OUTSIDE THE FRAME
Financial markets – stocks, bonds, commodities and options – are more interconnected globally than ever before.
This is because of the growth in international trade and cross-border investment, and very liquid and nimble capital markets. When one part of the world sneezes, the rest of the world catches a cold almost instantly.
This cascading risk is what the US and global markets faced in March 2020 with a rapid decline in the value of assets – of equity bonds and even gold at the same time – leading to the precipice of ‘a systemic collapse.
Fortunately, thanks to fiscal and monetary intervention by the Treasury, Federal Reserve and Congress, the worst-case scenario has been avoided.
Their actions injected liquidity into short-term funding markets, which spilled over into credit markets and facilitated consumer spending, which in turn stabilized asset values and maintained business continuity. In short, the economic shock of lockdowns and other effects of COVID-19 has not accelerated in the financial sector as it surely could have.
How to strengthen the financial system
As we dodged the bullet last year, financial regulators and lawmakers will be asking: How can our financial system be better prepared for the next shock? Are there any vulnerabilities that should be fixed?
Answering these questions requires a thorough understanding of the different components of our financial system.
The financial sector is divided between the regulated banking sector and the non-bank financial intermediation sector (NBFI).
In the United States, regulators including Federal Reserve, Treasury, Federal Deposit Insurance Corp. (FDIC), the Federal Housing Finance Agency (FHFA) and the Office of the Comptroller of the Currency (OCC), provide comprehensive regulatory oversight of the banking sector. . Thanks to the Dodd-Frank Act and other reforms following the 2008 financial crisis, this sector is more resilient and relatively smaller than it was ten years ago.
The NBFI industry is considerably larger, but it operates primarily under the responsibility of market and client protection regulators, including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), not the regulators. prudential.
The NBFI industry includes familiar entities such as pension funds, insurance companies, private equity firms, credit funds, hedge funds, investment firms, brokerage firms as well as money market funds (MMF) and real estate investment trusts (REITs). This sector sells investment and loan products which collectively represent approximately $ 75 trillion, or nearly 60%, of the total financial sector.
The sheer size of the NBFI sector and the tensions experienced in short-term funding markets during the economic shock of March-April 2020 prompted calls to expand the prudential regulatory framework to include the NBFI sector.
The problem of high leverage
Typical sources of systemic risk that warrant oversight and could benefit from regulatory oversight include, alone or more significantly combined: high leverage, maturity transformation (i.e. providing immediate liquidity while holding assets) illiquid) and the concentration of credit.
When an economic shock occurs and asset prices fall and credit contracts, these risks can create a feedback loop between prices and credit that amplifies the effect of the shock and strains the financial system. Moreover, since the NBFI sector is an interconnected quilt made up of various submarkets, an economic shock affecting one market can infect other markets, resulting in systemic risk.
Additional regulatory oversight must both be tailored to relevant risks and recognize the important role NBFI plays in the performance of our vibrant economy. From this perspective, certain sectors of the NBFI require, at most, additional benign regulatory oversight. That is, Congress must resist the temptation to over-regulate and treat the NBFI as monolithic.
At the same time, Congress faces the onslaught of lobbying against any new oversight or regulation from powerful financial industry interest groups.
Main constituents of the NBFI sector
Mutual funds, private equity funds, pension funds and insurance companies are the main constituents of the NBFI industry. They own tens of trillions of dollars in government and corporate stocks and debt. Mutual funds, private equity funds and pension funds have limited leverage and engage very little in the transformation of maturity or liquidity. The insurance industry is already regulated and its leverage is largely supported by stable cash flow from insurance premiums, while its asset / liability maturity risks are limited largely due to the predictable nature long-term liabilities.
Hedge funds are also in the non-banking sector with around $ 3.4 trillion in assets. Hedge funds invest primarily in stocks and adopt a range of leverage, depending on their strategy. Since the hedge fund industry consists of hundreds of companies, concentration risk is negligible except due to financial correlation. In view of these factors, any further regulation should focus on faster, uniform and detailed disclosure of risk positions, including through derivatives. This would facilitate better risk monitoring not only within the hedge fund industry, but also any implication of systemic risk for the macroeconomics. Public disclosure of positions could be done on a deferred and aggregated basis so as not to reveal proprietary information.
Residential Mortgage REITs and Secured Loan Bonds (CLOs) also fall into the NBFI sector. Mortgage REITs are heavily leveraged and fund long term agency mortgage backed receivables with short term funding in the repo market. They naturally suffered from the economic shock of COVID-19, but benefited from the intervention of the Fed. It would be interesting to monitor their leverage effect and their degree of maturity transformation, in particular to limit fears of moral hazard inherent in excessively leveraged markets.
Secured loan obligations
Secured Loan Bonds (CLOs) have proven to be useful for prudential regulation of the banking sector, as they provide for the transfer of default risk from the banking sector to a diverse group of investors. If the risk of default does not disappear, diffuse ownership mitigates bank concentration risk and thus mitigates systemic risk. Since CLOs are backed by leveraged loan pools issued by banks, CLOs are indirectly regulated through banking and other regulations. Whether additional surveillance or limitations on CLOs would produce net benefits is debatable (and would likely be inconsistent with current monetary and fiscal policy).
Money market funds
Money market funds (MMFs) invest in low-risk, short-term debt securities (less than 60 days of average maturity), for example, treasury bills, commercial paper and municipal securities. Investors looking for a slightly higher return than holding cash find MMFs an attractive alternative for their excess funds, but they demand immediate liquidity. To make the promise of liquidity credible, regulations require money market funds to hold at least 30% of weekly liquid assets. Nonetheless, some money market funds experienced liquidity problems in March 2020, which contributed to the Fed’s preventive intervention. The question of whether it is appropriate for money market funds backed by commercial paper and municipal bonds to pledge immediate liquidity without additional constraints or limits on liquidity through variable pricing or other mechanisms is (rightly so) ) reviewed by US and foreign authorities.
SP Kothari is a professor at the MIT Sloan School of Management and former chief economist at the United States Securities and Exchange Commission from 2019 to 2021.