by Stephen G. Cecchetti, Brandeis International Business School
Introduction: Unintended consequences from well-intended banking regulations may create a shadow banking sector that is a risk to the nation’s financial stability.
In the comprehensive banking reforms adopted in the 1933 Glass-Steagall Act, legislators included a prohibition on paying interest on demand deposits and set caps on the interest rates that banks could pay holders of savings accounts. The interest rate rules were quickly implemented by the Federal Reserve Board under its Regulation Q. But in the 1970s, when inflation started spiking, the interest rate on 12-month Treasury notes went up with it (see the accompanying figure), and real yields became negative (below -6% in 1974), financial institutions looked for a way around Regulation Q.
The response of the banks to this market opportunity was the NOW account, which paid interest and allowed check writing but did not fit the regulatory definition of a demand deposit. A much greater, more durable innovation came in 1971 in the form of the money market mutual fund (money market fund for short, or MMF). The MMF is a “shadow bank”: It takes deposits and makes loans, but it has no bank charter, is not regulated as a bank, and thus was not covered by Regulation Q. These new investment vehicles quickly boomed. By the time Regulation Q was phased out in the 1980s, the volume of MMF deposits had overtaken that of traditional demand deposits.
In banking circles, this well-known story is a cautionary tale. Driven by the cascade of bank failures during the Great Depression, lawmakers thought that capping deposit rates would make the system safer. They would protect banks from dangerous competition that would induce risky lending and, they believed, ultimately lead to another wave of failures. Instead, by restricting banks’ ability to compete, Regulation Q eventually drove a significant fraction of checking and savings customers out of the regulated system altogether and into the new MMFs. It could be argued that this enormous flow of money out of the regulated banking system eventually led to the collapse of the savings and loan industry in the 1980s and to the web of opaque interconnections between banks and shadow banks that contributed to the chaos of the global financial crisis that started in 2007.
Banks are fundamental to the operation of a modern economy. At the same time, they can be a source of instability both for themselves and for the economy as a whole. Nearly 150 banking crises have erupted around the world since 1970. The cost of these crises has been enormous, each one on average wiping out nearly one-fourth of a year’s GDP in the country where it occurred. Our collective goal must be to secure the stability of the financial system while preserving the essential benefits it provides.
Is Regulation On Track?
Central banks and supervisors, backed by legislative authority, have been rising to the challenges posed by the global financial crisis that began in 2007, reforming bank regulation in a way that is surely making regulated institutions safer. But these officials are working within a system that still regulates institutions according to their legal form, a system that gave birth to the Depression-era deposit rate rules that caused financial turmoil in the 1970s and ’80s.
Hence, today’s postcrisis regulatory efforts run the same risk as yesteryear’s: evolving financial conditions creating customer demands that can’t be met by banks, then banks partly adjusting by finding a way around the new rules (as they did with NOW accounts), and – potentially more threatening – new shadow banks arising to take the remaining unmet demand completely outside of the bank regulatory system. What this means is that our current efforts to secure stability could ultimately leave us with safe but not terribly useful banks operating in a financial system that is still unsafe.The solution is to widen our perspective and shift the frame of our thinking away from institutions and toward activities and functions. We need a system in which every institution providing a banking service faces the same regulation and supervision, whether it happens to be a chartered bank or not.
By banking service I mean the fundamental functions of intermediation: credit transformation, liquidity transformation, maturity transformation, and access to the payments system. Each transformation function generates returns by producing assets with a characteristic that diverges from that of the bank’s liabilities: Credit transformation produces assets that are riskier than liabilities; liquidity transformation, where assets are less liquid than liabilities; and maturity transformation, in which assets are longer term than liabilities. And access to the payments system comes from providing liabilities that are accepted as payment.
A traditional bank performs all of these intermediation functions – funding long-term, illiquid, high-risk assets with short-term, liquid, low-risk liabilities. In doing so, banks significantly reduce the cost of credit provision relative to what it would be if lending were done directly. They achieve this efficiency in numerous ways. The most important is by overcoming information asymmetries in the extension of credit – that is, screening potential borrowers to establish creditworthiness and monitoring borrowers to ensure performance once loans are made. The consensus view is that banks have a comparative (and likely absolute) advantage over other types of intermediaries in conducting these activities.
But as intermediaries, banks are inherently fragile. By offering withdrawal on demand on a first-come first-served basis, they are subject to runs. Because bank assets are generally opaque – liability holders cannot readily evaluate what they are worth – perceived as well as actual losses can produce runs. And problems at one bank (again, real or perceived) can spread rapidly to others, creating systemwide panic. If banks are forced to sell their assets in an attempt to meet withdrawals, they just make the situation worse.
In response to this fragility, public policy created a safety net with two elements: deposit insurance and central bank liquidity support (known as the lender of last resort). The first reduces the likelihood of deposit runs, and the second eliminates the need for forced asset sales. But these protections create a new systemic risk: moral hazard. With the public guarantees in place, a bank’s owners and managers reap the benefits of their success but not the full costs of their failures, so they may engage in too much credit transformation, too much liquidity transformation, and too much maturity transformation. Too much, that is, relative to what society needs. And that is the basic rationale for regulation.
In line with that rationale, the global financial regulatory reforms in Basel III are based on the idea that the system needs to create limits that guide financial sector participants to act in ways that are in the public interest. Enhanced capital requirements are designed to address the tendency of banks to engage in too much credit transformation. Liquidity requirements are intended to reduce the urge to engage in too much liquidity and maturity transformation. In each case, the idea is to impose a type of bank tax. For a given asset composition, capital requirements restrict the liability structure. And for a given liability composition, liquidity requirements restrict banks’ asset structure.
But if the post-crisis regulatory system is to make the system safer in the face of inevitable stresses to come, we need to ensure that all banking functions are treated equally. That is, if an entity has assets more risky, less liquid, or of longer maturity than its liabilities, and if it faces the possibility of runs or forced sales, it should face capital and liquidity requirements regardless of its legal form.
In fact, today our greatest concern is market-based intermediation. It includes repurchase agreements (repo), asset-backed commercial paper (ABCP), securities lending, securitization, and MMF and bond mutual fund investments. Each of these shadow banking activities provides a traditional banking service:
- Repo involves exchanging a security for cash, surely a case of liquidity and maturity transformation and – if the security is risky – credit transformation as well (see Reforming Try-Party Repo).
- MMFs hold commercial paper assets and offer demandable liabilities – the liabilities are lower risk, more liquid, and shorter term than the assets (see Form vs. Function: Regulating Money Market Funds).
- ABCP is short-term commercial paper issued to finance things such as shares of securitization pools – again, the liabilities are lower risk, more liquid, and shorter term than the assets.
- Bond mutual funds hold corporate or foreign private bond issues and offer the ability of their shareholders to sell at end-of-trading-day (estimated) net asset values – liquid, short-term liabilities and much less liquid, long-term assets.
- Finally, in securities lending, the lender can take the collateral from the borrower, sell or repo it, and use the proceeds to purchase a relatively illiquid security – liquid liabilities are transformed into illiquid assets.
It is worth noting that, prior to the crisis, banks were heavily involved in some of these activities. But regulators identified repo and securities lending, which can be as short as overnight, as a potential source of fragility. The response is higher capital requirements, especially the unweighted leverage ratio, and liquidity requirements, in the form of the Liquidity Coverage Ratio. Combined, these have increased the cost for banks to engage in these activities, driving them out of the banking system in manner analogous to what Regulation Q.
Has this shift in market-based intermediation increased systemic risk? To see the systemic risk implications of this market-based intermediation, notice that institutions providing bank services need bank-like balance sheet structures and hence have bank-like fragilities – that is, they are subject to runs. And like banks, shadow banks create two types of externalities: panics and fire sales. As with a traditional bank, the shadow bank’s liability holders are likely to have little knowledge of the quality of the entity’s assets. It’s true that MMFs and bond mutual funds are more transparent than a traditional bank, as their assets are themselves marketable securities. But that transparency has its limits, especially in times of stress. So if one of these funds suffers from a run or simply fails, liability holders can get spooked and generate pandemonium.
The risks of panics and fire sales in the traditional banking system have been managed with the combination of deposit insurance and a lender of last resort. During the height of the crisis, U.S. authorities afforded shadow banking functions similar backstops, among them insurance for MMFs and liquidity backstops for commercial paper issuers.
(note: For example, from October 27, 2008, to February 1, 2010, the Federal Reserve operated the Commercial Paper Funding Facility. And from September 19, 2008, to September 18, 2009, the U.S. Treasury provided guarantees to money market mutual funds.) Some of these moves were executed by the Federal Reserve using authorities that became restricted by the 2010 Dodd-Frank Act. As a result, the Fed can no longer provide liquidity backstops to non-banks except through programs with broad access that are approved by the Secretary of the Treasury. That means it will be more difficult to solve such problems in the future.
But how likely are such problems going forward? Some recent developments may convey the impression that systemic risk and shadow banking have been contained since the crisis. After all, the structure of bank balance sheets has improved – banks have been meeting higher regulatory requirements for equity funding, so they have less leverage than they did
before the crisis. And shadow banking has waned as a proportion of all credit intermediation. As shown by the red line in the second figure, the bank fraction of intermediation dropped by almost half between 1980 and 2007, from about 80% to about 45%, but it has since risen to the current level of about 60%. That makes the fraction of intermediation inside the regulatory perimeter larger now than at any time since 1992. From the perspective of systemic risk, that’s a good thing.
And as the table shows, with the exception of corporate bond volume – directly held as well as in mutual funds – each form of shadow banking and other non-bank intermediation activity has shrunk, in some cases considerably.
So, yes, we have come some way in addressing the systemic nature of regulated banks through tighter prudential regulation; and yes, shadow banking is playing a smaller role. But before we declare victory, we need to ask what is restraining shadow banking activity and whether it is likely to remain modest in scale. Although the recent shrinkage is surely part of the ongoing reaction to the changed regulatory environment, the adjustment process is far from over, and there are other factors at play.
Two things should lead us to worry. First, current yield curves are very flat, so funding long-term assets with very short-term liabilities is far less appealing than it was before the crisis. Partly as a result, banks have been extending the maturities of their liabilities – after all, there has been little opportunity cost in doing so. The incentive to rely on short-term funding will climb again once the yield curve reverts to some semblance of normality. When that occurs, we may see a revival in a variety of shadow banking vehicles, especially repo.
Second, and more importantly, serious arbitrage of the new financial regulations will not get underway until the regulations are finalized and the interest rate environment has returned to normal. Regarding potential arbitrage by banks, regulators now know where to look and what to do. But authorities remain far less prepared for the vigorous return of shadow banking, especially if, as is likely, financial innovation produces a variety of new shadows.
We should not be fooled by recent trends. Instead, we should use the time afforded us by these temporary conditions to develop a more functional regulatory scheme. We will then be better prepared when shadow banking reemerges, as it is already doing in other parts of the world and almost surely will in the United States, too.
This means we need a way to address the systemic risk created by the non-bank financial system. That’s where functional regulation comes in. Let’s look at two examples: money market funds and repo. As I said earlier, these are banks and banking activities in everything but name. It is true that the SEC has tightened the regulatory requirements on institutional money market funds (which account for roughly one-third of total MMF assets). Institutional MMFs are now required to have floating net asset values and have the option of imposing withdrawal fees and redemption gates. I agree with SEC Commissioner Kara Stein that the latter changes, especially gates, make runs more likely – that is, by failing to impose capital and liquidity requirements on MMFs, we have failed to solve the problem. Functional regulation of MMFs means that they would face the same regulatory requirements as chartered banks.
For repurchase agreements, functional regulation means a change in their
treatment in bankruptcy. Currently, the holder of collateral posted by a repo counterparty can simply sell it if the counterparty fails to deliver the cash needed to reclaim it. So long as the collateral is highly liquid – such as Treasury securities or something similar – all is well. If the collateral is illiquid, the move to sell it will quickly lead to fire sales. This argues for creating a threshold for inclusion of securities in the bankruptcy mass. For example, we might
consider a rule whereby securities that are included in the list of high-quality liquid assets that qualify under the Basel III liquidity coverage ratio would be exempt, while others would not.
The lesson is, we need banking services, and we need a financial system in which the transformation of credit, liquidity, and maturity, as well as access to the payments system, are supplied efficiently and safely. Banks have done that in the past and continue to do it today. And work is progressing to ensure that they do it safely. Critical to the success of that work is ensuring that certain financial institutions are not disadvantaged just because they have a bank charter or take on a certain legal form. That will harm the banks and it will leave the wider financial system at greater risk – remember Regulation Q? All banking activities, regardless of how they are provided, should be treated the same way.