Brookings on Safety of Financial System , Post-Crisis
Brookings Institution
Are we safer? A look at the financial system, post-crisis
Tuesday, November 17, 2015
Key Topics & Takeaways
- Unintended Consequences of the Liquidity Coverage Ratio (LCR): Yale scholar Gorton maintained that the LCR is a prime example of the Lucas Critique – which he explained means that macroeconomic policies have unintended consequences. However, Gorton asserted that despite the Bank for International Settlement’s forecast on how much extra collateral would be required in the financial system as a result of the LCR, there was “no serious attempt” to understand the unintended consequences of this rule.
- New Regulatory Approach for Shadow Banking: Fed Governor Tarullo explained that regulatory attention should be focused on specific risks posed by non-bank financial intermediaries, not on entities themselves, and added that the “optimal regulatory response” would not be to impose bank-like regulation on non-banks. Tarullo added that it would be “wrong to assume that all shadow banking ought to be regulated to safeguard financial stability” and called for regulators to develop “prudential market regulation,” whereby traditional investor protections would also incorporate a “system wide financial stability perspective.”
- Importance of the Legal Entity Identifier (LEI): Tarullo agreed that the LEI could help monitor financial stability risks arising from shadow banking activities by identifying the nexus between the regulated and unregulated sectors.
Speakers
- Ben Bernanke, Distinguished Fellow in Residence, Economic Studies
- Daniel K. Tarullo, Federal Reserve Governor
- Gary B. Gorton, Professor of Management & Finance, Yale School of Management
- Betsy Graseck, Managing Director, Research Division, Morgan Stanley
- David Wessel, Director of the Hutchins Center on Fiscal and Monetary Policy, Brookings
- Darrell Duffie, Dean Witter Distinguished Professor of Finance, Stanford University
- Victoria Ivashina, Professor of Business Administration, Harvard Business School
- Nellie Liang, Economist, Federal Reserve Board
Introduction
Welcome remarks by Ben Bernanke
Bernanke opened by reiterating that the financial system is indeed safer since the financial crisis, and referenced several regulatory reforms including enhanced loss absorption rules implemented post-crisis.
Bernanke briefly explained that the panelists will consider some of the consequences of ongoing financial reforms, what remaining risks to financial stability exist, and whether regulators have the tools to address those risks. He also questioned whether there areas where regulation has gone too far that would make the system less safe in some ways. Bernanke also outlined the topics of the day: the effects of new collateral rules, liquidity in the bond market, and potential risks stemming from shadow banking.
Panel 1: Are new collateral rules making the financial system less safe?
Gary Gorton, Professor of Management and Finance, Yale School of Management
Gorton presented on the effects of the Basel III Liquidity Coverage Ratio (LCR) and its effects on collateral mobility. Gorton asserted that the “world [of finance] is different now” and indicated that the financial reforms resulted in a shift from a system of mobile collateral to immobile collateral. Gorton’s research illustrated that “privately produced safe debt” has grown to be the dominant percentage of total safe debt since the late 1970s. Financial reforms such as the LCR, he explained, “for the most part” have aimed to “go back to a system of immobile collateral” by requiring collateral to be “posted and stuck there.”
Gorton maintained that the LCR is a prime example of the Lucas Critique – which he explained means that macroeconomic policies have unintended consequences. However, Gorton asserted that despite the Bank for International Settlement’s forecast on how much extra collateral would be required in the financial system as a result of the LCR, there was “no serious attempt” to understand the unintended consequences of this rule.
Gorton equated the unintended consequences of the LCR, which he claimed will fuel shadow banking activities, with what happened in the 1860s to early 1900s with U.S. banknotes, which were, at the time, required to be backed 1:1 by U.S. Treasuries. Gorton argued that the collateral requirements resulted in a “huge under-issuance problem,” Treasury scarcity, arbitrage opportunities, and eventually gave rise to a shadow banking system in the form of demand deposits. In conclusion, Gorton explained that policymakers cannot just “shrug off the Lucas critique” of unintended consequences, and reiterated that the lessons from the establishment of the national banking system and the LCR are “exactly the same” in that they both will cause shadow banking to arise.
Betsy Graseck, Managing Director, Research Division, Morgan Stanley
Graseck responded to Gorton’s research by agreeing that financial reforms have made the system safer. She also agreed with Gorton’s findings that: 1) the LCR does reduce the velocity of bank balance sheets; 2) Treasury yields reflect a convenience yield; and 3) the LCR should incent banks to take on some riskier assets. Graseck explained that due to the LCR, banks are holding eight times more Treasuries than they did pre-crisis, and that the LCR created a “special status for Treasuries” since they are “at least 20 percent more valuable” to banks post-crisis than RMBS (residential mortgage backed securities). Graseck also explained that the LCR should drive banks to take on some riskier assets, to barbell the balance sheet, all other things equal, in order to deliver a return on equity (ROE) in excess of their cost of capital.
Graseck referenced Morgan Stanley’s paper published earlier this year on the effects of regulation on market liquidity, and explained that new financial regulations – such as margin requirements for derivatives, total loss absorbing capacity (TLAC), and money market fund reforms – have made Treasuries more valuable to banks. As such, Graseck argued this indicates that there are additional rules besides that LCR that will increase demand for Treasuries, and that the interaction of those rules “forces some unusual outcomes,” such as where firms reduce their operating deposits to shrink their systemically important footprint.
Question and Answer
Bernanke summarized Gorton’s research by stating that the key takeaway is that regulatory reform leads to unintended consequences.
A member from the audience noted that the Basel Committee designed the LCR to “drive ROE down” to create “safer institutions.” Gorton responded that the Lucas Critique is “a serious thing;” and “quibbling over the numbers is not right. [Policymakers] need to do better than that.” Graseck added that banks have to deliver ROE in excess of 10-11 percent, which is approximately their cost of capital under the new regulatory regime, in order to attract investors who seek the best risk-adjusted return in the marketplace, which she estimated to be above 10-11 percent. Gorton added that regulators do not decide how much banks earn; they just determine where such market activities occur (i.e. in shadow banks or elsewhere).
Another audience participant asked what the average citizen or ‘layperson’ who is concerned about the effects of the last recession about what government and private sector should be doing to prevent the next crisis. Gorton explained that financial crises are the norm in the U.S. and other market economies, and reiterated that he “does not see this time as being any different.”
Panel 2: What’s happening to liquidity in the bond market?
David Wessel, Director of the Hutchins Center on Fiscal and Monetary Policy, Brookings
Wessel noted that significant reforms have taken place in the financial system as a result of the financial crisis have impacted the way that the Treasury market works, and noted frequent assertions of decreased liquidity in treasury markets.
Darrell Duffie, Dean Witter Distinguished Professor of Finance, Stanford University
Duffie examined whether regulatory reforms have changed bond market liquidity in a significant way.
He noted that the regulatory reforms have induced banks to act as agents in a transaction, as well as to shift from intermediating low-risk products to higher risk products, though he noted constraints imposed by the supplementary leverage ratio (SLR). Duffie explained that reduced dealer inventories could give rise to disintermediation of the banks, through the rise of shadow bank intermediation and bond trading on all-to-all platforms.
Duffie maintained that the “usual measures of liquidity look good” considering the substantial reforms that have been made to the financial system, and argued that there are no signs of “serious problems with financial market liquidity.” Duffie pointed to low bid-ask spreads in the Treasury markets, as an indicator of stability in the bond markets.
However, he noted that turnover and trade sizes are “dramatically lower,” which may pose some potential problems. Duffie cautioned that the effects are “still playing out” and predicted that the bond market will become more volatile once interest rates normalize. In turn, he explained that policymakers will find out whether the market can handle a “sudden rush for the exits.”
In corporate bond markets, Duffie noted that bid-ask spreads are “quite benign” but trade sizes are down, and recalled that some of these effects were driven by factors other than financial reforms, as heightened transparency requirements [through the Trade Reporting and Compliance Engine (TRACE)] were enacted before the crisis and may have adversely affected market liquidity. Duffie suspected that hedge funds and other levered investors could be “potential victims” of sudden bond fund redemptions. His overall conclusion was that it is “too early to say” whether financial reform has reduced bond market liquidity.
Victoria Ivashina, Professor of Business Administration, Harvard Business School
Ivashina agreed that it is “too early to draw conclusions” about the effect of regulation on market liquidity but argued that the current evidence does not suggest that the market and policymakers should worry about liquidity levels. However, she argued that the average liquidity indicators do not signal what will happen in the event of tail risk events, such as the spikes in Treasury markets on October 15, 2014, which she explained are rare.
Nellie Liang, Economist, Federal Reserve Board
Liang explained that she agrees with Duffie’s assessment that changes are occurring and the effects are still playing out. Still, Liang asserted that reduced market liquidity comes at the benefit of a more stable financial system. Liang also referenced structural changes in fixed income markets that preceded the financial crisis, including TRACE (since 2002), which she explained “removed information advantages that dealers had” historically. In addition, Liang noted that since the financial crisis, dealers’ market making activities have declined due to their own changes in risk appetite, as well as from effects of financial reform.
Liang noted that mutual fund intermediation “has become more complex” and referenced the “fundamental mismatch” between on-demand redemption offered by funds and the less liquid assets in which they are investing, and added that such risks are being addressed by the Securities and Exchange Commission (SEC) and the Financial Stability Oversight Council (FSOC).
Shadow Banking: Thinking Critically about Non-Bank Financial Intermediation
In his remarks, Tarullo recalled that the financial crisis highlighted two major vulnerabilities: 1) the magnitude of too-big-to-fail; and 2) the size and fragility of the shadow banking system and the extent to which it was integrated with the regulated banking system. Tarullo noted that specific fragilities that contributed to the financial crisis have been addressed, including increased capital, improved accounting, and other regulatory standards. Tarullo affirmed that the financial system is “safer than before the crisis,” but cautioned that “safer does not mean safe enough.”
Tarullo signaled that the banking agencies will be proposing the Net Stable Funding Ratio (NSFR) in the “next few months,” and noted that the Fed is currently reviewing its annual stress testing and capital planning exercises. While recognizing the progress made within the banking industry, Tarullo cautioned that circumstances in the shadow banking sphere are “somewhat different,” and noted that “risks to financial stability may arise new from activities mostly or completely outside the gambit of prudentially regulated firms.” Tarullo acknowledged that it would be difficult to “navigate the perils of underappreciating the risks to financial stability arising from, and the costs from overreacting to, new forms of nonbank financial intermediation.” Thus, he offered three observations: 1) it is essential to disaggregate the various activities that fall under the term ‘shadow banking’ to assess the risks and benefits they pose; 2) it would be helpful to identify the nexus of specific ‘shadow banking’ activities to the prudentially regulated sector; and 3) institutional considerations will be important in “defining the potential, and actual, regulatory responses to nonbank intermediation.”
Tarullo explained that the variety of non-bank intermediation reinforces the importance of focusing regulatory attention on specific risks, not on entities themselves, and added that the “optimal regulatory response” would not be to impose bank-like regulation on non-banks. Tarullo also called for the need to balance the risk assessment of specific forms of non-bank intermediation with the benefits those intermediation services provide. For instance, he explained that the proliferation of mutual funds offer a variety of diversified investment vehicles to American consumers, and nonbank intermediaries increase the diversity of the economy’s capital providers, as well as provide credit to borrowers that are underserved by traditional banks.
Tarullo reiterated that non-bank intermediation activities “often grouped under the heading shadow banking are not monolithic” and that the “level of a particular activity is less important than the degree of vulnerability that it creates.” He added that it would be “wrong to assume that all shadow banking ought to be regulated to safeguard financial stability.” Thus, Tarullo called for regulators, when “assessing whether regulation is appropriate for specific forms of nonbank intermediation” to balance “the resulting increase in socially beneficial credit, capital, or savings options against any associated increase in risks to the safety and stability of the financial system as a whole.”
Tarullo explained that the key risks to bear in mind in regulatory assessments of non-bank intermediation include: 1) the extent of reliance on maturity or liquidity transformation; 2) the creation of cash-equivalent assets; 3) the use of leverage; and 4) the degree of interconnection with the traditional banking sector. Tarullo cautioned that careful analysis of these factors is needed, and that one way to limit the growth of the shadow banking sector is to make sure that the regulated sector is not “unnecessarily burdened.” In doing so, Tarullo asserted that the Fed has tailored regulation to the size and scope of banking activities, and incorporated a measure of a firm’s reliance on short-term wholesale funding in the long-term debt requirement under TLAC as well as the G-SIB surcharge. Still, Tarullo cautioned that, while it would be “inadvisable to apply bank style regulation to non-banks,” a degree of consistent regulatory treatment is desirable to address bank-like risks in the non-bank financial sector and reduce regulatory arbitrage. For instance, he explained, minimum haircuts for securities financing transactions (SFTs) have been applied market-wide.
Tarullo argued that by allowing FSOC to designate non-bank intermediaries as systemically important financial institutions, Dodd-Frank “fills a gap that existed in the pre-crisis period.” With that said, Tarullo maintained that the “vast majority of firms engaged in [non-bank intermediation] activities will not satisfy the statutory test for designation” and that it is “unclear” that the statutory prudential requirements for designated firms would be “necessary or appropriate” in dealing with the risks to financial stability posed by the activities of these firms. Instead, Tarullo advanced the idea of “prudential market regulation,” whereby traditional investor protections would also incorporate a “system wide financial stability perspective.” Such a regulatory approach would take into account “system-wide demands on liquidity during stress periods, and correlated risks that could exacerbate liquidity, redemption, or fire sale pressures.”
Tarullo recapped SEC Chair Mary Jo White’s regulatory roadmap for regulating the asset management industry. However, he cautioned about the potential drawbacks of such institutional approaches: that if the primary regulator over one sector believes that regulation is creating debilitating disadvantages for firms in that sector, they might be tempted to roll back regulation. This, he explained, took place in the 1970s during deregulation of banks.
Tarullo concluded by stating that the “financial system as a whole is obviously safer” post-crisis but called on financial regulators to “develop effective […] mechanisms” for “prudential market regulation.”
Question and Answer
In response to a question, Tarullo countered the idea that “the recipe” is one for never ending regulation. He argued that regulators are trying to identify and regulate specific activities that actually do pose risk to financial stability.
Tarullo argued that FSOC is actually “quite thoughtful” in its assessment of how activities might give rise to financial stability risks. Within the Fed, he explained that there is a “pretty sophisticated effort” to think through potential stability risks, as well. He argued that there are “some advantages” to having a decentralized regulatory system.
When asked, Tarullo explained that it is natural to expect a search for yield in an era of sustained low interest rates, which is a downside of accommodative monetary policy. Tarullo shared that he is more comfortable shifting away from “calendar guidance” but something “outlook driven.” Tarullo stated that all policy actions have merits and downside risks, but that this is not a reason for classifying them as “bad policy action[s].”
A member of the audience questioned whether the Legal Entity Identifier (LEI) could help monitor financial stability risks arising from shadow banking activities. Tarullo agreed that the LEI could help monitor shadow banking activities by identifying the nexus between the regulated and unregulated sectors.
In response to a question from the audience, Tarullo explained that consolidated regulation and supervision helps address any potential problems arising from overseas subsidiaries of U.S.-based firms. In addition, he explained that using international frameworks to extend regulation to overseas affiliates helps address arbitrage.
Tarullo concluded by stating that the financial system is safer since the crisis but cautioned that the “moment we decide we are safe enough is when the problems will start to arise.” Still, he did not agree that the system will “always need more regulation” but explained that regulators’ analytical processes always need to be aware of how markets are changing.
Session 4: Thinking Critically about Non-Bank Financial Intermediation
In response to a question, Bernanke disagreed that the Dodd-Frank Act would prevent the Federal Reserve from intervening in a crisis as it did during the financial crisis under his leadership. He explained that Dodd-Frank added some restrictions, but the important ability of the Fed to serve as a lender of last resort for a class of borrowers is preserved. In addition, Bernanke explained that new authorities granted under Dodd-Frank include an orderly liquidation authority to put a firm “out of its misery, so to speak” to preserve financial stability. Bernanke closed by stating that it is essential that the Fed preserved its lender of last resort facility, and an inability to do that would have been “a very serious problem.”
Gorton agreed that stress testing is one regulatory tool that came out of the crisis that helped move discretion back to the regulators, which was a “good thing” that resulted from the financial crisis.
Duffie cautioned that foundations in repurchase (repo) markets are still not sound, so “there’s a lot more to do.” Bernanke countered that there has been a lot of progress made in making repo markets more sound, including operationally.
In response to an audience question about whether Glass-Steagall should be reinstated, Gorton argued that there is “no real going back” to Glass-Steagall, and Bernanke explained that he is “puzzled” as to why this is a topical theme because during the financial crisis both commercial and investment banks lost money so Glass-Steagall was “pretty irrelevant.” In fact, Bernanke argued, Glass-Steagall would have been “destabilizing’ because it would have prevented some of the acquisitions that happened during the event.
More information about this event can be accessed here.
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Brookings Institution
Are we safer? A look at the financial system, post-crisis
Tuesday, November 17, 2015
Key Topics & Takeaways
- Unintended Consequences of the Liquidity Coverage Ratio (LCR): Yale scholar Gorton maintained that the LCR is a prime example of the Lucas Critique – which he explained means that macroeconomic policies have unintended consequences. However, Gorton asserted that despite the Bank for International Settlement’s forecast on how much extra collateral would be required in the financial system as a result of the LCR, there was “no serious attempt” to understand the unintended consequences of this rule.
- New Regulatory Approach for Shadow Banking: Fed Governor Tarullo explained that regulatory attention should be focused on specific risks posed by non-bank financial intermediaries, not on entities themselves, and added that the “optimal regulatory response” would not be to impose bank-like regulation on non-banks. Tarullo added that it would be “wrong to assume that all shadow banking ought to be regulated to safeguard financial stability” and called for regulators to develop “prudential market regulation,” whereby traditional investor protections would also incorporate a “system wide financial stability perspective.”
- Importance of the Legal Entity Identifier (LEI): Tarullo agreed that the LEI could help monitor financial stability risks arising from shadow banking activities by identifying the nexus between the regulated and unregulated sectors.
Speakers
- Ben Bernanke, Distinguished Fellow in Residence, Economic Studies
- Daniel K. Tarullo, Federal Reserve Governor
- Gary B. Gorton, Professor of Management & Finance, Yale School of Management
- Betsy Graseck, Managing Director, Research Division, Morgan Stanley
- David Wessel, Director of the Hutchins Center on Fiscal and Monetary Policy, Brookings
- Darrell Duffie, Dean Witter Distinguished Professor of Finance, Stanford University
- Victoria Ivashina, Professor of Business Administration, Harvard Business School
- Nellie Liang, Economist, Federal Reserve Board
Introduction
Welcome remarks by Ben Bernanke
Bernanke opened by reiterating that the financial system is indeed safer since the financial crisis, and referenced several regulatory reforms including enhanced loss absorption rules implemented post-crisis.
Bernanke briefly explained that the panelists will consider some of the consequences of ongoing financial reforms, what remaining risks to financial stability exist, and whether regulators have the tools to address those risks. He also questioned whether there areas where regulation has gone too far that would make the system less safe in some ways. Bernanke also outlined the topics of the day: the effects of new collateral rules, liquidity in the bond market, and potential risks stemming from shadow banking.
Panel 1: Are new collateral rules making the financial system less safe?
Gary Gorton, Professor of Management and Finance, Yale School of Management
Gorton presented on the effects of the Basel III Liquidity Coverage Ratio (LCR) and its effects on collateral mobility. Gorton asserted that the “world [of finance] is different now” and indicated that the financial reforms resulted in a shift from a system of mobile collateral to immobile collateral. Gorton’s research illustrated that “privately produced safe debt” has grown to be the dominant percentage of total safe debt since the late 1970s. Financial reforms such as the LCR, he explained, “for the most part” have aimed to “go back to a system of immobile collateral” by requiring collateral to be “posted and stuck there.”
Gorton maintained that the LCR is a prime example of the Lucas Critique – which he explained means that macroeconomic policies have unintended consequences. However, Gorton asserted that despite the Bank for International Settlement’s forecast on how much extra collateral would be required in the financial system as a result of the LCR, there was “no serious attempt” to understand the unintended consequences of this rule.
Gorton equated the unintended consequences of the LCR, which he claimed will fuel shadow banking activities, with what happened in the 1860s to early 1900s with U.S. banknotes, which were, at the time, required to be backed 1:1 by U.S. Treasuries. Gorton argued that the collateral requirements resulted in a “huge under-issuance problem,” Treasury scarcity, arbitrage opportunities, and eventually gave rise to a shadow banking system in the form of demand deposits. In conclusion, Gorton explained that policymakers cannot just “shrug off the Lucas critique” of unintended consequences, and reiterated that the lessons from the establishment of the national banking system and the LCR are “exactly the same” in that they both will cause shadow banking to arise.
Betsy Graseck, Managing Director, Research Division, Morgan Stanley
Graseck responded to Gorton’s research by agreeing that financial reforms have made the system safer. She also agreed with Gorton’s findings that: 1) the LCR does reduce the velocity of bank balance sheets; 2) Treasury yields reflect a convenience yield; and 3) the LCR should incent banks to take on some riskier assets. Graseck explained that due to the LCR, banks are holding eight times more Treasuries than they did pre-crisis, and that the LCR created a “special status for Treasuries” since they are “at least 20 percent more valuable” to banks post-crisis than RMBS (residential mortgage backed securities). Graseck also explained that the LCR should drive banks to take on some riskier assets, to barbell the balance sheet, all other things equal, in order to deliver a return on equity (ROE) in excess of their cost of capital.
Graseck referenced Morgan Stanley’s paper published earlier this year on the effects of regulation on market liquidity, and explained that new financial regulations – such as margin requirements for derivatives, total loss absorbing capacity (TLAC), and money market fund reforms – have made Treasuries more valuable to banks. As such, Graseck argued this indicates that there are additional rules besides that LCR that will increase demand for Treasuries, and that the interaction of those rules “forces some unusual outcomes,” such as where firms reduce their operating deposits to shrink their systemically important footprint.
Question and Answer
Bernanke summarized Gorton’s research by stating that the key takeaway is that regulatory reform leads to unintended consequences.
A member from the audience noted that the Basel Committee designed the LCR to “drive ROE down” to create “safer institutions.” Gorton responded that the Lucas Critique is “a serious thing;” and “quibbling over the numbers is not right. [Policymakers] need to do better than that.” Graseck added that banks have to deliver ROE in excess of 10-11 percent, which is approximately their cost of capital under the new regulatory regime, in order to attract investors who seek the best risk-adjusted return in the marketplace, which she estimated to be above 10-11 percent. Gorton added that regulators do not decide how much banks earn; they just determine where such market activities occur (i.e. in shadow banks or elsewhere).
Another audience participant asked what the average citizen or ‘layperson’ who is concerned about the effects of the last recession about what government and private sector should be doing to prevent the next crisis. Gorton explained that financial crises are the norm in the U.S. and other market economies, and reiterated that he “does not see this time as being any different.”
Panel 2: What’s happening to liquidity in the bond market?
David Wessel, Director of the Hutchins Center on Fiscal and Monetary Policy, Brookings
Wessel noted that significant reforms have taken place in the financial system as a result of the financial crisis have impacted the way that the Treasury market works, and noted frequent assertions of decreased liquidity in treasury markets.
Darrell Duffie, Dean Witter Distinguished Professor of Finance, Stanford University
Duffie examined whether regulatory reforms have changed bond market liquidity in a significant way.
He noted that the regulatory reforms have induced banks to act as agents in a transaction, as well as to shift from intermediating low-risk products to higher risk products, though he noted constraints imposed by the supplementary leverage ratio (SLR). Duffie explained that reduced dealer inventories could give rise to disintermediation of the banks, through the rise of shadow bank intermediation and bond trading on all-to-all platforms.
Duffie maintained that the “usual measures of liquidity look good” considering the substantial reforms that have been made to the financial system, and argued that there are no signs of “serious problems with financial market liquidity.” Duffie pointed to low bid-ask spreads in the Treasury markets, as an indicator of stability in the bond markets.
However, he noted that turnover and trade sizes are “dramatically lower,” which may pose some potential problems. Duffie cautioned that the effects are “still playing out” and predicted that the bond market will become more volatile once interest rates normalize. In turn, he explained that policymakers will find out whether the market can handle a “sudden rush for the exits.”
In corporate bond markets, Duffie noted that bid-ask spreads are “quite benign” but trade sizes are down, and recalled that some of these effects were driven by factors other than financial reforms, as heightened transparency requirements [through the Trade Reporting and Compliance Engine (TRACE)] were enacted before the crisis and may have adversely affected market liquidity. Duffie suspected that hedge funds and other levered investors could be “potential victims” of sudden bond fund redemptions. His overall conclusion was that it is “too early to say” whether financial reform has reduced bond market liquidity.
Victoria Ivashina, Professor of Business Administration, Harvard Business School
Ivashina agreed that it is “too early to draw conclusions” about the effect of regulation on market liquidity but argued that the current evidence does not suggest that the market and policymakers should worry about liquidity levels. However, she argued that the average liquidity indicators do not signal what will happen in the event of tail risk events, such as the spikes in Treasury markets on October 15, 2014, which she explained are rare.
Nellie Liang, Economist, Federal Reserve Board
Liang explained that she agrees with Duffie’s assessment that changes are occurring and the effects are still playing out. Still, Liang asserted that reduced market liquidity comes at the benefit of a more stable financial system. Liang also referenced structural changes in fixed income markets that preceded the financial crisis, including TRACE (since 2002), which she explained “removed information advantages that dealers had” historically. In addition, Liang noted that since the financial crisis, dealers’ market making activities have declined due to their own changes in risk appetite, as well as from effects of financial reform.
Liang noted that mutual fund intermediation “has become more complex” and referenced the “fundamental mismatch” between on-demand redemption offered by funds and the less liquid assets in which they are investing, and added that such risks are being addressed by the Securities and Exchange Commission (SEC) and the Financial Stability Oversight Council (FSOC).
Shadow Banking: Thinking Critically about Non-Bank Financial Intermediation
In his remarks, Tarullo recalled that the financial crisis highlighted two major vulnerabilities: 1) the magnitude of too-big-to-fail; and 2) the size and fragility of the shadow banking system and the extent to which it was integrated with the regulated banking system. Tarullo noted that specific fragilities that contributed to the financial crisis have been addressed, including increased capital, improved accounting, and other regulatory standards. Tarullo affirmed that the financial system is “safer than before the crisis,” but cautioned that “safer does not mean safe enough.”
Tarullo signaled that the banking agencies will be proposing the Net Stable Funding Ratio (NSFR) in the “next few months,” and noted that the Fed is currently reviewing its annual stress testing and capital planning exercises. While recognizing the progress made within the banking industry, Tarullo cautioned that circumstances in the shadow banking sphere are “somewhat different,” and noted that “risks to financial stability may arise new from activities mostly or completely outside the gambit of prudentially regulated firms.” Tarullo acknowledged that it would be difficult to “navigate the perils of underappreciating the risks to financial stability arising from, and the costs from overreacting to, new forms of nonbank financial intermediation.” Thus, he offered three observations: 1) it is essential to disaggregate the various activities that fall under the term ‘shadow banking’ to assess the risks and benefits they pose; 2) it would be helpful to identify the nexus of specific ‘shadow banking’ activities to the prudentially regulated sector; and 3) institutional considerations will be important in “defining the potential, and actual, regulatory responses to nonbank intermediation.”
Tarullo explained that the variety of non-bank intermediation reinforces the importance of focusing regulatory attention on specific risks, not on entities themselves, and added that the “optimal regulatory response” would not be to impose bank-like regulation on non-banks. Tarullo also called for the need to balance the risk assessment of specific forms of non-bank intermediation with the benefits those intermediation services provide. For instance, he explained that the proliferation of mutual funds offer a variety of diversified investment vehicles to American consumers, and nonbank intermediaries increase the diversity of the economy’s capital providers, as well as provide credit to borrowers that are underserved by traditional banks.
Tarullo reiterated that non-bank intermediation activities “often grouped under the heading shadow banking are not monolithic” and that the “level of a particular activity is less important than the degree of vulnerability that it creates.” He added that it would be “wrong to assume that all shadow banking ought to be regulated to safeguard financial stability.” Thus, Tarullo called for regulators, when “assessing whether regulation is appropriate for specific forms of nonbank intermediation” to balance “the resulting increase in socially beneficial credit, capital, or savings options against any associated increase in risks to the safety and stability of the financial system as a whole.”
Tarullo explained that the key risks to bear in mind in regulatory assessments of non-bank intermediation include: 1) the extent of reliance on maturity or liquidity transformation; 2) the creation of cash-equivalent assets; 3) the use of leverage; and 4) the degree of interconnection with the traditional banking sector. Tarullo cautioned that careful analysis of these factors is needed, and that one way to limit the growth of the shadow banking sector is to make sure that the regulated sector is not “unnecessarily burdened.” In doing so, Tarullo asserted that the Fed has tailored regulation to the size and scope of banking activities, and incorporated a measure of a firm’s reliance on short-term wholesale funding in the long-term debt requirement under TLAC as well as the G-SIB surcharge. Still, Tarullo cautioned that, while it would be “inadvisable to apply bank style regulation to non-banks,” a degree of consistent regulatory treatment is desirable to address bank-like risks in the non-bank financial sector and reduce regulatory arbitrage. For instance, he explained, minimum haircuts for securities financing transactions (SFTs) have been applied market-wide.
Tarullo argued that by allowing FSOC to designate non-bank intermediaries as systemically important financial institutions, Dodd-Frank “fills a gap that existed in the pre-crisis period.” With that said, Tarullo maintained that the “vast majority of firms engaged in [non-bank intermediation] activities will not satisfy the statutory test for designation” and that it is “unclear” that the statutory prudential requirements for designated firms would be “necessary or appropriate” in dealing with the risks to financial stability posed by the activities of these firms. Instead, Tarullo advanced the idea of “prudential market regulation,” whereby traditional investor protections would also incorporate a “system wide financial stability perspective.” Such a regulatory approach would take into account “system-wide demands on liquidity during stress periods, and correlated risks that could exacerbate liquidity, redemption, or fire sale pressures.”
Tarullo recapped SEC Chair Mary Jo White’s regulatory roadmap for regulating the asset management industry. However, he cautioned about the potential drawbacks of such institutional approaches: that if the primary regulator over one sector believes that regulation is creating debilitating disadvantages for firms in that sector, they might be tempted to roll back regulation. This, he explained, took place in the 1970s during deregulation of banks.
Tarullo concluded by stating that the “financial system as a whole is obviously safer” post-crisis but called on financial regulators to “develop effective […] mechanisms” for “prudential market regulation.”
Question and Answer
In response to a question, Tarullo countered the idea that “the recipe” is one for never ending regulation. He argued that regulators are trying to identify and regulate specific activities that actually do pose risk to financial stability.
Tarullo argued that FSOC is actually “quite thoughtful” in its assessment of how activities might give rise to financial stability risks. Within the Fed, he explained that there is a “pretty sophisticated effort” to think through potential stability risks, as well. He argued that there are “some advantages” to having a decentralized regulatory system.
When asked, Tarullo explained that it is natural to expect a search for yield in an era of sustained low interest rates, which is a downside of accommodative monetary policy. Tarullo shared that he is more comfortable shifting away from “calendar guidance” but something “outlook driven.” Tarullo stated that all policy actions have merits and downside risks, but that this is not a reason for classifying them as “bad policy action[s].”
A member of the audience questioned whether the Legal Entity Identifier (LEI) could help monitor financial stability risks arising from shadow banking activities. Tarullo agreed that the LEI could help monitor shadow banking activities by identifying the nexus between the regulated and unregulated sectors.
In response to a question from the audience, Tarullo explained that consolidated regulation and supervision helps address any potential problems arising from overseas subsidiaries of U.S.-based firms. In addition, he explained that using international frameworks to extend regulation to overseas affiliates helps address arbitrage.
Tarullo concluded by stating that the financial system is safer since the crisis but cautioned that the “moment we decide we are safe enough is when the problems will start to arise.” Still, he did not agree that the system will “always need more regulation” but explained that regulators’ analytical processes always need to be aware of how markets are changing.
Session 4: Thinking Critically about Non-Bank Financial Intermediation
In response to a question, Bernanke disagreed that the Dodd-Frank Act would prevent the Federal Reserve from intervening in a crisis as it did during the financial crisis under his leadership. He explained that Dodd-Frank added some restrictions, but the important ability of the Fed to serve as a lender of last resort for a class of borrowers is preserved. In addition, Bernanke explained that new authorities granted under Dodd-Frank include an orderly liquidation authority to put a firm “out of its misery, so to speak” to preserve financial stability. Bernanke closed by stating that it is essential that the Fed preserved its lender of last resort facility, and an inability to do that would have been “a very serious problem.”
Gorton agreed that stress testing is one regulatory tool that came out of the crisis that helped move discretion back to the regulators, which was a “good thing” that resulted from the financial crisis.
Duffie cautioned that foundations in repurchase (repo) markets are still not sound, so “there’s a lot more to do.” Bernanke countered that there has been a lot of progress made in making repo markets more sound, including operationally.
In response to an audience question about whether Glass-Steagall should be reinstated, Gorton argued that there is “no real going back” to Glass-Steagall, and Bernanke explained that he is “puzzled” as to why this is a topical theme because during the financial crisis both commercial and investment banks lost money so Glass-Steagall was “pretty irrelevant.” In fact, Bernanke argued, Glass-Steagall would have been “destabilizing’ because it would have prevented some of the acquisitions that happened during the event.
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