The financial crisis showed that the safety net for traditional banks can work.
Although 436 banks failed from January 2008 through April 2012 – some large, like Washington Mutual, but none the size of Lehman Brothers – the FDIC handled them efficiently, depositors insured by the FDIC didn’t lose money, and the failures probably won’t cost taxpayers a dime.
For some, this raises an obvious question: Why not devise a safety net for shadow banking?
From “Shadow Banking and Financial Regulation” by Morgan Ricks, Harvard Law School, September 18, 2010:
Without a safety net, banking is unstable.
(Editor’s note: See Shadow Banking, part 1 for an explanation of shadow banking and its problems. See Shadow Banking, part 2 for proposed reforms.)
In the terrible days of 2008, Americans who had their money in money market funds, insurance companies, exchange traded funds, mutual funds, stock brokerages, university endowments, hedge funds, real estate, pension plans, municipalities, and other large pools of money were tossed in high seas. Many capsized.
Meanwhile, Americans who had their money in deposits at a bank sailed along just fine.
That’s different from 100 years ago, when frantic depositors lined up outside their closed banks and pleaded for their life savings.
The main reason for the difference is the federal safety net that Congress and regulators developed for banks during the two decades 1913-1933. Here it is:
1. The Federal Reserve: Banks that run into financial trouble, but aren’t insolvent, can get emergency loans from the Federal Reserve. (If the banks are insolvent, the FDIC seizes them.) Banks pay interest on those loans. The Federal Reserve gets most of the money to make those loans – in fact, most of its income – by buying paper dollars from the U.S. Treasury at printing cost, selling them at face value to banks, using the profits to buy securities, and collecting interest on those securities.
2. The FDIC: Bank deposits are insured up to $250,000 by the Federal Deposit Insurance Corporation. Banks pay premiums to the FDIC to get this insurance for their depositors. The FDIC uses the premiums to cover its costs when it seizes an insolvent bank. If it needs more money, it can borrow from the U.S. Treasury, but it is supposed to pay the Treasury back later by collecting from other banks. The FDIC did not borrow from the Treasury for this crisis. (Deposits that don’t pay interest are insured without limit until the end of this year, because of the crisis.).
The main purpose of the Federal Reserve loans and the FDIC insurance is to prevent panics and runs on traditional banks, at no cost to the taxpayer. Still, the taxpayer stands behind both the Federal Reserve and the FDIC in a crisis.
In the 2007-2009 panic, the Federal Reserve, the FDIC and the U.S. Treasury temporarily put a safety net in place for shadow banks, to halt multiple runs. They insured money market fund deposits, and they poured money into the financial markets through two dozen emergency programs. They said they would do whatever it takes to keep credit flowing.
Many observers have found that these emergency actions were important and effective in stabilizing the financial markets and preventing another Great Depression.
Some concluded that if the Federal Reserve, the FDIC and the U.S. Treasury are going to provide a safety net for shadow banking in a crisis, to stop runs, they should do it before a crisis, to try to prevent runs, and they should charge shadow banks for the protection, as the Fed and FDIC do with traditional banks.
That’s not what happened. Congress and the American people were furious at bankers and did not want to give them a new safety net. Instead, the Dodd-Frank Act, which was Congress’ response to the financial crisis, hit traditional and shadow bankers with a bunch of new rules.
The Dodd-Frank Act also told regulators they can never again bail out specific institutions. But they can take emergency actions to keep a broad class of borrowers from collapsing. Federal Reserve Chairman Ben Bernanke said he thinks that’ll be enough of a safety net to do the job in an emergency.
From “Bernanke Sees Need for More Curbs on Shadow Banking” by Joshua Zumbrun and Steve Matthews, Bloomberg News, April 9, 2012:
Bernanke said the Dodd-Frank Act had removed some of the Fed’s ability to make emergency loans, saying that “we can no longer lend to an individual firm as we did in the crisis.”
“Fortunately, I don’t think that they weaken our ability to provide backstop liquidity where necessary,” Bernanke said. The Fed is still able to lend through the discount window or to a broad class of borrowers in an emergency, he said.
In other words, the next crisis will probably unfold a lot like the last one: Regulators will save the financial markets, to prevent another Great Depression, but shadow banks won’t have insurance to protect the savings of individual Americans.
That’s fine with banks, who oppose shadow banking insurance in part for the same reason they opposed FDIC insurance in the 1930s: They don’t want to have to pay the premiums.
Besides, many large shadow banks are owned by or affiliated with traditional banks, so in a round-about way they get the benefit of the federal safety net without having to pay for it. This includes money market funds, securitizing firms, securities dealers, hedge funds, pensions, insurance companies and more.
During the crisis, this became a dangerous drain on traditional banks.
From “Shadow Banking Regulation” by Tobias Adrian and Adam B. Ashcraft, Federal Reserve Bank of New York, April 2012:
… the crisis revealed—and was in many respects propagated by — the extent to which banks had become the core of the backstop arrangements for the non-bank sector. The crisis also revealed the woeful inadequacy of these arrangements, as banks struggled and failed to effectively play this backstop role and governments and central banks had to resort to a variety of extraordinary measures to preserve broader financial stability.
To solve these problems and prevent panics, shadow banking needs a safety net of its own, some experts believe.
From “Shadow Banking Regulation” by Adrian and Ashcraft:
The dilemma of the current regulatory reform efforts is that the motivation for shadow banking has likely become even stronger as the gap between capital and liquidity requirements on traditional institutions and non-regulated institutions has increased.
The objective of reform should be to reduce the risks associated with shadow maturity transformation through more appropriate, properly priced and transparent backstops—credible and robust credit and liquidity “puts.” (RepoWatch’s editor’s note: In traditional banking, FDIC insurance is a credit put. Federal Reserve loans are liquidity puts.)
Regulation has done some good, but more work needs to be done to prevent shadow credit intermediation from continuing to be a source of systemic concern.
Some say the safety net needs to be a government program.
From “Interview with Ricardo Caballero” by Douglas Clement, The Region Magazine, Federal Reserve Bank of Minneapolis, June 1, 2011:
Caballero: … the system doesn’t need capital but rather insurance or a guarantee that the system will survive. … Banks should pay a fee in advance for this insurance, and the fee should be proportional to the systemic risk of their balance sheets. Since the fee is much cheaper than the cost of actual capital, they should be required to buy a lot of insurance.
Region: And this aggregate insurance should be provided by government?
Caballero: Yes. It is the most efficient way because only the government has enough credibility not to have to post collateral in advance.
Others caution that it would be better to find another solution, because putting a government safety net behind the entire shadow banking system, thought in the U.S. to equal the traditional banking system in size, would be a lot to ask of governments that are already overextended.
New York University economists Viral V. Acharya and T. Sabri Öncü argue against a proposal to incorporate U.S. shadow banking into the existing safety net for traditional banks. From “A proposal for the resolution of systemically important assets and liabilities: The case of the repo market,” March 23, 2012:
… such a guarantee scheme effectively amounts to transferring the credit risk of virtually most parts of the securitization market to the government’s balance sheet. While “conforming” mortgages in the U.S. are already being backstopped by Fannie Mae and Freddie Mac, the proposed guarantee scheme would extend such a backstop to subprime securitized pools, corporate loans, automobile receivables, credit-card receivables, and so on. Due to its potential sovereign risk concerns in an environment of difficult fiscal position for the government, the idea of extending guarantees to practically all financial assets of the economy should be viewed with caution.
Such caution would be even more necessary for governments other than the U.S. whose balance sheets are already heavily stretched.
(Editor’s note: See ** below for Acharya and Öncü’s proposal for a repo resolution authority.)
Safety net proposals
Following are 10 safety net proposals. Though different in detail, all are efforts to make collateral safe, like the FDIC makes deposits safe, and to require financial institutions to pay for it.
-Seven of the proposals involve using insurance to make the collateral safe.
-One proposes that the government itself make loans and create securities, to make sure the quality of the collateral is good.
-Two set up clearing houses to gradually sell collateral after a borrower defaults and avoid fire sales, which can drive down the value of collateral and spread losses throughout the financial markets.
In all cases, the American taxpayer would bear the ultimate cost if funds were inadequate. In such an event, supporters claim, the cost to the taxpayer would still be less than the damage to the economy of another 2008-style financial crisis.
Use insurance to make collateral safe
(1) Require financial institutions to use only U.S. government securities as collateral for short-term borrowings like repurchase agreements. Or, said another way, issue more Treasuries to meet lenders’ demands for safe collateral, thereby reducing their demand for Wall Street securities that seem safe but aren’t. (Some countries, like India, already restrict repo collateral to government securities.)
From “Institutional Cash Pools and theTriffin Dilemma of the U.S. Banking System” by Zoltan Pozsar, International Monetary Fund, August 2011:
.. an elegant way to solve the financial system’s fragility due to the rise of institutional cash pools and “shadow” banking would be to issue more Treasury bills and to explicitly incorporate the supply management of bills into the macroprudential tool kit (used to prevent financial instability). While not without costs or alternatives, this approach is less troublesome and complicated than the alternative of intense real-time monitoring and regulation of the shadow banking system.
From “Shadow Banking Regulation” by Adrian and Ashcraft:
In our view, as long as the tri-party repo market accepts a significant amount of collateral other than U.S. Treasury and Agency securities (such as private label ABS and corporate bonds), the tri-party market will remain prone to runs and constitute a source of systemic risk.
The Depository Trust and Clearing Corporation in New York already operates a $400-billion-dollar-a-day repo market that accepts only government securities.
(2) Redirect Fannie Mae and Freddie Mac into providing catastrophic insurance for asset-backed securities held or issued by financial institutions. The two agencies would not be allowed to buy the securities themselves but only insure them. They would charge the institutions a risk-based premium for the insurance, and they would set the underwriting standards for the loans they insured.
From “An Analysis of Government Guarantees and the Functioning of Asset-Backed Securities Markets” by Diana Hancock and Wayne Passmore, Federal Reserve Board Division of Research and Statistics, September 7, 2010:
We argue that an institutional structure for stemming “runs,” analogous to the current set up for the Federal Deposit Insurance Corporation, could be deployed to insure pre-specified asset-backed instruments. Such an insurer would likely benefit from the accumulated information and infrastructure that is embodied in the Fannie Mae and Freddie Mac organizations. Hence, the provision of federally-backed catastrophic insurance on pre-specified asset-backed instruments provided at risk-based premiums could provide a rationale for restructuring the housing-related government-sponsored enterprises towards a public purpose. Regardless of its institutional structure, a federally-backed catastrophic bond insurer would provide greater financial stability and ensure that credit is provided at reasonable cost both in times of prosperity and during downturns. Moreover, the explicit pricing of the government-backed guarantee would mitigate the market distortions that have been created by implicit government guarantees during prosperity.
(3) Have the government sell relatively expensive disaster insurance to financial institutions, to guarantee the value of their riskier assets including mortgage-backed securities. The insurance could be optional, except that institutions would be required to buy it for assets financed by short-term loans like repos or asset-backed commercial paper. The insurance premiums would get higher as the institution increased its short-term funding. The insurance would be transferable, if the banks sold the assets to a new owner. Insurance policies would require a deductible, to give the institutions skin in the game.
From “The Fall of the House of Credit” by Alistair Milne, Cambridge University Press, 2009:
It is appropriate to introduce a relatively expensive charge for systemic risk insurance, not just in response to the current crisis but as a permanent measure.
(4) Treat most short-term loans, such as repo loans, like bank deposits. Create FDIC-type insurance that guarantees both deposits placed with banks and short-term loans made to financial institutions. Any company that wanted to take deposits or to get short-term loans would have to be licensed and regulated by bank regulators, and it would have to buy the insurance. Riskier operations would cost more to insure. The licensed companies would be eligible for emergency loans from the Federal Reserve. Unlicensed companies wouldn’t be regulated or insured, and they couldn’t accept deposits or short-term loans. They could raise money only by borrowing long term or selling stock. If they became insolvent, they’d be unwound in bankruptcy court.
From “A Regulatory Design for Monetary Stability” by Morgan Ricks, Harvard Law School, September 26, 2011:
A key virtue of this regime is its relative simplicity. It represents a surgical approach to a specific market failure, rather than the scattershot approach of recent policy. Our current approach asks regulators to evaluate all manner of financial firms, industries, and activities in order to gauge their supposed “systemic risk”—a nebulous concept that has yet to be defined, much less operationalized, in anything approaching a satisfactory way.
Ricks further explains his plan in “Reforming the short-term funding markets,” May 2012:
It is a sobering fact that, more than four years after the fall of Bear Stearns, the fragility of the short-term funding markets remains largely unaddressed. These markets remain susceptible to destabilizing panics, yet the regulatory response has been fragmented and appears to be flagging. There is a compelling need for a systematic approach in this area.
(5) Create special banks for money market funds, create special banks to make safe collateral, and limit who can repo.
Create Narrow Savings Banks for money market funds: Money market funds would have to choose between (a) letting their share price fluctuate in value, or (b) becoming Narrow Savings Banks that would operate like money market funds do today, with a stable share price of $1, but with a federal safety net, insurance for their deposits, and regulation.
Create Narrow Funding Banks to make safe collateral:
-Narrow Funding Banks would be regulated like normal banks.
-They’d be eligible for Federal Reserve loans, but they’d have no deposits and no FDIC insurance.
-Their only business would be to buy regulator-approved, asset-backed securities from securitizing firms. Securitizing firms could not sell to anyone else.
-These banks could also hold high-quality government securities.
-To raise money, they could repo and they could issue longer-term debt.
-Anyone who wanted asset-backed securities would have to get them by making a repo loan to a Narrow Funding Bank or by buying the longer-term debt of a Narrow Funding Bank.
-If this doesn’t produce enough safe collateral, the Fed itself might have to issue some securities, perhaps called Fed Notes, to be used only as repo collateral.
Limit who can repo: Narrow Savings Banks, Narrow Funding Banks, and traditional banks could repo, up to a set percent of the value of the collateral. Repo collateral would be restricted to government securities, securities from Narrow Funding Banks, and other securities approved by regulators.
Other companies that wanted to repo, like hedge funds, would have to be licensed and regulated, and their repo volumes would be restricted. Any unregulated repo would not get the valuable “safe harbor” treatment currently given repo agreements in bankruptcy court, where repo lenders can keep the collateral and do not have to share with other creditors.
From “Regulating the Shadow Banking System” by Gary Gorton and Andrew Metrick, Yale University, October 18, 2010:
The basic idea of Narrow Funding Banks is to bring securitization under the regulatory umbrella. What may seem radical at first glance is based in the recognition that securitization is just banking by another name …
(6) Have regulated private insurance companies insure well-underwritten mortgage-backed securities. The government would then reinsure the securities, for a fee, and it would pay claims only after the private insurance companies were insolvent.
From “Reforming America’s housing finance market, a report to Congress” by the Obama Administration, February 2011:
… a group of private mortgage guarantor companies that meet stringent capital and oversight requirements would provide guarantees for securities backed by mortgages that meet strict underwriting standards. A government reinsurer would then provide reinsurance to the holders of these securities, which would be paid out only if shareholders of the private mortgage guarantors have been entirely wiped out. The government reinsurer would charge a premium for this reinsurance, which would be used to cover future claims and recoup losses to protect taxpayers.
(7) Several people are proposing insurance for one corner of shadow banking, to cover commodities markets in circumstances like the failure of MF Global.
From “MF Global trustee calls for fund to protect customers” by Azam Ahmed, New York Times, April 24:
The trustee tasked with returning more than $1.6 billion in missing customer money after the demise of MF Global has suggested establishing an insurance fund for commodities customers to safeguard assets in the event of a future collapse, according to a statement he read at a Congressional hearing on Tuesday. …
Since MF Global collapsed on Oct. 31, farmers, ranchers and retirees have been without roughly a third of the funds they held at the firm. Currently, commodities customers do not have a safety net should their money go missing, unlike bank customers whose deposits are insured by the Federal Deposit Insurance Corporation.
Mr. Giddens remarks echo those of Bart Chilton, a commissioner of the Commodity Futures Trading Commission, who has been advocating for an insurance fund for months.
Have the government itself make loans and create securities
(8) Have government itself create safe asset-backed securities, especially from loans to small business, by pooling loans, securitizing them and selling them.
From “Boosting Finance Options for Business” by the Bureau for International Settlements, March 2012:
Launch a feasibility study, led by the Association of Financial Markets in Europe, to explore the creation of an aggregation agency to lend directly to small and medium-sized enterprises and/or to pool small and medium-sized enterprises loans to facilitate small and medium-sized enterprises access to the public corporate bond markets.
Set up a clearing house to avoid panic sales of collateral after a borrower defaults
(9) ** Create a repo resolution authority. If a repo borrower defaults, repo lenders with government securities as collateral could go ahead and sell the securities. But repo lenders with riskier collateral would have to give the collateral to the authority, and the authority would immediately pay them based on an estimate of amount due. Then the authority would sell off the collateral over a period of months. In the end, the lender may be due money or may have to repay the authority, depending on the price the authority gets for the securities. This process provides assurance to repo lenders that they will be repaid quickly in a default, hopefully discouraging runs, and it prevents fire sales of collateral.
The authority would be funded by fees paid by repo lenders, and it would have access to Federal Reserve loans as a backstop. Repo loans backed by exceedingly risky collateral, or owed to unapproved repo lenders, might not be accepted by the authority and in that case would go to bankruptcy court to be pooled with other creditors. Congress could require large repo lenders with strong collateral to join the authority, and it could require lenders accepting low-quality collateral to limit the amount they lend.
From “A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market” by Viral V. Acharya and T. Sabri Öncü, New York University, March 22, 2012:
… if these markets are not reformed and their participants not made to internalize the risk that large quantities of underlying repo collateral could be put up for liquidation in an illiquid market, then runs on the repo market will occur in the future, potentially leading to new systemic crises, in spite of the huge regulatory apparatus being built around financial firms on other fronts and markets.
This proposal for a repo resolution authority is part of a broader proposal from Acharya and Öncü that recommends international regulators not only regulate systemically important financial institutions but also stabilize systemically important assets and liabilities – using government insurance, clearing houses that set borrowing limits, or central bank loans, all for a fee. Examples of systemically important assets are asset-backed commercial paper, risky repo collateral, and exposures to systemically important financial institutions. Examples of systemically important liabilities are deposits, repos and over-the-counter derivatives.
(10) Require tri-party repo borrowers and lenders to fund a special bank that would help repo lenders who suddenly find themselves stuck with collateral from a defaulted repo borrower. The special bank could make the repo lender a loan – taking the collateral as security – with money the special bank borrowed from the Federal Reserve. This would buy time for the repo lender to sell the collateral, or refinance it, in an orderly way.
From “Statement on the Release of the Tri-party Repo Infrastructure Reform Task Force’s Final Report” by the Federal Reserve Bank of New York, February 15, 2012:
The Federal Reserve is escalating its efforts to explore additional policy options to address the remaining sources of instability identified in the New York Fed’s May 2010 White Paper. … Ideas that have surfaced and could be considered include restrictions on the types of collateral that can be financed in tri-party repo and the development of an industry-financed facility to foster the orderly liquidation of collateral in the event of a dealer’s default.
The way forward
In the 1930s, after decades of bank runs, and against the wishes of key bankers and the Roosevelt Administration, Americans finally forced Congress to create FDIC insurance for traditional banks, paid for by the banks.
Ever since, Americans have banked with confidence that their insured deposits were safe.
Some observers hope we can deal as effectively with shadow banks, but without having to endure decades of runs first.
Among their solutions, as reported in this series: Insure that collateral is safe, break up the giant banks, charge a transaction tax, steer key transactions through a central clearing house, or close shadow banking down.
From “Shadow Banking Regulation” by Adrian and Ashcraft, April 2012:
The shadow banking system is a web of specialized financial institutions that channel funding from savers to investors through a range of securitization and secured funding techniques.
While shadow banks conduct credit and maturity transformation similar to traditional banks, shadow banks do so without the direct and explicit public sources of liquidity and tail risk insurance via the Federal Reserve’s discount window and the Federal Deposit Insurance Corporation (FDIC) insurance.
Shadow banks are therefore inherently fragile, not unlike the commercial banking system prior to the creation of the public safety net.