Short term investors are extremely risk-adverse. They demand two things at minimum – ready access to and the safety of their principal. When risk unexpectedly emerges they become nervous, always on the verge of a flight to safety. As we have seen, a large enough flight can turn into a stampede which can cause significant collateral damage.

In the 30’s the risk posed by bank runs was finally tamed by the adoption of the financial safety net for bank deposits. This was not adopted for reasons of altruism, that government was somehow responsible for safeguarding the deposits of widows and orphans and should protect them from risk. Rather it was a pragmatic solution to the risk of bank runs which had the potential to damage the general economy.

In the last two decades a new breed of investors, institutional short-term or shadow bank investors, has emerged who are just as skittish as pre-30’s bank depositors and whose panics can cause as much or even more damage. The fact that commercial paper investors are intolerant of risk is documented by Covitz, Liang and Suarez, in “The Evolution of a Financial Crisis: Collapse of the Asset-Backed Commercial Paper Market” (2012). This is consistent with the reports of commentators on the FSB’s money market fund proposals that there was in fact no run on MMFs but rather a flight to quality as investors shifted from prime MMFs to government-debt MMFs.

How to address the dangers posed to the broader economy by the reactions of these investors to risk is perhaps the central question of financial regulation or, as expressed by Morgan Ricks in Money and (Shadow) Banking: A Thought Experiment (2012), “The instability of the short-term funding markets is, arguably, the central problem for financial regulatory policy”. According to certain commentators, the only way to fully address this new source of risk is to expand the regulatory perimeter, including the safety net, in order to embrace the new investments, in effect replicating the adoption of the safety net in the 1930s for the benefit of short term investors of all types.  In my earlier posting, I had floated a more limited suggestion along these lines.

In an IMF Staff Discussion Note dated December 4, 2012 entitled “Shadow Banking and Policy”, Claessens, Pozsar, Ratnovski and Singh referenced several problems facing any such solution:

“It is unclear whether it is appropriate for the government to engage in creating financial market assets with the sole purpose of catering to a particular investment clientele. For example, this may create moral hazard in that the private sector may come to expect that the government will accommodate its demand for specific types of assets. In addition, continually assessing the demand-supply balances to avoid safe claims shortages may be complex, since the definition of safe assets is not clear, constantly changing, and can vary internationally. Also, some demand for safe assets is driven by factors other than the investment needs of cash pools. For example, demand-side policies may implicitly subsidize banks’ investments in market-based debt instruments, which would be distortive. Finally, demand-side policies would do little to deal with systemic risks elsewhere in shadow banking, such as in collateral intermediation.”

The most popular alternative solution is to concentrate on separating shadow banking activities from traditional banks by severing links and establishing firewalls, and then to leave these activities relatively unregulated. A particularly pointed example of such a view is that of Melanie Fein, a former senior counsel to the Board of Governors of the Federal Reserve System. In “The Shadow Banking Charade” (2013) and her comments on the FSB’s money market fund proposals, she outlines in detail the evolution of banking regulations in the 1980’s and 1990’s and the role of regulators in enabling and even encouraging banks to shake off the constraints which traditionally had kept them in line:

“To the extent shadow banking caused the crisis, it did so because banking regulators misjudged the evolution of financial risks within the regulated banking system and allowed large banking organizations to become immersed in shadow banking activities with insufficient capital, liquidity, or supervisory oversight. The crisis in the shadow banking system was a crisis of the regulated banking system.”

In her view, banks themselves are the largest shadow banks and regulations should be directed primarily if not solely at controlling their behavior and not that of non-bank financial intermediaries:

“Shadow banking activities are not inherently risky, although they can become so when conducted by highly leveraged, government-backed institutions perceived as too-big-to-fail…

Shadow banking activities of banking organizations pose greater risk to the financial system than such activities outside the regulated banking system. When conducted by banks and their affiliates, such activities have access to deposits (both insured and uninsured) as a source of funding and leverage. Such activities thereby have greater capacity to multiply risk and threaten the safety and soundness of affiliated banks as well as to weaken the ability of parent bank holding companies to serve as a source of strength to their subsidiary banks. Because these activities occur under the immediate purview of banking regulators, they enjoy the perception of an implicit government guarantee. This guarantee gives them an artificial competitive advantage over other firms and is a source of moral hazard. Shadow banking activities conducted inside the regulated banking system are within the federal safety net and thus pose potential liability to the taxpayers.

The critical undertaking for regulators is to identify which shadow banking activities are appropriate for government-backed banking organizations and which are not. Questions such as whether nonbank affiliates of banks should have access to deposits and the federal safety net are appropriate. The policy question that arose in the 1980s concerning the viability of the traditional model of banking should be re-visited. Federal Reserve officials have said one of the key policy debates under consideration is whether to break up large financial institutions or impose other prohibitions on affiliations of commercial banks with certain business lines. Certainly it is incumbent on regulators to reign in banking organizations deemed too-big-to-fail.”

Doubts about the efficacy of a policy aimed solely at banks’ activities have been raised, again as outlined by IMF staff:

“This view, however, ignores the fact that it may be impossible to fully separate traditional banking from shadow baking, and it would come with large costs. Commercial banks increasingly rely on hard and tradable claims, with the distinct economic benefits of hedging, diversification, and better availability of funding. And even if direct links were severed (e.g., as in how the Vickers proposal in the United Kingdom aims to separate a bank’s retail operations from its other activities), by virtue of its mere size shadow banking activity could still have macroeconomic and systemic implications, since externalities with adverse real-sector consequences can arise regardless. Also, by moving shadow banking outside the regulatory perimeter, policymakers may have less information on how it is operating.”

Notwithstanding the assertions of the contesting parties, the correct approach will ultimately be dependent upon whether or not the primary cause for the massive expansion of shadow banking leading up to the crisis is determined to have been bank arbitrage activities or the demand for alternative safe assets. The answer is still not apparent as IMF staff makes clear:

Addressing the shadow banking system is a work in progress for regulators and policymakers, and research is yet to catch up fully with the issues.  While driven partly by regulatory arbitrage, the shadow banking system performs a number of economically useful functions. However, research has not been able to differentiate the economic drivers of shadow banking from regulatory arbitrage, making policy recommendations more difficult. Regardless, a multifaceted policy response to systemic risks arising from shadow banking is necessary. Such responses, if effective, may make the shadow banking system smaller in size but unable to perform its useful economic functions in safer ways. Since not all components of the response are yet clear, more policy-oriented research is needed.”

The regulatory agenda being promoted to date reflects this uncertainty. The first targets of the regulators were indeed the banks. As a result of the new capital, liquidity and leverage requirements of Basel III as well as the Volcker- and Vickers-type rules, participation by banks in shadow banking activities will be less attractive. As if these were not sufficient deterrents, the Basel Committee has also specifically targeted the securitization activities of banks in a consultation document dated December 18, 2012 entitled “Revisions to the Basel Securitization Framework”. The response of industry participants to this document has been quite negative, particularly in respect of the proposed capital requirements for investments in high quality senior securitization exposures.

According to the Canadian Bankers Association, the proposed calibration of capital proposals “fail to produce capital requirements that are commensurate with the actual risk of securitization exposures. This is particularly evident with the proposed capital floor level and maturity adjustment, which significantly increase capital charges on longer-dated, senior high quality exposures.” 

The Toronto-Dominion Bank maintained that the proposals fail to recognize the credit protection offered by subordinated note holders and originators with the result that banks will be forced “to reduce their exposures to senior high quality products in favour of riskier products… in order to achieve minimum capital adjusted returns.”

This was echoed by the Canadian Bankers Association:

“As currently proposed, banks would be able to more cost-effectively finance client assets through purchasing the assets outright without the benefit of the paid-in capital support provided by clients in existing securitization structures…  Indeed, the proposed capital floor would eliminate the capital savings from securitization, effectively giving no credit to the bank for transferring away risk… The proposed rules will cause banks, as investors of these securities, to demand a higher yield to achieve an adequate return from the higher capital requirements. In response, two possibilities can ensue:

  1. If the issuers do not increase the yield on their issued securities, then banks, as investors will be forced to significantly reduce their exposure to senior high-quality asset-backed securities (ABS) and fill the void with riskier whole loan purchases. The ABS will instead be held by unregulated funds, who can price the risk more economically. This result would be yet another example of how more punitive capital rules have the unintended consequence of motivating banks to hold riskier assets and for safer assets to flow away from regulated financial institutions and into the unregulated shadow banking system.  
  2. If banks, as issuers, have to increase yields on ABS to meet demand, they will likely reduce the use of securitization as a funding vehicle. Instead, banks will be pushed to be more reliant on the unsecured wholesale debt market as a funding channel. As a result, banks will have a less diversified funding base and be more highly levered, thereby creating greater riskiness to the overall financial system.”

In the view of Credit Suisse, “The imposition of rules that materially increase the capital requirements of securitizations could have the unintended consequence of creating disincentives for banks to be active in the securitization markets” (Credit Suisse). It is, however, not at all clear that this was an unintended consequence. Rather it is squarely in keeping with the goal of separating shadow banking activities from banks.

Having accomplished this and thus eliminated the systemic risks posed by bank arbitrage (which is undoubtedly a wildly optimistic prognosis), the regulators could have chosen to pause in order to see how things settled. Only after a period of operating under the new rules would the unintended consequences of this already radical reorganization of financial realties begin to emerge and a more nuanced assessment be made of whether the operation of demand—side factors would leave a shadow banking rump which was systemically important or not. If the latter, then presumably nothing further need be done over and above improving transparency and keeping the sector under close surveillance. If systemic concerns remained or emerged, then measures could be adopted to address these specific risks. One would have thought, given the FSB’s own pronouncements, that this would have been the preferred course of action. In its Integrated Overview of Policy Recommendations, the FSB maintained that “the authorities’ approach to shadow banking has to be a targeted one. The objective is to ensure that shadow banking is subject to appropriate oversight and regulation to address bank-like risks to financial stability emerging outside the regular banking system while not inhibiting sustainable non-bank financing models that so not pose such risks”. In their comments on shadow banking entities, Clifford Chance drew what one would have thought to have been the proper conclusion: “Given that the primary objective is to control systemic risk, regulators should focus only on those activities that can be demonstrably shown to be a significant source of real systemic risk. We do not believe that all activities deemed to be ‘shadow banking activities’ should be regulated, or regulated any more than at present.”

As described in my previous posting, such a ‘targeted’ approach was not in fact adopted. Rather, the regulators apparently decided to also seriously encumber the operation of non-bank shadow banking activities at the outset, without the benefit of any evidence that such activities would remain a significant source of systemic risk once the separation of banks from shadow banking activities took effect. That this has not been lost on shadow banking participants can be clearly seen in the comments delivered on the FSB’s shadow banking proposals.

By far the strongest response emanated from the MMF industry, relating especially to the proposals to eliminate stable NAV funds or impose other quasi-capital requirements. In the view of almost all commentators, these proposals are likely to largely destroy the industry. In making their arguments, they rejected several of the claims and assumptions underlying the FSB proposals. Especially since the most recent round of regulatory changes in 2010, it is claimed that MMFs are extremely transparent. According to commissioner Luis A. Aguilar, “many do not realize that due to the 2010 Amendments, money market funds have become one of the most transparent financial instruments for both regulators and inventors” (Statement on Money Market Funds as to Recent Developments (2012)).  More importantly, it was asserted that MMFs have in fact not proven to be susceptible to runs. As expressed by HSBC Global Asset Management,

“In other words, and contrary to much commentary, there wasn’t a ‘run’ from US MMFs per se: rather investors sought to avoid losses by ‘switching’ their exposure from the banking system to the US government; there was a classic ‘flight to qualify’. The flight came to an end when the Federal Reserve’s Temporary Guarantee Programme effectively made prime MMFs ‘as good as’ treasury MMFs and made further switching unnecessary.”

In any case, according to Federated Investors, Inc., the proposals would be ineffective in accomplishing their stated purpose:

“It is contended that what prevents a run-or resolves it before it causes a panic – is liquidity. Using V-NAV rather than C-NAV, imposing holdbacks or other redemption limits, a two-tiered capital structure, or “bank-like” regulations, does not address this core issue.”

Neither, it is contended, is there any evidence that such requirements would eliminate the first-mover advantage. (See Greene and Broomfield, “Promoting risk mitigation, not migration; a comparative analysis of shadow banking reforms by the FSB, U.S.A. and EU (2013)).

However, perhaps in the spirit of accepting a lesser evil, there was support for the imposition of a redemption gate accompanied by a redemption or liquidity fee. As described by SIFMA,

“The gate, when triggered, would prohibit investors from redeeming and provide a period of time for a fund to restore its liquidity. At the time the gate is lifted, the fund would impose a fee on subsequent redemptions until such time as liquid assets in the fund were restored to a pre-determined level. The gate would operate for a brief period. The purpose of the gate would be to allow time for the fund to implement the liquidity fee and make any other necessary determinations regarding the fund’s next steps. Only a gate can truly stop a run”.

According to J.P. Morgan Asset Management, “the standby character of these proposals appropriately balances the goal of allowing MMFs to operate normally when not under stress, yet promote stability, flexibility and reasonable fairness when stressed.”

Thus, “in the absence of a credible deposit insurance policy for the money market fund industry (emphasis added in light of my previous posting), suspension of convertibility should be the preferred option; for regulators, for fund sponsors and for investors. Liquidity gates and liquidity fees provide the clearest disincentive to institutional investors to seek to gain a first-mover advantage by running from their fund; they also provide the strongest policy tool to stop a run once it is underway, by breaking the downward value spiral.” (Mark Hannam, Institutional Money Market Fund Association, “Money Market Funds, Bank Runs and First-Mover Advantage (2013); a conclusion supported in their comments by HSBC Global Asset Management; SIFMA and Blackrock; but see Federated for the contrary view.) 

In addition, it was suggested that concerns around “sponsor support”, which introduces a level of ambiguity about risk ownership which could have a distortionary effect on the pricing of such risk, should be addressed though banking regulation prohibiting bank sponsors from providing support to their MMFs (See Blackrock, HSBC Global Asset Management, Melanie Fein).

Notwithstanding the vehemence with which MMF industry participants have expressed their views, early signals that they have failed to sway regulators include a statement by Ben Bernanke that “a run on money market funds also remained a possibility”  and signals from the European Commission that is “planning to introduce tighter restrictions on stable value money market funds, which some believe would ‘kill off’ the € 490bn industry”. (On a (unintentionally) humorous (at least so it seems to me) note, Bernanke is also reported on saying that the Fed was “monitoring a wide range of asset markets for signs investors were ‘reaching for yield’ in a way that might pose risks to the financial system, given that interest rates were so low”.)

The other aspect of the FSB proposals to attract substantial negative reaction was the quasi-capital proposal of minimum haircuts for repo transactions. This was broadly seen to be, if not destructive of the market, at least potentially distortionary. It was contended that the proposed methodology of calculating haircuts ignores counterparty risk in favour of concentrating on collateral price volatility. “As historic haircuts would clearly have taken into account counterparty risk alongside collateral price volatility, this could significantly distort future haircut levels. Applying extended haircuts to credit-worthy counterparties on an ongoing basis could result in costly implications for the availability of liquidity to credit-worthy participants” (Deutsche Bank).

As expressed by the Association of British Insurers:

“The imposition of statutory minimum haircuts would introduce new potential risks to the financial system. If they are set at too high a level they pose a systemic risk to market liquidity. [As transactions which would otherwise have been below the levels would be lost]. If they are set too low then there is a potential moral hazard risk that participants may abdicate their responsibility to conduct their own risk analysis and simply gravitate to the regulatory minimum haircut as a market standard. There is also a danger that where ‘haircuts’ are not calibrated to a firm’s individual risk appetites they could lead to pro-cyclical effects.

Indeed, we are concerned that these proposals are being made with little analysis of the potential impacts, including the possibility that these requirements could be costly to introduce and enforce while ultimately creating risks that could equal or exceed those that they are intended to address. We note also that stock lending and repo markets provide an important liquidity and price discovery mechanism for the financial markets and the imposition of statutory haircuts may have the negative impact of discouraging market participants.”

Furthermore, considerable doubt was expressed over whether minimum haircuts would in any case be effective to achieve their intended purpose of reducing the risks of runs:

“It is unclear the extent to which haircuts would ever be an effective tool in reducing the risk of a ‘run on repo’ identified in the recent financial crisis. These occurred as a result of sudden changes in market sentiment driven by a complex range of factors and were limited to a specific asset class and the US market. The role which minimum haircuts would play in preventing a repeat of such a scenario is not obvious – certainly not when placed alongside other regulatory interventions designed to target capital, liquidity and leverage directly” (Deutsche Bank).

It may be worth noting that the FT article noted above also reported that “a second leaked draft from the Commission suggests it is likely to expand this regulatory push to cover all funds engaged in securities lending or repo transactions.”

It remains to be seen whether the proposed regulations will be successful in disentangling shadow banking and commercial banking activities. However, it must be admitted that the efforts in that direction are serious and have a chance of accomplishing their goal, however unsatisfactory this may be to the banking community. What may be accomplished in the non-bank shadow banking world is at this point in much greater doubt. If the views of the commentators are to be given credence, one of the two main goals of the regulators, the elimination of debilitating runs, will not be accomplished, but several well understood shadow banking activities will be rendered unattractive in the process. As a result, investors will inevitably seek alternative homes for their money. As explained by Federated in their letter on MMFs,

“In the event that MMFs are eliminated, it is reasonable to assume that a significant percentage of the assets will move to bank deposits, which would transfer the risk from MMF investors to the insurers of those banking institutions…Fundamental changes to MMF structure and regulation that make MMFs less attractive and useful will increase systemic risk, not reduce it, and will stifle economic recovery, rather than foster it”.

Under this scenario, the size of banks already found to pose systemic risks to the global financial system will be augmented. Cash that was not shifted to bank deposits would likely flow into alternative money-equivalent products offered by as yet unregulated, and thus unmonitored, sources of finance – the so-called ‘deep’ shadows.  There is also some danger that, having thus been “laundered” in the deep shadows, this money could flow back into the banking system undetected. These results would seem to be contrary to another pillar of the FSB proposals, that of increased transparency, making unexpected future events more rather than less likely. “This migration would decrease transparency and hinder efforts by authorities to monitor systemic risk” (Greene and Bloomfield). Wouldn’t a more effective approach have been to leave the ‘near shadows’, that is, the usual source of shadow bank financing, sufficiently attractive to non-bank intermediaries to attract enough activity so that any remaining in the deep shadows would not have systemic effect?  That way, if the transparency of the near shadows was enhanced at the same time, impending problems could at least be foreseen more readily.  As it is, non-bank financial activities are more rather than less likely to operate in places unknown and unmonitored until such time as they are revealed in potentially unpleasant ways.