Today we release CFS monetary and financial measures for July 2014. CFS Divisia M4, which is the broadest and most important measure of money, grew by 2.6% in July 2014 on a year-over-year basis versus 2.5% in June.
For Monetary and Financial Data Release:
For more on Divisia methodology and past releases for the U.S.:
The SEC adopted amendments to the rules that govern money market mutual funds under the Investment Company Act. According to the SEC, the amendments are designed to address money market funds’ susceptibility to heavy redemptions in times of stress, improve their ability to manage and mitigate potential contagion from such redemptions, and increase the transparency of their risks while preserving their benefits.
Specifically, the SEC adopted amendments that are intended to:
- remove the valuation exemption that permitted institutional non-government money market funds to maintain net asset value (“NAV”) per share, and require those funds to sell and redeem shares based on the current market-based value of the securities in their underlying portfolios rounded to the fourth decimal place; i.e., transact a “floating” NAV;
- provide Boards of Directors of money market funds with new tools to stem heavy redemptions, as well as afford them the discretion to suspend redemptions temporarily;
- require all nongovernment money market funds to impose a liquidity fee if the fund’s weekly liquidity level falls below a designated threshold;
- increase the diversification of the portfolios of money market funds, enhance their stress testing, and improve transparency by requiring money market funds to report additional information to the SEC and investors; and
- require the investment advisers to certain large unregistered liquidity funds to provide additional information about those funds to the SEC.
The effective date of these amendments is October 14, 2014. Other specific compliance dates will occur within the rule release.
It will be interesting to see whether the new money market rules are satisfactory to the banking regulators, acting either through their bank regulatory caps or in the name of FSOC. Notably, in a recent speech, the President and CEO of the Federal Reserve Bank of Boston said this: “While I would have preferred even more protection against financial runs on money market mutual funds, this element of the recent rulemaking does represent a meaningful improvement. Still, I am certainly on record as questioning whether the imposition of withdrawal restrictions (‘gates’) and fees will help to stabilize money market mutual funds in crisis situations” [footnotes omitted].
In his speech at the New York Conference on the Risks of Wholesale Funding, President of the Federal Reserve Bank of Boston Eric S. Rosengren stated that there should be a “comprehensive re-evaluation” of the capital regulation of broker-dealers (i.e., intermediaries that effect transactions in securities), given the lessons of the financial crisis. In other words, the capital regulations imposed on broker-dealers should be raised materially. According to Mr. Rosengren, the market’s perception that broker-dealers were not financially sound because they did not hold enough capital resulted in a reduction in liquidity in the credit markets that support economic activity during the financial crisis; thus, economic activity was severely impaired. Accordingly, Mr. Rosengren suggested, there should be an increase in capital requirements for any bank holding company with significant broker-dealer operations.
Mr. Rosengren states that an increase in capital requirements would result in a reduction of the profitability of broker-dealers (or bank holding companies). He does not make explicit the consequences from that. Any reduction in profitability (meaning any increase in expenses) will inevitably reduce the level of activity and increase the cost that others (such as market participants) must pay to justify the expense of the activity. If Mr. Rosengren’s concern is that broker-dealers are not reliable providers of liquidity to the credit markets, then it is hard to see how increasing their capital requirements improves liquidity in those markets. Rather, his proposal should result in a material reduction of liquidity in the credit markets, which (in theory) should result in a material increase in corporate borrowing costs.
Mr. Rosengren’s proposal would seem less damaging to the market if banks were able to step in and provide the liquidity that his proposal would force broker-dealers to reduce. However, banks are prevented generally by statute or banking regulations from engaging in many broker-dealer activities. Furthermore, if the Dodd-Frank “push-out” rule goes into effect as scheduled, then swaps activities will be pushed out of banks into broker-dealer or other non-bank entities, increasing the importance of these institutions as providers of liquidity to the credit markets. In short, a Congressional policy that forces credit activities out of banks, combined with a regulatory policy that disfavors the provision of credit activities by non-banks, does not seem a good fit. The end result has to be a reduction in liquidity in the credit markets provided by regulated financial institutions, which may be compensated somewhat by an increase in credit market participation by unregulated institutions (or “shadow banks”), which the regulators also seem to disfavor.
A further irony of Mr. Rosengren’s approach of effectively disfavoring broker-dealers and the capital markets, as compared to banks, can be seen in the mortgage market. Using deposits to make mortgage loans (or borrowing short term and lending long term) has long been recognized to produce a mismatch. What made this mismatch workable is that banks were able to sell their mortgage loans to the capital markets through securitizations. But if banking regulators adopt regulations that reduce the liquidity of the capital markets, including securitizations, isn’t one effect to make it far more difficult for banks to sell their loans, which will exacerbate the funding mismatch at banks?
Higher capital charges advocated by Mr. Rosengren are already coming into effect, which will have the (negative) consequence of reducing liquidity in the credit markets. Recent reports demonstrate that broker-dealers are beginning to withdraw significant amounts of money from the lending markets as a result of the more punitive capital regulations imposed by the bank regulators (who have authority over the capital held by the holding companies that own the broker-dealers).
Federal Reserve Bank of New York President William C. Dudley delivered opening remarks at the Workshop on the Risks of Wholesale Funding. The Workshop was held in New York on August 13, 2014 and was sponsored by the Federal Reserve Bank of Boston and the Federal Reserve Bank of New York.
Mr. Dudley’s remarks focused on the role of wholesale financing (such as money-market mutual funds and tri-party repo) in the financial crisis. As Mr. Dudley explained, in the years preceding the crisis, market participants came to rely on short-term funding to finance longer-term assets, creating maturity mismatches. This type of financing, especially when used to finance illiquid and opaque assets such as mortgage-backed securities, is inherently prone to bank runs and self-fulfilling prophecies of financial weakness.
But while these risks have long been recognized in the banking sector, where recurring bank runs were eventually eliminated with a combination of deposit insurance, the Federal Reserve’s role as “lender of last resort” and prudential regulation, they were not as effectively perceived or addressed in the “shadow banking” system. The financial crisis began when losses in the mortgage market forced market participants to sell assets, pushing prices down and spurring lenders to demand more margin. This created a vicious circle that made the weaknesses of the shadow banking system more apparent as the liquidity crisis spread with startling speed and severity.
The Federal Reserve (“Fed”) and the U.S. Treasury Department (“Treasury”) stepped in with a number of programs designed to inject liquidity into the system and stabilize the markets. The Fed intervened in the tri-party repo markets, money-market mutual funds, and even directly in the market for commercial paper, among other places. Although these stopgap measures were effective at that time, Mr. Dudley argued, they were not a sufficient response to the weaknesses of the shadow banking system, especially since Dodd-Frank imposed more stringent conditions on the Fed’s authority to engage in emergency lending in the future. The Workshop on the Risks of Wholesale Funding was organized as part of the Fed’s ongoing efforts to increase the stability of the U.S. financial system. Below is a link to a PDF of the agenda for the workshop that, in turn, contains links to several papers that were presented. One of the topics discussed was whether the Bankruptcy Code’s safe harbor for repurchase transactions should be reconsidered and potentially limited to liquid securities (and not, for instance, to mortgage-backed securities).
Representative Carolyn Maloney (D-NY) wrote a letter to Secretary of the Treasury Jacob Lew in which she voiced her concern that the FSOC process for identifying and designating nonbank systemically important financial companies has “created needless uncertainty,” and recommended that FSOC communicate sooner with companies under consideration.
Representative Maloney made suggestions to improve the FSOC designation process that included the following:
- FSOC should provide notice to companies that have advanced to Stage 2 of the designation process, either affirmatively or upon request;
- FSOC should begin engagement with a company that is under consideration once the company has advanced to Stage 2 rather than waiting until Stage 3;
- once FSOC has provided a company with notice that they have advanced to Stage 3, FSOC should identify the particular issues that it believes merit further review in order to determine whether the company is systemically important; and
- once FSOC votes on a proposed designation for a particular company, FSOC should adopt a policy of automatically granting an oral hearing to the company upon request.
According to Representative Maloney, these “modest changes would improve the designation process without undermining the Council’s ability to identify, monitor, and mitigate systemic risk.”
In a statement by the U.S. Treasury Department, it affirmed that it is committed to conducting FSOC business in an open and transparent manner and is reviewing Representative Maloney’s proposals.
Representative Maloney’s letter is interesting in that it consists of mild criticism by a Democrat of a regulatory organization that has received severe criticism from Republicans. Thus, it may be viewed as an attempt to find middle ground or to blunt a call for more significant changes to FSOC’s operations. The implementation of Representative Maloney’s recommendations would represent some improvement in the manner in which FSOC conducts its process. Recognizing that a fuller review of FSOC would be impractical in our divided Congress, adoption of her suggestions would be preferable from a policy perspective, although her suggesetions would leave open fundamental questions about the FSOC, including its organization, mandate, authority, processes and even continued existence.
The U.S. Government Accountability Office (“GAO”) issued a report examining how financial reforms have altered market expectations of the potential government rescue of a failing large bank. The report examines whether funding advantages remain for the largest bank holding companies due to an expectation that these banks would receive government support if they were ever to fail.
“Too big to fail” is the notion that the federal government would intervene to prevent the failure of large, complex financial institutions to avoid destabilizing the broader economy. According to GAO, expectations that the government will rescue the too-big-to-fail firms can counterweigh investor incentives to properly price the risks of the firms they view as too big to fail and, potentially, as giving rise to funding and other advantages for these large firms.
The report found that any funding advantage that once may have been available to a financial institution deemed too big to fail has been reduced drastically or eliminated. Market participants with whom GAO spoke believe that recent regulatory reforms have reduced, but not eliminated, the likelihood that the federal government would prevent the failure of one of the largest bank holding companies.
Here is a throwaway line from the GAO Report (page 16): “Since the onset of the financial crisis, the largest banks have grown bigger in many major advanced economies, even as the financial sector has shrunk. . . . ” It should be evident that the tremendous increase in largely fixed regulatory costs offers a major advantage to big players (whether banks, broker-dealers, advisers or funds) that can spread out these costs due to greater business volume. It is fairly inconceivable that a small investment firm could be competitive with a large firm as a registered swap dealer given the cost of compliance with the regulatory scheme. If, on one hand, it is the case that the regulatory requirements inherently favor large firms and, on the other hand, that regulatory policy is intended to foster competition from smaller and mid-sized firms in order to avert “too-big-to-fail,” then rulemakers should consider whether the regulatory requirements and regulatory policy are in agreement.
Big Is Beautiful.
Senator Kirsten Gillibrand (D-NY) introduced a bill, titled “The Cyber Information Sharing Tax Credit Act,” which is intended to address cyber security vulnerabilities and incentivize businesses of all sizes to join sector-specific information-sharing organizations that provide refundable tax credits for all costs associated with joining.
According to Senator Gillibrand, “Businesses should take the same precautions to defend their data as they do with their buildings and inventory. Just as they purchase insurance and security systems, they should enter into agreements with information sharing organizations to help defend against cyber threats.”
SIFMA President Bentsen issued a statement regarding the bill, calling on Congress to prioritize the bill and cybersecurity generally. He stated that the “legislation would significantly strengthen cyber defenses as it would encourage the industry to share vital threat intelligence with the government without fear of liability and codify important privacy protections for individuals.”