Brookings Event on Liquidity and the Role of the Lender of Last Resort
On April 30, the Brookings Institution held an event entitled “Liquidity and the Role of the Lender of Last Resort” where industry experts, academics, and government officials discussed issues related to: the function and liquidity adequacy of banks; the liquidity coverage ratio, net stable funding ratio, and short-term wholesale funding market reform; liquidity needs in the post-crisis world; and liquidity provision for bank resolution.
In his opening remarks, Martin Neil Baily, Senior Fellow of Economic Studies at Brookings, stated that liquidity is not just an “inside the beltway” issue because it affects the entire economy. He said that the economics profession was largely unprepared for the financial crisis of 2008 and that it was questionable whether economists had an adequate understanding of how the financial sector impacts the broader economy. Baily also said that a “whack-a-mole” theory of regulation, where regulators hit down anything that pops up as risky, has caused the “pendulum” of regulation to swing too tight.
Session 1 – Lender of Last Resort: Examining the Function and Liquidity Adequacy of Banks
Presentations
Donald Kohn, former Vice Chairman of the Board of Governors of the Federal Reserve (Fed) and Senior Fellow of Economic Studies at Brookings, said a critical function of central banks is to limit panics and fire sales through their lending capabilities and worried that the new restrictions on the Fed’s 13(3) lending authority may prevent it from taking the helpful actions that it did in the last crisis. He explained that these new restrictions: 1) require approval of the Treasury Secretary, which could lead to political influence; 2) emphasize security of repayment and value of collateral; and 3) send the names of any firms who receive loans to Congress, which may lead to a negative stigma and a reluctance of firms to seek this liquidity.
Mark Flannery, BankAmerica Professor of Finance at the University of Florida, said current regulations are trying to cut back on the excessive credit intermediation that occurred before the crisis. He expressed regret at a lack of cost-benefit analysis that shows the benefits outweigh the costs of new liquidity requirements. He called the liquidity coverage ratio (LCR) a “coarse, blunt instrument” and said the rule would lead to costs resulting from rearranging the priority of claims on bank assets while creating more incentives for runs on banks.
Flannery also said “shadow intermediation” would increase as banking intermediation is restricted and said lawmakers should change the bankruptcy law so that information intensive assets do not apply to a bankruptcy stay. He added that capital and liquidity ratios “ought to be related.”
John Dugan, Partner at Covington and Burling, said liquidity was critical to the problems seen in the financial crisis and said that on the “scorecard of liquidity tools” the government preserved three important tools, added two, and eliminated or restricted four.
Dugan elaborated that the tools that were preserved were: 1) the Fed’s discount window for depository institutions; 2) deposit insurance; and 3) some aspects of emergency discount lending to non-depository institutions. The tools added, he said were: 1) an orderly liquidation fund (OLF) to provide emergency liquidity to resolve failing large financial institutions, which he said is very important; and 2) requirements for banks to hold more liquidity, which he said has potential collateral consequences. The tools which were removed or restricted, he continued, were: 1) the exchange stabilization fund to guarantee money market funds (MMFs); 2) systemic risk exception power of the Federal Deposit Insurance Corporation (FDIC) to open institutions related to banks, which now needs Congressional approval; 3) restrictions on lending to non-depository institutions; and 4) the encouraging of stronger institutions to buy weaker ones in a time of crisis.
Dugan said the temporary liquidity guarantee program should be restored without needing Congress and that the Fed’s emergency lending powers should not be cut back. He also suggested that broker-dealers and investment banks be provided with the kind of liquidity given to banks as they are also subject to runs in short term funding markets, but noted that this would come with additional regulatory restrictions.
Darrell Duffie, Dean Witter Distinguished Professor of Finance at Stanford University, questioned why 13(3) overly limits the ability of the Fed to provide liquidity to non-bank broker-dealers, saying that they are systemic and can fail from a lack of liquidity. He explained that the Fed would have to “sit on its hands” until the crisis spread and a number of non-banks got into trouble. He noted that the Fed can stand in and provide liquidity for central clearing parties, contingent on all private sources of capital being unavailable.
Charles Calomiris, Henry Kaufman Professor of Financial Institutions at Columbia University, said liquidity crises are always driven by insolvency crises and that the regulatory error of the last financial crisis was not reacting to a two-year decline in the creditworthiness of financial institutions.
Calomiris said the separation of liquidity from capital standards is “idiotic” and that the regulatory framework needs to define the extent of substitutability between capital and liquidity, as well as its limits. He also stressed the importance of a cash buffer and said if capital and cash requirements are set correctly then systemic risk can be avoided. He concluded that an ad-hoc policy is worse than defined sets of rules.
Panel Discussion
David Wessel, Director of the Hutchins Center on Fiscal and Monetary Policy, expressed surprise at the apparent consensus of the panelists in the presentations that the Fed and its lender of last resort function has too much restriction under the new structure. He then asked the panel if the rules on self-insurance and requiring banks to hold liquidity have gone too far and if banks should hold more cash.
Calomiris said the rules “could do a lot better” in fixing the inability of banks to roll over their debt in a crisis environment and added that banks should hold 10 percent of assets as equity, 10 percent as contingent convertibles (CoCos), and 20 percent as cash held at the Fed.
Dugan disagreed with these suggested levels and said there is a difficult trade-off in self-insurance between making banks safer and taking money away from contributing to the economy.
Calomiris worried the Basel requirements for liquidity are not as good of a buffer as a cash ratio would be and added that while holding cash has a cost, it would not be a prohibition on lending because a bank could scale itself up.
Flannery said regulations have gone too far and have become “horribly burdensome.”
Wessel then asked what the cost would be of banks holding too much liquidity.
Flannery responded that there would be less lending in general and that there would be a risk of creating safer banks while lessening the overall safety of the financial system. Kohn said he did not know yet whether the rules have gone too far, but regulators have to be careful about activity migrating outside banks to the shadow financial system.
Next, Wessel asked what role bankruptcy plays in the regulatory structure.
Duffie noted that Chapter 14 of the bankruptcy code is being looked at to allow failing financial firms to be dealt with more quickly and to change the treatment of qualified financial contracts. Kohn added that the international aspect of bankruptcy will be very important and that reform should be done on a global basis. He added that there is still a role for the orderly liquidation authority (OLA) in Title II of the Dodd-Frank Act as systemically important financial institutions (SIFIs) cannot be dealt with in normal bankruptcy proceedings.
Wessel asked if the drive for transparency creates a stigma for firms that prevents them from acting in their best interests and going to the Fed for liquidity.
Duffie said he did not think going to the Fed created a stigma in the past and that it would likely not be a problem in another crisis situation. However, he said, if there was a one-off situation where one firm needed a lender of last resort then there would be a stigma.
An audience member asked how one can tell when an institution is insolvent and how regulators can determine who to lend to.
Calomiris said what matters is when the markets doubt an institution’s solvency and that the Fed should look to keep firms’ market value ratios above 9 or 10 percent to avoid lending to an insolvent institution.
Kohn said insolvency is very hard to tell and that a lot depends on what prices are in the market at the time. He added that there is not a lot of good data to make this determination.
Another member of the audience asked about the Fed’s actions of lending to other central banks during the crisis, to which Kohn replied that these international swap lines were very important. He added, however, that the International Monetary Fund (IMF) would do better to make this decision than the Fed but noted that it has more conditions on its credit.
A different audience member asked how the government can take a long-run view of the financial system when politicians are always thinking about reelection. Dugan said the government should respect the independence of Federal agencies and noted that political concerns have been problematic as they have prevented technical fixes and adjustments to the Dodd-Frank Act.
Session 2 – Liquidity Coverage Ratio, Net Stable Funding Ratio and Short-Term Wholesale Funding Market Reform
In his opening remarks, Douglas J. Elliott, Fellow of Economic Studies at Brookings, explained that banks make illiquid long term loans while taking short term deposits and thus liquidity concerns matter, as was evidenced in the crisis. He noted that the LCR in Basel III will be effective in 2015 and the net stable funding ratio (NFSR) will be effective in 2018.
Presentations
Mark Van Der Weide, Deputy Director of the Division of Banking Supervision and Regulation at the Fed, said liquidity regulations are needed to solve market failures of self-insurance and inter-bank lending in the private markets. He said the business of banks requires maturity transformation which could lead to rapid outflows of capital and that while banks will naturally keep some liquid assets, their normal levels are not socially optimal.
Van Der Weide said that the government should not rely on inter-bank markets and that it would be “imprudent” to think that banks will lend to potentially insolvent firms as they are often opaque. He also said positions of banks are strongly correlated with one another as they are increasingly interconnected and thus when one firm is stressed all other firms are likely to be stressed.
He said the two ways to address this issue are through central bank lending and banking regulation and that the reasons to not rely just on central bank lending are: 1) legal limits on who can borrow from the Fed; 2) moral hazard; and 3) risks for taxpayers.
Van Der Weide said the Basel III liquidity rules are important on the micro level to level the global playing field and on a macro level to increase financial stability by reducing the likelihood of a SIFI failure. He added that some of the limitations of the Basel III rules are that they do not address: 1) broker-dealers, MMFs, or shadow banks; 2) maturity mismatch; 3) liquidity adequacy of each branch; 4) currency mismatches; 5) penalties on matched books; 6) high quality liquid assets (HQLA), such as covered bonds, municipal bonds (munis), and mortgage backed securities (MBS); 7) a slow transition path; and 8) favorable treatment of central bank lending.
He also mentioned that amendments to the NSFR would address: 1) stable funding extension to credits for matched books; 2) six-month maturity lines; 3) an accelerated transition path; 4) excluded definition of illiquid assets for private label MBS and 6) maturity mismatches within a 30-day window.
He noted that the Fed cannot regulate every liquidity risk and thus supervision will be the first line of defense to fill regulatory gaps and mitigate risks. He also said regulators need to be willing to change rules “in the face of new learning.”
Van Der Weide noted that the Fed’s next goal is to address short term funding through capital surcharges and minimum margin requirements.
Marc Saidenberg, Principal at Ernst & Young LLP, said he does not believe that the liquidity regulations should be seen as a statement that there is no role for public sector support of financial institutions. He noted that there is a trade-off between complexity that comes from being risk sensitive and striving to have simplicity in the regulations, adding that the funding markets are “more complicated than the rules give them credit.” He noted a need to deepen the shared understanding of activities and enhance data and to compare market activities with regulatory objectives.
Paul R. Ackerman, Senior Executive Vice President and Treasurer of Wells Fargo & Company, said he is a proponent of banks having an “ample amount” of liquidity as he has a “healthy respect” of bank runs. He stated, however, that some parts of the LCR need to be fixed and that the rules have not been subject to a good cost-benefit analysis that considers trade-offs. For example, he continued, the LCR creates disincentives for banks to finance municipalities as the LCR requires assets to be held for the length of muni deposits. He also said the limitation on agency securities in HQLA should be eliminated as it is not based in data.
Ackerman said the administration of the LCR is increasingly complex, citing that 20,000 data elements on liquidity must be sent to the Fed and that this number will increase by four or five times in the future. He said this increase in complexity will decrease the rule’s efficacy.
Adam Gilbert, Managing Director at JPMorgan Chase & Co, said “a lot has been accomplished” and more will come in terms of bank resiliency. He noted that: capital has doubled; leverage has been sharply reduced; HQLA holdings have increased; stress tests are in place; intraday credit in the tri-party repo market has been reduced by $1 trillion; and structural liquidity has increased. He said other areas to address are: 1) standardized haircuts; 2) interim tenors between 30-365 days; 3) increasing availability of repo clearing of liquid assets; 4) stressed market capacity analysis in risk profiles; and 5) applying policies to all significant market participants.
He cautioned regulators about the concept of “bad deposits” in their classification of operational and non-operational deposits, saying banks will not want to take non-operational deposits. He also raised question with how leverage and liquidity will interact. He concluded that pricing, structure, and availability of products will change under the new requirements.
Discussion
Elliott began the discussion by asking what the cost-benefit calculations have been to date on these new requirements.
Van Der Weide said cost-benefit analysis is “hard to do” but that the Fed tries to “quantify both sides” and look at the intersections and synergies of its rules. He noted that the calculation of benefits is more difficult and the Fed uses more qualitative factors. Van Der Weide said the Fed found “net benefits socially to the economy” for the LCR and NSFR.
Saidenberg said it is easier to project immediate costs than longer term benefits and that regulators must make judgments on projected outcomes. Gilbert added that it is important to be “upfront on intended outcomes” and that policies are hard to fix once they are in place.
Elliott then asked how banks will react to the new requirements.
Gilbert said banks will change the product, structure, and availability in lines of credit and that “deposits may end up getting eschewed or turned out.” Ackerman said that Wells Fargo will keep more cash on its balance sheet and increase the cost of credit and risk taking as there will be fewer deposits to deploy.
Elliott then asked if there is real value to maturity transformation as a whole, to which Gilbert replied that the banking model of maturity transformation has been successful at promoting economic growth.
A member of the audience asked what the optimal mix of tools would look like to reduce vulnerability to runs.
Van Der Weide said that while there is a “decent argument” that capital rules can address banking problems, he is “not convinced” that the LCR and NSFR are enough for short-term funding concerns as these issues go “well beyond the banking system” and the Fed’s regulations are bank-centric. He then noted the importance of margin requirements for derivatives markets and securities financing transactions.
Saidenberg added that regulators should tailor their rules and not be afraid to change rules that have already been completed.
When asked by an audience member why the cap on agencies securities in HQLA should be eliminated, Ackerman said these products were very liquid in the financial crisis. Gilbert agreed that the cap should be removed and suggested that there could be a haircut applied to these securities.
Another audience member asked how the LCR would affect banks’ appetites for deposits, to which Gilbert replied that banks may change their structures and have less of an appetite for deposits. Ackerman said that the requirements will not change Wells Fargo’s appetite for customer deposits and that he does not think there are “bad deposits.”
Next, an audience member asked about differences in definitions across different countries. Van Der Weide said that the Basel group is working to make sure countries implement the requirements effectively and faithfully, but noted the challenge of having global applicability. Saidenberg added that firms that are subject to regulations in multiple countries will have higher costs.
Keynote Address by Mary Miller
Mary Miller, Under Secretary for Domestic Finance at the U.S. Department of the Treasury, stated that since the financial crisis there has been a focus on capital, but said liquidity can be even more important. She noted that there are different ways of thinking about liquidity including: 1) liquidity of financial instruments or the measure of ease that assets can be converted into cash; and 2) liquidity of institutions which is results from the liquidity of the assets that a financial institution holds.
Miller said that liquidity stress tests should consider specific aspect of assets as well as market conditions and noted that if many institutions need to sell their safe assets in times of stress, there will be price impacts. She said the new liquidity requirements along with central clearing margin requirements will increase the need for HQLA by several trillion dollars, but noted an estimate by the Bank of International Settlements (BIS) that stated the available supply will be several times larger than this demand. Another consideration Miller mentioned is that the supply of safe liquid assets will decrease as countries’ deficits decline.
Miller said that floating rate notes were the first new product from the Treasury in 17 years and will help with liquidity needs. She also mentioned the reverse repo program as a possible substitute source of safe assets, but noted these cannot be rehypothecated and used for margin or collateral.
Question and Answer
Baily asked Miller if she is concerned with the ability of small and medium-sized enterprises to receive capital.
Miller replied that this is a legitimate concern as the new regulatory landscape has been a problem for less-liquid securities.
Baily then asked about limitations to lending options including the exchange stabilization fund and if Miller has any concerns about the restrictions.
Miller replied that the distinction between being credit-impaired and liquidity-impaired is important and that the exchange stabilization fund was intended to be used in currency crises and should not be broadly available. She continued that part of the problem in 2008 was that the market did not know the rules of the road, but that now there is more clarity on how things will work in a crisis.
Baily asked if credit has been curtailed or if there is just a reluctance to borrow.
Miller said that the data is unsatisfactory and not granular enough to know, but noted that there has been an increase in the number of initial public offerings (IPOs) recently.
Baily then asked Miller if derivatives trading may be shifting overseas as a result of U.S. rules.
Miller said that the U.S. is still in the early days of setting up swap execution facilities (SEFs) and that Europe is still “ironing out” its regulations. She noted that the U.S. regulations extend “a lot of time relief to allow other countries to catch up.”
A member of the audience asked what Miller thought about the issue of asset managers being reviewed by the Financial Stability Oversight Council (FSOC), to which Miller said the review is in its early stages. She added that no judgments or decisions have been made and that the review is “just a deep dive to understand the players and activities” in this heterogeneous industry.
Baily followed up and asked to what extent asset managers are systemic. Miller said that “for the most part” asset managers act as agents rather than principals, but risk can arise if there is a “stampede” out of an asset class. She added that the Treasury is seeking to understand how assets are deployed.
Session 3 – Liquidity Needs in the Post-Crisis World and Liquidity Provision for Bank Resolution
Presentations
Randall D. Guynn, Partner at Davis Polk & Wardwell, said that the FDIC’s single point of entry (SPOE) strategy for resolving a failing global systemically important bank (GSIB) has been endorsed as the most promising solution to the issue of “too big to fail.” He noted that the SPOE features include: 1) the parent company being put into receivership through bankruptcy; 2) parent company resources used at its subsidiaries; 3) operating subsidiaries being kept open; and 4) long term unsecured debt at the parent company being used as a debt shield of short term debts.
He said the success of the SPOE depends on the parent having loss absorbing resources “on both sides of the sheet” and explained that a bridge financial company would be established containing all the failed parent company assets, while leaving behind all claims. He said the SPOE can quickly separate a failed institution into “a good bank and a bad bank.” This good bank, Guynn continued, must have access to capital for the SPOE to be successful, but noted it may be a challenge for the private sector to provide this capital in a crisis. He said that if there is no lender of last resort in this situation then “bailouts will be inevitable.”
Guynn added that the restrictions on 13(3) could make it more difficult for the Fed to lend to this good bank and said the Fed should be given clear authority to lend under the SPOE strategy in the bankruptcy code.
Paul H. Kupiec, Resident Scholar at the American Enterprise Institute, said that “hard wired liquidity rules are expensive” and added that he “can’t see how [they] won’t lead to reduced credit and reduced intermediation.” He presented an idea that the Fed sell “systemic liquidity options” where the Fed would auction a one month option and allow the holder to “repo collateral overnight” with the Fed. He suggested that the Fed take bids from dealers and the shadow financial institutions and use prices on the secondary market to anticipate liquidity problems. He added that the LCR and NSFR would have to be adjusted to give credit for liquidity options.
Paul Saltzman, President of The Clearing House Association, said that regulators are too often focused on the resiliency of intermediaries rather than the resiliency of the markets themselves. He said implementation of the LCR and NSFR may be accelerated by the marketplace and called the rules “very prescriptive.” He expressed concern with disclosure impacts, as they may be a self-fulfilling prophecy that leads to bank runs; and also with the Fed’s liquidity stress tests becoming a binding constraint.
Saltzman stated that the political environment re-characterized the lender of last resort action as a bailout, but stressed that it is important not to conflate these two ideas.
Marcus Stanley, Policy Director of Americans for Financial Reform, said that he does not believe Dodd-Frank has restricted the lender of last resort function. He said that it has changed the structure of the Fed’s authorities and may have even increased its abilities. He noted that the law added new avenues for liquidity assistance including: 1) a Treasury line of credit for the OLA; 2) discount window access for non-bank financial utilities; and 3) having no restrictions on 13(3) for duration, solvency, and the definition of “broad-based.” Stanley added that the SPOE commitment to keep subsidiaries open with a Treasury line of credit has an “effectively unlimited” pay-back timeline for OLA funds.
Steven H. Strongin, Head of Goldman Sachs Global Investment Research at Goldman Sachs, said the reason there has not been very much push back from banks on the LCR and NSFR is because the requirements reflect how banks view their liquidity. However he said that if there is a “formal, bright line” on how much liquidity to hold, it may make it more difficult to hold that amount, adding that this could turn into a best practice becoming a binding constraint.
Strongin said that regulations have reduced the probability of a 2008 style crisis, where banks lost liquidity, but have increased the probability of a 1987 style crisis where the markets ran out of liquidity, saying funding problems at banks will be replaced by market liquidity problems. He added that the requirements will keep the risks in the real economy as risk will be not eliminated but only transferred.
Discussion
Kohn began the panel discussion asking how various regulations negative impacts, such as the Volcker Rule and leverage ratio, can be ameliorated.
Strongin said that problem of the new regulations is their cumulative effect and trying to figure out what the binding rules are for each asset. He explained that the Comprehensive Capital Analysis and Review (CCAR) and Volcker Rule penalize firms where assets are warehoused and thus the willingness to warehouse for a client is reduced.
Saltzman questioned what would happen when “everyone is rushing to HQLA” and how liquidity of non-high quality assets would be impacted. He noted that the private sector determination of quality is being replaced with a government determination.
Kupiec said that the stricter the LCR is, the more activity will go into the shadow banking sector, noting that overnight repo markets serve a purpose.
Strongin said for short term instruments there is no risk information to analyze and thus long term risk data must be applied to short term products.
Guynn stated that if banks are forced to over-insure then corporate America may self-insure as well if they think that they cannot get liquidity from banks, causing a “costly overhang on the economy.”
Strongin then pointed out that after the crisis large firms have been able to fund themselves more cheaply through the bond markets, while smaller firms, who rely on banks, have had to pay relatively higher prices. He also noted that there may be issues in the short term bond market after the SPOE is employed depending on how long it takes the buy side to get comfortable with the end results.
Kohn then asked what can be done to change the political discourse and improve the education process about the financial industry.
Saltzman said that the banking industry “needs to show more humility” and “recalibrate their approach to opposing new regulations.” He said that the industry has been vilified for 2,000 years and that the sector must present a value proposition and stress their important role in lending and employment. Guynn added that the banking industry should support a better economy as people are less apt to vilify banks if they are happy with their jobs and future prospects.
A member of the audience asked if the liquidity rules were “going overboard” and if they are pushing the problem into the real economy. Strongin said that the current approach to liquidity requirements is unnecessary and that the “belt and suspenders” regulations do not address the underlying transparency issues.
Stanley said the issue with short term funding is that the market, while generating money for those involved, is unstable and fragile, adding that the industry has let “money creation get away from us a bit.”
When asked about the liquidity option plan, Kohn noted that the Fed used a similar plan for the “Y2K” preparations, where they sold options to get liquidity on the first business day of the year 2000. He expressed concern, however, with doing something like this more broadly for non-banks as it may create moral hazard.
Keynote Address – Ben Bernanke
Ben Bernanke, former Chair of the Federal Reserve and Distinguished Fellow in Residence for Economic Studies at Brookings, described the “rich man’s panic” of 1907 to illustrate the five standard stages of a financial crisis: 1) losses, especially to important financial institutions; 2) runs on banks, where depositors pull their money out; 3) fire sales, or dumping assets and causing prices to drop; 4) contagion; where interconnections cause prices to drop at many institutions; and ) economic impact, when credit and transactions are negatively affected causing a recession.
Bernanke said that the original mission of the Fed was to be a lender of last resort, thus lending freely but at a penalty rate. The spirit of this function, he continued, is to lend against a broad range of assets while charging a penalty rate high enough to prevent moral hazard but lower the “fear rate” of the market.
He said the 2008 crisis met these five traits of a panic, noting: 1) losses in real estate assets held by financial institutions; 2) runs on wholesale funding; 3) fire sales of assets and stocks; 4) contagion throughout the financial system; and 5) the recession that followed. Bernanke said that the Fed was slow to recognize the crisis because the runs were not from depositors but rather they were “invisible runs” of repos and commercial paper.
He said there are important concerns since the crisis with the changes in the financial system, as some of the legal authorities of the Fed have changed. He noted that 13(3) cannot be used to address a single firm and that Treasury must sign off on these actions. He also said that the tougher repayment standard and disclosures make sense from a taxpayer perspective but may make it more difficult for the Fed to be effective in another crisis.
Discussion
When asked how liquidity requirements should be designed, Bernanke explained that stress testing has become an important part of assessing liquidity, noting that asset liquidity may depend on various market and economic conditions.
Elliott then asked what the social value of maturity transformation is. Bernanke replied that you have to have maturity transformation in order to have cash and that he is skeptical that maturity transformation could be made the responsibility of the government. He said the challenge arises from moral hazard and how much maturity transformation is too much.
A member of the audience asked Bernanke for this thoughts on banks being “too big to fail.” Bernanke said that many parts of regulatory reform sought to address this problem, including the OLA and capital surcharges, but said that the problem is “not solved yet.” He explained that it is not just the size of an institution that matters but also its complexity and opaqueness.
Another audience member asked if Bernanke has ever considered asset class concentration limits. Bernanke said that the challenge in oversight is stress testing across the whole financial system but noted that the new regulatory approach seeks to predict the impact of a common shock across banks.
A different audience member asked if the movement to central clearing makes these clearing houses “too big to fail” and if they should be bailed out in the event of a failure. Bernanke said with regard to central clearing houses, “if you put all of you eggs in one basket, you had better watch that that basket.” He explained that Dodd-Frank gave the Fed new authority to backstop the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to make sure that central clearing parties meet safely and soundness standards and enable the Fed be a lender of last resort. He said that central clearing concentrates risk, but puts it in a place where it can be properly overseen. He said that the way to deal with “too big to fail” is to make it “extremely unlikely” that an institution will fail and noted that the participants of the clearing house, not taxpayers, would absorb the costs of a failure.
Elliott then asked how non-bank liquidity issues should be addressed. Bernanke said that there need to be mechanisms, required liquidity levels, or other approaches to address liquidity concerns for non-banks such as MMFs. He noted that the idea of a floating net asset value (NAV) has received a lot of attention.
A member of the audience asked Bernanke for his thoughts on smaller businesses paying higher costs to receive capital while large companies can fund themselves more cheaply. Bernanke said that a lot of things that happened to small businesses recently have been cyclical but that this issue needs to be looked at, as there is “always the possibility of recalibrating.” He said the liquidity requirements should be considered a work in progress and that they are “not set in stone at this juncture.”
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On April 30, the Brookings Institution held an event entitled “Liquidity and the Role of the Lender of Last Resort” where industry experts, academics, and government officials discussed issues related to: the function and liquidity adequacy of banks; the liquidity coverage ratio, net stable funding ratio, and short-term wholesale funding market reform; liquidity needs in the post-crisis world; and liquidity provision for bank resolution.
In his opening remarks, Martin Neil Baily, Senior Fellow of Economic Studies at Brookings, stated that liquidity is not just an “inside the beltway” issue because it affects the entire economy. He said that the economics profession was largely unprepared for the financial crisis of 2008 and that it was questionable whether economists had an adequate understanding of how the financial sector impacts the broader economy. Baily also said that a “whack-a-mole” theory of regulation, where regulators hit down anything that pops up as risky, has caused the “pendulum” of regulation to swing too tight.
Session 1 – Lender of Last Resort: Examining the Function and Liquidity Adequacy of Banks
Presentations
Donald Kohn, former Vice Chairman of the Board of Governors of the Federal Reserve (Fed) and Senior Fellow of Economic Studies at Brookings, said a critical function of central banks is to limit panics and fire sales through their lending capabilities and worried that the new restrictions on the Fed’s 13(3) lending authority may prevent it from taking the helpful actions that it did in the last crisis. He explained that these new restrictions: 1) require approval of the Treasury Secretary, which could lead to political influence; 2) emphasize security of repayment and value of collateral; and 3) send the names of any firms who receive loans to Congress, which may lead to a negative stigma and a reluctance of firms to seek this liquidity.
Mark Flannery, BankAmerica Professor of Finance at the University of Florida, said current regulations are trying to cut back on the excessive credit intermediation that occurred before the crisis. He expressed regret at a lack of cost-benefit analysis that shows the benefits outweigh the costs of new liquidity requirements. He called the liquidity coverage ratio (LCR) a “coarse, blunt instrument” and said the rule would lead to costs resulting from rearranging the priority of claims on bank assets while creating more incentives for runs on banks.
Flannery also said “shadow intermediation” would increase as banking intermediation is restricted and said lawmakers should change the bankruptcy law so that information intensive assets do not apply to a bankruptcy stay. He added that capital and liquidity ratios “ought to be related.”
John Dugan, Partner at Covington and Burling, said liquidity was critical to the problems seen in the financial crisis and said that on the “scorecard of liquidity tools” the government preserved three important tools, added two, and eliminated or restricted four.
Dugan elaborated that the tools that were preserved were: 1) the Fed’s discount window for depository institutions; 2) deposit insurance; and 3) some aspects of emergency discount lending to non-depository institutions. The tools added, he said were: 1) an orderly liquidation fund (OLF) to provide emergency liquidity to resolve failing large financial institutions, which he said is very important; and 2) requirements for banks to hold more liquidity, which he said has potential collateral consequences. The tools which were removed or restricted, he continued, were: 1) the exchange stabilization fund to guarantee money market funds (MMFs); 2) systemic risk exception power of the Federal Deposit Insurance Corporation (FDIC) to open institutions related to banks, which now needs Congressional approval; 3) restrictions on lending to non-depository institutions; and 4) the encouraging of stronger institutions to buy weaker ones in a time of crisis.
Dugan said the temporary liquidity guarantee program should be restored without needing Congress and that the Fed’s emergency lending powers should not be cut back. He also suggested that broker-dealers and investment banks be provided with the kind of liquidity given to banks as they are also subject to runs in short term funding markets, but noted that this would come with additional regulatory restrictions.
Darrell Duffie, Dean Witter Distinguished Professor of Finance at Stanford University, questioned why 13(3) overly limits the ability of the Fed to provide liquidity to non-bank broker-dealers, saying that they are systemic and can fail from a lack of liquidity. He explained that the Fed would have to “sit on its hands” until the crisis spread and a number of non-banks got into trouble. He noted that the Fed can stand in and provide liquidity for central clearing parties, contingent on all private sources of capital being unavailable.
Charles Calomiris, Henry Kaufman Professor of Financial Institutions at Columbia University, said liquidity crises are always driven by insolvency crises and that the regulatory error of the last financial crisis was not reacting to a two-year decline in the creditworthiness of financial institutions.
Calomiris said the separation of liquidity from capital standards is “idiotic” and that the regulatory framework needs to define the extent of substitutability between capital and liquidity, as well as its limits. He also stressed the importance of a cash buffer and said if capital and cash requirements are set correctly then systemic risk can be avoided. He concluded that an ad-hoc policy is worse than defined sets of rules.
Panel Discussion
David Wessel, Director of the Hutchins Center on Fiscal and Monetary Policy, expressed surprise at the apparent consensus of the panelists in the presentations that the Fed and its lender of last resort function has too much restriction under the new structure. He then asked the panel if the rules on self-insurance and requiring banks to hold liquidity have gone too far and if banks should hold more cash.
Calomiris said the rules “could do a lot better” in fixing the inability of banks to roll over their debt in a crisis environment and added that banks should hold 10 percent of assets as equity, 10 percent as contingent convertibles (CoCos), and 20 percent as cash held at the Fed.
Dugan disagreed with these suggested levels and said there is a difficult trade-off in self-insurance between making banks safer and taking money away from contributing to the economy.
Calomiris worried the Basel requirements for liquidity are not as good of a buffer as a cash ratio would be and added that while holding cash has a cost, it would not be a prohibition on lending because a bank could scale itself up.
Flannery said regulations have gone too far and have become “horribly burdensome.”
Wessel then asked what the cost would be of banks holding too much liquidity.
Flannery responded that there would be less lending in general and that there would be a risk of creating safer banks while lessening the overall safety of the financial system. Kohn said he did not know yet whether the rules have gone too far, but regulators have to be careful about activity migrating outside banks to the shadow financial system.
Next, Wessel asked what role bankruptcy plays in the regulatory structure.
Duffie noted that Chapter 14 of the bankruptcy code is being looked at to allow failing financial firms to be dealt with more quickly and to change the treatment of qualified financial contracts. Kohn added that the international aspect of bankruptcy will be very important and that reform should be done on a global basis. He added that there is still a role for the orderly liquidation authority (OLA) in Title II of the Dodd-Frank Act as systemically important financial institutions (SIFIs) cannot be dealt with in normal bankruptcy proceedings.
Wessel asked if the drive for transparency creates a stigma for firms that prevents them from acting in their best interests and going to the Fed for liquidity.
Duffie said he did not think going to the Fed created a stigma in the past and that it would likely not be a problem in another crisis situation. However, he said, if there was a one-off situation where one firm needed a lender of last resort then there would be a stigma.
An audience member asked how one can tell when an institution is insolvent and how regulators can determine who to lend to.
Calomiris said what matters is when the markets doubt an institution’s solvency and that the Fed should look to keep firms’ market value ratios above 9 or 10 percent to avoid lending to an insolvent institution.
Kohn said insolvency is very hard to tell and that a lot depends on what prices are in the market at the time. He added that there is not a lot of good data to make this determination.
Another member of the audience asked about the Fed’s actions of lending to other central banks during the crisis, to which Kohn replied that these international swap lines were very important. He added, however, that the International Monetary Fund (IMF) would do better to make this decision than the Fed but noted that it has more conditions on its credit.
A different audience member asked how the government can take a long-run view of the financial system when politicians are always thinking about reelection. Dugan said the government should respect the independence of Federal agencies and noted that political concerns have been problematic as they have prevented technical fixes and adjustments to the Dodd-Frank Act.
Session 2 – Liquidity Coverage Ratio, Net Stable Funding Ratio and Short-Term Wholesale Funding Market Reform
In his opening remarks, Douglas J. Elliott, Fellow of Economic Studies at Brookings, explained that banks make illiquid long term loans while taking short term deposits and thus liquidity concerns matter, as was evidenced in the crisis. He noted that the LCR in Basel III will be effective in 2015 and the net stable funding ratio (NFSR) will be effective in 2018.
Presentations
Mark Van Der Weide, Deputy Director of the Division of Banking Supervision and Regulation at the Fed, said liquidity regulations are needed to solve market failures of self-insurance and inter-bank lending in the private markets. He said the business of banks requires maturity transformation which could lead to rapid outflows of capital and that while banks will naturally keep some liquid assets, their normal levels are not socially optimal.
Van Der Weide said that the government should not rely on inter-bank markets and that it would be “imprudent” to think that banks will lend to potentially insolvent firms as they are often opaque. He also said positions of banks are strongly correlated with one another as they are increasingly interconnected and thus when one firm is stressed all other firms are likely to be stressed.
He said the two ways to address this issue are through central bank lending and banking regulation and that the reasons to not rely just on central bank lending are: 1) legal limits on who can borrow from the Fed; 2) moral hazard; and 3) risks for taxpayers.
Van Der Weide said the Basel III liquidity rules are important on the micro level to level the global playing field and on a macro level to increase financial stability by reducing the likelihood of a SIFI failure. He added that some of the limitations of the Basel III rules are that they do not address: 1) broker-dealers, MMFs, or shadow banks; 2) maturity mismatch; 3) liquidity adequacy of each branch; 4) currency mismatches; 5) penalties on matched books; 6) high quality liquid assets (HQLA), such as covered bonds, municipal bonds (munis), and mortgage backed securities (MBS); 7) a slow transition path; and 8) favorable treatment of central bank lending.
He also mentioned that amendments to the NSFR would address: 1) stable funding extension to credits for matched books; 2) six-month maturity lines; 3) an accelerated transition path; 4) excluded definition of illiquid assets for private label MBS and 6) maturity mismatches within a 30-day window.
He noted that the Fed cannot regulate every liquidity risk and thus supervision will be the first line of defense to fill regulatory gaps and mitigate risks. He also said regulators need to be willing to change rules “in the face of new learning.”
Van Der Weide noted that the Fed’s next goal is to address short term funding through capital surcharges and minimum margin requirements.
Marc Saidenberg, Principal at Ernst & Young LLP, said he does not believe that the liquidity regulations should be seen as a statement that there is no role for public sector support of financial institutions. He noted that there is a trade-off between complexity that comes from being risk sensitive and striving to have simplicity in the regulations, adding that the funding markets are “more complicated than the rules give them credit.” He noted a need to deepen the shared understanding of activities and enhance data and to compare market activities with regulatory objectives.
Paul R. Ackerman, Senior Executive Vice President and Treasurer of Wells Fargo & Company, said he is a proponent of banks having an “ample amount” of liquidity as he has a “healthy respect” of bank runs. He stated, however, that some parts of the LCR need to be fixed and that the rules have not been subject to a good cost-benefit analysis that considers trade-offs. For example, he continued, the LCR creates disincentives for banks to finance municipalities as the LCR requires assets to be held for the length of muni deposits. He also said the limitation on agency securities in HQLA should be eliminated as it is not based in data.
Ackerman said the administration of the LCR is increasingly complex, citing that 20,000 data elements on liquidity must be sent to the Fed and that this number will increase by four or five times in the future. He said this increase in complexity will decrease the rule’s efficacy.
Adam Gilbert, Managing Director at JPMorgan Chase & Co, said “a lot has been accomplished” and more will come in terms of bank resiliency. He noted that: capital has doubled; leverage has been sharply reduced; HQLA holdings have increased; stress tests are in place; intraday credit in the tri-party repo market has been reduced by $1 trillion; and structural liquidity has increased. He said other areas to address are: 1) standardized haircuts; 2) interim tenors between 30-365 days; 3) increasing availability of repo clearing of liquid assets; 4) stressed market capacity analysis in risk profiles; and 5) applying policies to all significant market participants.
He cautioned regulators about the concept of “bad deposits” in their classification of operational and non-operational deposits, saying banks will not want to take non-operational deposits. He also raised question with how leverage and liquidity will interact. He concluded that pricing, structure, and availability of products will change under the new requirements.
Discussion
Elliott began the discussion by asking what the cost-benefit calculations have been to date on these new requirements.
Van Der Weide said cost-benefit analysis is “hard to do” but that the Fed tries to “quantify both sides” and look at the intersections and synergies of its rules. He noted that the calculation of benefits is more difficult and the Fed uses more qualitative factors. Van Der Weide said the Fed found “net benefits socially to the economy” for the LCR and NSFR.
Saidenberg said it is easier to project immediate costs than longer term benefits and that regulators must make judgments on projected outcomes. Gilbert added that it is important to be “upfront on intended outcomes” and that policies are hard to fix once they are in place.
Elliott then asked how banks will react to the new requirements.
Gilbert said banks will change the product, structure, and availability in lines of credit and that “deposits may end up getting eschewed or turned out.” Ackerman said that Wells Fargo will keep more cash on its balance sheet and increase the cost of credit and risk taking as there will be fewer deposits to deploy.
Elliott then asked if there is real value to maturity transformation as a whole, to which Gilbert replied that the banking model of maturity transformation has been successful at promoting economic growth.
A member of the audience asked what the optimal mix of tools would look like to reduce vulnerability to runs.
Van Der Weide said that while there is a “decent argument” that capital rules can address banking problems, he is “not convinced” that the LCR and NSFR are enough for short-term funding concerns as these issues go “well beyond the banking system” and the Fed’s regulations are bank-centric. He then noted the importance of margin requirements for derivatives markets and securities financing transactions.
Saidenberg added that regulators should tailor their rules and not be afraid to change rules that have already been completed.
When asked by an audience member why the cap on agencies securities in HQLA should be eliminated, Ackerman said these products were very liquid in the financial crisis. Gilbert agreed that the cap should be removed and suggested that there could be a haircut applied to these securities.
Another audience member asked how the LCR would affect banks’ appetites for deposits, to which Gilbert replied that banks may change their structures and have less of an appetite for deposits. Ackerman said that the requirements will not change Wells Fargo’s appetite for customer deposits and that he does not think there are “bad deposits.”
Next, an audience member asked about differences in definitions across different countries. Van Der Weide said that the Basel group is working to make sure countries implement the requirements effectively and faithfully, but noted the challenge of having global applicability. Saidenberg added that firms that are subject to regulations in multiple countries will have higher costs.
Keynote Address by Mary Miller
Mary Miller, Under Secretary for Domestic Finance at the U.S. Department of the Treasury, stated that since the financial crisis there has been a focus on capital, but said liquidity can be even more important. She noted that there are different ways of thinking about liquidity including: 1) liquidity of financial instruments or the measure of ease that assets can be converted into cash; and 2) liquidity of institutions which is results from the liquidity of the assets that a financial institution holds.
Miller said that liquidity stress tests should consider specific aspect of assets as well as market conditions and noted that if many institutions need to sell their safe assets in times of stress, there will be price impacts. She said the new liquidity requirements along with central clearing margin requirements will increase the need for HQLA by several trillion dollars, but noted an estimate by the Bank of International Settlements (BIS) that stated the available supply will be several times larger than this demand. Another consideration Miller mentioned is that the supply of safe liquid assets will decrease as countries’ deficits decline.
Miller said that floating rate notes were the first new product from the Treasury in 17 years and will help with liquidity needs. She also mentioned the reverse repo program as a possible substitute source of safe assets, but noted these cannot be rehypothecated and used for margin or collateral.
Question and Answer
Baily asked Miller if she is concerned with the ability of small and medium-sized enterprises to receive capital.
Miller replied that this is a legitimate concern as the new regulatory landscape has been a problem for less-liquid securities.
Baily then asked about limitations to lending options including the exchange stabilization fund and if Miller has any concerns about the restrictions.
Miller replied that the distinction between being credit-impaired and liquidity-impaired is important and that the exchange stabilization fund was intended to be used in currency crises and should not be broadly available. She continued that part of the problem in 2008 was that the market did not know the rules of the road, but that now there is more clarity on how things will work in a crisis.
Baily asked if credit has been curtailed or if there is just a reluctance to borrow.
Miller said that the data is unsatisfactory and not granular enough to know, but noted that there has been an increase in the number of initial public offerings (IPOs) recently.
Baily then asked Miller if derivatives trading may be shifting overseas as a result of U.S. rules.
Miller said that the U.S. is still in the early days of setting up swap execution facilities (SEFs) and that Europe is still “ironing out” its regulations. She noted that the U.S. regulations extend “a lot of time relief to allow other countries to catch up.”
A member of the audience asked what Miller thought about the issue of asset managers being reviewed by the Financial Stability Oversight Council (FSOC), to which Miller said the review is in its early stages. She added that no judgments or decisions have been made and that the review is “just a deep dive to understand the players and activities” in this heterogeneous industry.
Baily followed up and asked to what extent asset managers are systemic. Miller said that “for the most part” asset managers act as agents rather than principals, but risk can arise if there is a “stampede” out of an asset class. She added that the Treasury is seeking to understand how assets are deployed.
Session 3 – Liquidity Needs in the Post-Crisis World and Liquidity Provision for Bank Resolution
Presentations
Randall D. Guynn, Partner at Davis Polk & Wardwell, said that the FDIC’s single point of entry (SPOE) strategy for resolving a failing global systemically important bank (GSIB) has been endorsed as the most promising solution to the issue of “too big to fail.” He noted that the SPOE features include: 1) the parent company being put into receivership through bankruptcy; 2) parent company resources used at its subsidiaries; 3) operating subsidiaries being kept open; and 4) long term unsecured debt at the parent company being used as a debt shield of short term debts.
He said the success of the SPOE depends on the parent having loss absorbing resources “on both sides of the sheet” and explained that a bridge financial company would be established containing all the failed parent company assets, while leaving behind all claims. He said the SPOE can quickly separate a failed institution into “a good bank and a bad bank.” This good bank, Guynn continued, must have access to capital for the SPOE to be successful, but noted it may be a challenge for the private sector to provide this capital in a crisis. He said that if there is no lender of last resort in this situation then “bailouts will be inevitable.”
Guynn added that the restrictions on 13(3) could make it more difficult for the Fed to lend to this good bank and said the Fed should be given clear authority to lend under the SPOE strategy in the bankruptcy code.
Paul H. Kupiec, Resident Scholar at the American Enterprise Institute, said that “hard wired liquidity rules are expensive” and added that he “can’t see how [they] won’t lead to reduced credit and reduced intermediation.” He presented an idea that the Fed sell “systemic liquidity options” where the Fed would auction a one month option and allow the holder to “repo collateral overnight” with the Fed. He suggested that the Fed take bids from dealers and the shadow financial institutions and use prices on the secondary market to anticipate liquidity problems. He added that the LCR and NSFR would have to be adjusted to give credit for liquidity options.
Paul Saltzman, President of The Clearing House Association, said that regulators are too often focused on the resiliency of intermediaries rather than the resiliency of the markets themselves. He said implementation of the LCR and NSFR may be accelerated by the marketplace and called the rules “very prescriptive.” He expressed concern with disclosure impacts, as they may be a self-fulfilling prophecy that leads to bank runs; and also with the Fed’s liquidity stress tests becoming a binding constraint.
Saltzman stated that the political environment re-characterized the lender of last resort action as a bailout, but stressed that it is important not to conflate these two ideas.
Marcus Stanley, Policy Director of Americans for Financial Reform, said that he does not believe Dodd-Frank has restricted the lender of last resort function. He said that it has changed the structure of the Fed’s authorities and may have even increased its abilities. He noted that the law added new avenues for liquidity assistance including: 1) a Treasury line of credit for the OLA; 2) discount window access for non-bank financial utilities; and 3) having no restrictions on 13(3) for duration, solvency, and the definition of “broad-based.” Stanley added that the SPOE commitment to keep subsidiaries open with a Treasury line of credit has an “effectively unlimited” pay-back timeline for OLA funds.
Steven H. Strongin, Head of Goldman Sachs Global Investment Research at Goldman Sachs, said the reason there has not been very much push back from banks on the LCR and NSFR is because the requirements reflect how banks view their liquidity. However he said that if there is a “formal, bright line” on how much liquidity to hold, it may make it more difficult to hold that amount, adding that this could turn into a best practice becoming a binding constraint.
Strongin said that regulations have reduced the probability of a 2008 style crisis, where banks lost liquidity, but have increased the probability of a 1987 style crisis where the markets ran out of liquidity, saying funding problems at banks will be replaced by market liquidity problems. He added that the requirements will keep the risks in the real economy as risk will be not eliminated but only transferred.
Discussion
Kohn began the panel discussion asking how various regulations negative impacts, such as the Volcker Rule and leverage ratio, can be ameliorated.
Strongin said that problem of the new regulations is their cumulative effect and trying to figure out what the binding rules are for each asset. He explained that the Comprehensive Capital Analysis and Review (CCAR) and Volcker Rule penalize firms where assets are warehoused and thus the willingness to warehouse for a client is reduced.
Saltzman questioned what would happen when “everyone is rushing to HQLA” and how liquidity of non-high quality assets would be impacted. He noted that the private sector determination of quality is being replaced with a government determination.
Kupiec said that the stricter the LCR is, the more activity will go into the shadow banking sector, noting that overnight repo markets serve a purpose.
Strongin said for short term instruments there is no risk information to analyze and thus long term risk data must be applied to short term products.
Guynn stated that if banks are forced to over-insure then corporate America may self-insure as well if they think that they cannot get liquidity from banks, causing a “costly overhang on the economy.”
Strongin then pointed out that after the crisis large firms have been able to fund themselves more cheaply through the bond markets, while smaller firms, who rely on banks, have had to pay relatively higher prices. He also noted that there may be issues in the short term bond market after the SPOE is employed depending on how long it takes the buy side to get comfortable with the end results.
Kohn then asked what can be done to change the political discourse and improve the education process about the financial industry.
Saltzman said that the banking industry “needs to show more humility” and “recalibrate their approach to opposing new regulations.” He said that the industry has been vilified for 2,000 years and that the sector must present a value proposition and stress their important role in lending and employment. Guynn added that the banking industry should support a better economy as people are less apt to vilify banks if they are happy with their jobs and future prospects.
A member of the audience asked if the liquidity rules were “going overboard” and if they are pushing the problem into the real economy. Strongin said that the current approach to liquidity requirements is unnecessary and that the “belt and suspenders” regulations do not address the underlying transparency issues.
Stanley said the issue with short term funding is that the market, while generating money for those involved, is unstable and fragile, adding that the industry has let “money creation get away from us a bit.”
When asked about the liquidity option plan, Kohn noted that the Fed used a similar plan for the “Y2K” preparations, where they sold options to get liquidity on the first business day of the year 2000. He expressed concern, however, with doing something like this more broadly for non-banks as it may create moral hazard.
Keynote Address – Ben Bernanke
Ben Bernanke, former Chair of the Federal Reserve and Distinguished Fellow in Residence for Economic Studies at Brookings, described the “rich man’s panic” of 1907 to illustrate the five standard stages of a financial crisis: 1) losses, especially to important financial institutions; 2) runs on banks, where depositors pull their money out; 3) fire sales, or dumping assets and causing prices to drop; 4) contagion; where interconnections cause prices to drop at many institutions; and ) economic impact, when credit and transactions are negatively affected causing a recession.
Bernanke said that the original mission of the Fed was to be a lender of last resort, thus lending freely but at a penalty rate. The spirit of this function, he continued, is to lend against a broad range of assets while charging a penalty rate high enough to prevent moral hazard but lower the “fear rate” of the market.
He said the 2008 crisis met these five traits of a panic, noting: 1) losses in real estate assets held by financial institutions; 2) runs on wholesale funding; 3) fire sales of assets and stocks; 4) contagion throughout the financial system; and 5) the recession that followed. Bernanke said that the Fed was slow to recognize the crisis because the runs were not from depositors but rather they were “invisible runs” of repos and commercial paper.
He said there are important concerns since the crisis with the changes in the financial system, as some of the legal authorities of the Fed have changed. He noted that 13(3) cannot be used to address a single firm and that Treasury must sign off on these actions. He also said that the tougher repayment standard and disclosures make sense from a taxpayer perspective but may make it more difficult for the Fed to be effective in another crisis.
Discussion
When asked how liquidity requirements should be designed, Bernanke explained that stress testing has become an important part of assessing liquidity, noting that asset liquidity may depend on various market and economic conditions.
Elliott then asked what the social value of maturity transformation is. Bernanke replied that you have to have maturity transformation in order to have cash and that he is skeptical that maturity transformation could be made the responsibility of the government. He said the challenge arises from moral hazard and how much maturity transformation is too much.
A member of the audience asked Bernanke for this thoughts on banks being “too big to fail.” Bernanke said that many parts of regulatory reform sought to address this problem, including the OLA and capital surcharges, but said that the problem is “not solved yet.” He explained that it is not just the size of an institution that matters but also its complexity and opaqueness.
Another audience member asked if Bernanke has ever considered asset class concentration limits. Bernanke said that the challenge in oversight is stress testing across the whole financial system but noted that the new regulatory approach seeks to predict the impact of a common shock across banks.
A different audience member asked if the movement to central clearing makes these clearing houses “too big to fail” and if they should be bailed out in the event of a failure. Bernanke said with regard to central clearing houses, “if you put all of you eggs in one basket, you had better watch that that basket.” He explained that Dodd-Frank gave the Fed new authority to backstop the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to make sure that central clearing parties meet safely and soundness standards and enable the Fed be a lender of last resort. He said that central clearing concentrates risk, but puts it in a place where it can be properly overseen. He said that the way to deal with “too big to fail” is to make it “extremely unlikely” that an institution will fail and noted that the participants of the clearing house, not taxpayers, would absorb the costs of a failure.
Elliott then asked how non-bank liquidity issues should be addressed. Bernanke said that there need to be mechanisms, required liquidity levels, or other approaches to address liquidity concerns for non-banks such as MMFs. He noted that the idea of a floating net asset value (NAV) has received a lot of attention.
A member of the audience asked Bernanke for his thoughts on smaller businesses paying higher costs to receive capital while large companies can fund themselves more cheaply. Bernanke said that a lot of things that happened to small businesses recently have been cyclical but that this issue needs to be looked at, as there is “always the possibility of recalibrating.” He said the liquidity requirements should be considered a work in progress and that they are “not set in stone at this juncture.”
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