At the 20th Annual Financial Markets Conference on March 30, Federal Reserve Vice Chairman Stanley Fischer delivered a speech highlighting the nonbank sector’s role in the financial crisis as well as two principles that should guide prudential regulation of nonbank intermediaries and activities.
“While there has been progress on the financial reform front, we should not be complacent about the stability of the financial system,” Fischer said. “Regulation often creates incentives for activity to move outside the regulatory perimeter, and market participants respond to incentives. Thus, we should expect that further reforms will certainly be needed down the road.”
After providing examples of how the nonbank sector’s distress translated to overall financial instability, including nonbank mortgage companies originating subprime mortgage loans and nonbank financial companies losing their ability to fund themselves through securitizations and commercial paper, Fischer highlighted five lessons from the nonbank financial sector’s failure.
The first lesson is that the recent financial crisis first manifested itself in the nonbank sector and was worse for the nonbank sector than it was for banks, Fischer said, adding: “A second lesson is that nonbank distress can harm the real economy. Mortgages, auto loans, and credit through securities issuance became harder to obtain. Some of the slack was taken up by commercial banks, but credit contracted sharply, and millions of Americans suffered.”
The third lesson was that many of the problems at nonbanks were similar to problems that plagued banks, problems such as insolvency, illiquidity and a general loss of confidence that led counterparties to become reluctant to deal with some nonbanks.
Entities such as the Federal Deposit Insurance Corp. and the Federal Reserve can address issues surrounding insolvency and illiquidity while bank supervisory agencies can address confidence concerns through stress testing; however, according to Fischer, “The lack of such powers for nonbanks made it much more difficult for the authorities to address the distress of nonbanks and its influence on the financial system.”
The fifth lesson was that nonbank distress can transmit to the banking sector through many channels, such as counterparty relationships, disruptions in funding markets and knock-on effects of asset fire sales. Fischer added that the failure of Lehman Brothers provided a good example of this.
So how should regulators approach nonbanks?
According to Fischer, not every nonbank financial institution or activity needs regulation, but when regulation is warranted, Fischer suggested two key principles for prudential regulation.
“First, we should be attentive to solvency and liquidity; second, we should recognize that the financial system will change over time, and thus close monitoring and analysis of the system are essential,” Fischer said. “Insolvency and illiquidity are classic financial stability concerns. And as mentioned, they were common themes of the distress at nonbanks that we observed during the crisis.”
The goal should be to promote solvency and liquidity while taking into account the unique structures and activities of each type of nonbank.
Fischer suggested having direct restrictions on the structure of liabilities, such as on the duration or use of wholesale funding, to prevent the sales of assets at fire sale prices, as well as requiring some nonbanks to maintain buffers of highly liquid assets, sized according to the risk that their liabilities will run off quickly in a stress situation.
“In other nonbanks, withdrawable liabilities are part of the structure of the entity or activity, and what varies is the degree of mismatch between the liquidity of assets and liabilities. For example, some open-ended mutual funds offer daily withdrawal privileges, but invest in assets that take longer to sell and settle, giving investors an incentive to withdraw quickly when distress arises. The fire sales of assets that may result can depress asset prices and increase volatility, with knock-on effects on other institutions and markets. Concerns have grown about this liquidity mismatch as the aggregate value of less liquid assets in such funds has grown,” Fischer said.
For promoting solvency, regulators can impose ratio-type capital requirements, such as leverage ratio requirements or risk-based requirements, or require firm to perform regular stress tests to demonstrate that they can remain solvent and continue to lend even under stress.
“It is often said that stronger regulation of the banking sector will cause activity to move outside the perimeter of regulation. This evolution also could lead to greater complexity, such as longer chains of interconnections, which makes it more difficult for market participants to understand the risks arising from their exposures,” Fischer said.
Importantly, Fischer said that increased regulation in the nonbank financial sector does not necessarily mean a potential for more risk to the overall economy.
“Some may raise concerns that increased regulation of nonbanks will only increase moral hazard and increase risk to the system on net. But moral hazard may already be present,” he said. “Over the past 20 years and more, governments have sometimes acted to contain damage from distress at nonbanks because of the economic damage that might have resulted from a failure to act. We should always be mindful of moral hazard incentives and seek to contain them, but well-designed regulation might reduce rather than increase moral hazard.”
Fischer stated that there has been some progress made in improving regulations of the nonbank sector, including the Dodd-Frank Act’s creation of the Financial Stability Oversight Council as well as securitization and derivative reforms, additional data collection on specific holdings of money funds and the Dodd-Frank Act’s creation of the Office of Financial Research.
“To sum up, much has been done to strengthen prudential regulation and supervision of the nonbank financial system, but more will need to be done. We must remain vigilant for changes in the system that increase systemic risk, and we should make appropriate changes to regulation and the structure of regulation as necessary. Recent regulatory changes, including a macroprudential approach on the part of U.S. regulators, should help us to do that. But we should never forget the International Monetary Fund’s all-purpose warning whenever it has been tempted to give an economy a clean bill of health: Complacency must be avoided,” Fischer concluded.