keeping up with the evolution of the financial system. Commercial and

investment banking organizations began engaging in activities that the market, bank

management, and regulators cannot assess, monitor, and/or control very well. As a result,

expanding supervision to the same activities that cannot be supervised well will not fix

the problem.

• Guaranteeing repo – a variety of proposals have been made, many of which include

provisions to limit government liability, such as limiting collateral to very safe securities and

charging a fee.

- The idea behind this approach is that repo is a primary source of funds for much of the

shadow banking system, but also provides value to large financial and nonfinancial

companies that have a demand for repo because they want a risk-free asset for cash

management purposes and bank deposits are only insured up to $250,000.

The Senior Supervisors Group provides a number of reasons for poor risk management practices in complex

financial institutions in the March 2008 report “Observations on Risk Management Practices during the Recent

Market Turbulence.”

Gary Gorton and Andrew Metrick propose a system of insurance for money market mutual funds combined with

strict regulation of securities used as collateral in repo transactions in “Regulating the Shadow Banking System.”20

- We see no reason why the government and taxpayer should step in and insure positions

taken by sophisticated investors with abilities to analyze the risk of securities that back

their loans. Therefore, there is no rationale for the government to provide guarantees even

in exchange for heavier regulation and supervision of repo markets.