PrefBlog

Jennifer Ryan of Bloomberg reports that U.K.: Banks to Split Consumer, Investment Arms:

The U.K. will force banks to separate their investment and consumer businesses as part of its acceptance of the findings of the John Vickers-led Independent Commission on Banking, business secretary Vince Cable said.

“Tomorrow, the government is going to launch this initiative on the banks, accepting in full the Vickers commission,” he told BBC television today. “We’re going to proceed with the separation of the banks, the casinos and the business lending parts of the banks.”

Former Bank of England Chief Economist Vickers recommended in a Sept. 12 report that banks build fire breaks between their consumer and investment banks and boost the amount of loss- absorbing equity and debt they hold to between 17 percent and 20 percent. Since 2007, the government has had to spend, pledge and loan 850 billion pounds ($1.3 trillion) to rescue British banksChancellor of the Exchequer George Osborne will say in Parliament tomorrow that the government will enact the reforms stemming from the report and the Treasury will publish its response. The changes are to be implemented by 2019.

The units inside the fire breaks will include all checking accounts, mortgages, credit cards and lending to small- and medium-sized companies, the report said in September. As much as a third of U.K. bank assets, or about 2.3 trillion pounds, will be included, the document said. Trading and investment banking activities will be excluded from the ring-fence. Standard & Poor’s said Sept. 14 the elements of a bank outside the ring fence face a credit-ratings cut as they won’t be able to count on government support.

This is echoed by the Guardian and the BBC, but journalists rarely do anything more than copy each other’s press releases anyway, so whether one can use the word “confirmed” is a matter of luck.

If it’s true – and if the attempt is successfull – I’m very pleased. As I said on March 24, 2008:

As I have stated so many times that Assiduous Readers are fed up to the back teeth with the incessant drone – we want a shadow banking system! We want to ensure that there are layers of regulation, with the banks at the inner core and a shock-absorber comprised of brokerages that will serve as a buffer between this core and a wild-and-wooly investment market. This will, from time to time, require (or, at least, encourage) the Fed to step in and take action, but the alternative is worse.

The Independent Commission on Banking has a refreshingly focussed website. In his opening remarks, Sir John Vickers made the points:

Structural separation would bring three main benefits:

• it would help insulate vital UK retail banking services from global financial shocks, which is of particular importance given the way that major UK banks combine retail banking with global wholesale/investment banking;
• it would make it easier and less costly to sort out banks – whether retail or investment banks – that still got into trouble despite greater loss-absorbing capacity. This is all part of getting taxpayers off the hook for the banks; and
• it would be good for competitiveness because UK retail banking can be made safer while international standards apply to the global wholesale and investment banking activities of UK banks.

The separation is intended to take place as follows:

We are recommending a strong ring-fence – otherwise there would be little point in having one – but also a flexible one. This in essence is how it would work.

Only ring-fenced banks would supply the core domestic retail banking services of taking deposits from ordinary individuals and SMEs and providing them with overdrafts.

Ring-fenced banks could not undertake trading or markets business, or do derivatives (other than hedging retail risks) or supply services to overseas (in the sense of non-European) customers, or services (other than payments services) resulting in exposures to financial companies.

Other activities – such as lending to large domestic non-financial companies – would be allowed either side of the fence.

The aggregate balance sheet of UK banks exceeds £6 trillion – more than four times annual UK output. On the basis above, between a sixth and a third of the balance sheet would be inside the fence.

The degree of capital required for core banks will be awesome:

The other element of reform for financial stability concerns the ability of banks, especially those of systemic importance, to bear losses. On this our main recommendations are:

• that large ring-fenced banks should have equity capital of at least 10% of risk-weighted assets and corresponding limits on overall leverage;
• that the retail and other activities of large banks should have primary loss-absorbing capacity – equity plus long-term unsecured debt (‘bail-in bonds’) that readily bears loss at the point of failure – of 17%-20% of risk-weighted assets.
• Remaining unsecured debt should also bear loss on failure if necessary; and depositor preference, so that insured deposits rank above all other unsecured debt.

The complete Final Report: Recommendations weighs in at a whopping 363 pages. I am quite disappointed at the discussion of “bail-in” debt:

First, the authorities should have a ‘primary bail-in power’ to impose losses in resolution on a set of pre-determined liabilities that are the most readily lossabsorbing. This should include the ability to be able to write down liabilities to recapitalise a bank (or part thereof) in resolution.46 As described in Paragraph 4.63, the class of (non-capital) liabilities that bears loss most readily is long-term unsecured debt. The Commission’s view is therefore that all unsecured debt with a term of at least 12 months at the time of issue – ‘bail-in bonds’47 – should be subject to the primary bail-in power.
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Second, the authorities should have a ‘secondary bail-in power’ that would allow them to impose losses on all unsecured51 liabilities beyond primary loss-absorbing capacity (again, including the ability to write down liabilities to re-capitalise a bank) in resolution, if such loss-absorbing capacity does not prove sufficient.

As I have said so many times, I strongly dislike giving “the authorities” so much discretionary power. But at least it means that bank regulators will be treated to many excellent meals when the next crisis rears its head!

SEC Chairman Mary L. Schapiro used her Remarks at SIFMA’s 2011 Annual Meeting to discuss Money Market Fund reform, a topic which I consider very important for financial stability.

Ms. Schapiro said:

While the SEC’s new money market fund reforms were a critical first step, and many voices have said “you’ve done enough,” I believe additional steps should be taken to address the structural features that make money market funds vulnerable to runs.
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As was stated in the FSOC Annual Report issued in July, the SEC – working with FSOC – is evaluating options to address the structural vulnerabilities posed by money market funds. We are focused in particular on a capital buffer option to serve as a cushion for money market funds in times of emergency and floating NAVs, which would eliminate the expectation of stability that accompanies the $1.00 stable NAV. Both of these reform options would ensure that investors who use money market funds realize the costs that might be imposed during rare market events.

The current focus on these two reform options is the result of a long and careful review conducted jointly with fellow financial regulators. In October 2010, the President’s Working Group released a Report on Money Market Funds.

The President’s Working Group report is titled Money Market Fund Reform Options and on its release:

The PWG now requests that the Financial Stability Oversight Council (FSOC), established by the Dodd-Frank Wall Street Reform and Consumer Protection Act, consider the options discussed in this report and pursue appropriate next steps. To assist the FSOC in any analysis, the Securities and Exchange Commission, as the regulator of money market funds, will solicit public comments, including the production of empirical data and other information in support of such comments. A notice and request for comment will be published in the near future.

The 2011 Annual Report of the FSOC has been discussed on PrefBlog. Anyway, back to Schapiro:

While floating NAVs would reinforce what money market funds are – an investment – and what they are not – a guaranteed product – this option poses challenges for policymakers, particularly in fostering an orderly transition from stable NAVs to floating NAVs.
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Another option, a capital buffer for money market funds, also holds promise. And much of the SEC staff’s energy, working jointly with staff from other FSOC member agencies, is focused on developing a meaningful capital buffer reform proposal. In addition, a capital buffer potentially could be combined with redemption restrictions in order to address incentives to run that may not be curtailed by a capital buffer alone.

I don’t remember seeing redemption restrictions being proposed before. Good old regulators! When in doubt, impose rationing, that’s the motto!

An express and transparent capital buffer would make explicit what for many, but not all, money market funds is implicit today: namely that there is a source of capital available to the fund in times of emergency. Today that source of capital comes from discretionary sponsor support. If a money market fund held a troubled security, for example, the fund’s sponsor – or the sponsor’s well-capitalized parent – might buy the security out of the fund’s portfolio.

Clearly such activity saved investors from losses and was in their interests. But it also had the perverse effect of lulling investors into the belief that losses were extremely remote, if not somehow impossible, due to sponsor support.
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A dedicated capital buffer, or similar structure, could provide that type of cushion. It could mitigate the incentive for investors to run since there would be dedicated resources to address any losses in the fund
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In assessing potential capital buffer structures, we are examining the pros and cons of various sources of the capital. The capital in a money market fund could come from (1) the fund’s sponsor, (2) the fund’s shareholders, or (3) the market, through the issuance of debt or a subordinated equity class. In addition, we are closely examining the appropriate size of any capital buffer. A challenge is how to establish a capital buffer that offers meaningful protection against unexpected events, without over-protecting and unnecessarily interfering with the prudent and efficient portfolio management of the fund.

Capital buffers have achieved a good level of academic support, as reported on PrefBlog in the post Squam Lake Group on Money Market Fund Regulation.

In a speech picked by Reuters, the new Republican SEC commissioner Daniel Gallagher made a speech on the topic titled SEC Reform After Dodd-Frank and the Financial Crisis:

To put a finer point on it, in light of the extensive disclosures regarding the possibility of loss, money market funds should not be treated by investors or by regulators as providing the surety of federally insured demand deposits.

So what is prompting this urgency to reform money market funds? What are the particular risks that money market funds, as currently constituted, pose to investors and to the capital markets? What problem are we solving here?

Well, as the events following the Lehman bankruptcy and Primary Reserve’s breaking of the buck showed, investors are treating money market funds as being perfectly safe – disclosures nonwithstanding. And problem is the effect on financial stability of the breathtaking run on money market funds that followed.

Like it or not, US MMFs have a huge systemic importance, as pointed out in an opinion piece by two partners at Dechert LLP (a law firm) titled How the Dodd-Frank Act Should Affect Mutual Funds, Including Money Market Funds:

Money market funds are an intermediary of short-term credit to the economy. They hold over 40 percent of outstanding commercial paper and approximately 65 percent of short-term municipal debt. Money market funds also manage a substantial portion of U.S. business short-term assets (24 percent as of 2006). As of December 29, 2010, money market funds had approximately $2.8 trillion of assets, or approximately 25 percent of all U.S. fund assets. Of the $2.8 trillion in money market funds, more than $1.8 trillion was invested in institutional money market funds.

I don’t think that there can be any doubt regarding the role played by MMFs in financial stability. But back to Gallagher:

I’ll admit that I just posed a bit of a trick question. We cannot know what risks money market funds pose unless – and this brings me to my second point – we have a clearer understanding of the effects of the Commission’s 2010 money market reforms. For some reason, much of the discussion surrounding the current need for money market reform sweeps aside the fact that the Commission has already responded to the 2008 crisis by making significant changes to Rule 2a-7. Notably, those amendments only became effective in May 2010.

The Rule 2a-7 amendments do not address the problem. Oh, they require a bit more liquidity, and they require a bit more box-ticking on credit quality – but the problem is, what if a money market fund holds a security that goes bust? There is no amount of box-ticking, no amount of analysis, that is going to eliminate that possibility.

First, I am hesitant about any form of so-called “capital” requirement, whether it takes the form of a “buffer” or of an actual capital requirement similar to those imposed on banks. Although I am not opposed to a bank-like capital requirement in principle, it is my understanding that the level of capital that would be required to legitimately backstop the funds would effectively end the industry.

His claim regarding his understanding is not footnoted, which is a shame.

However, if having sufficient capital would end the industry, then is the industry worth having? MMFs exist mainly for the purpose of doing an end-run around the banks – providing essentially the same services without having to submit to all the capital rules. In that sense, imposing a capital buffer rule that ends the industry can be seen more as a closing of a loophole than anything else.

In a very big sense, a bank with a large MMF operation can be viewed as simply having an unrecognized off-balance sheet obligation – something we’re trying to get away from!

I will note, however, that at least one industry participant has suggested the possibility of a stand-alone redemption fee. Although the details of the imposition of such a fee would need to be carefully considered, this suggestion avoids my worries about capital requirements. This minimal approach does not set up false expectations of capital protection, externalizes the costs of redemptions, and could be part of an orderly process to wind down funds when necessary. And, a meaningful redemption fee may cause a healthy process of self-selection among investors that could cull out those more likely to “run” in a time of stress. But despite my initial positive reaction to the notion of a redemption fee standing alone, grafting the fee onto a capital buffer regime will not assuage my concerns with such a capital requirement. Indeed, a combined approach retains all the problems of any capital solution, unless something significant is done to manage investor expectations regarding the level of protection provided.

His mention of a possible redemption fee has been left unfootnoted, but may be related to the paper by the Dechert partners referenced above:

The alternative suggested here is that, during a period of illiquidity, as declared by a money market fund’s board (or, alternatively, the SEC or another designated federal regulator), a money market fund may impose a redemption fee on a large share redemption approximately equal to the cost imposed by the redeeming shareholder and other redeeming shareholders on the money market fund’s remaining shareholders. For example, if redemptions in cash are expected to impact the market value of the fund’s remaining portfolio securities by an estimated dollar value or percentage, then the redeeming shareholders would be entitled to receive their principal value (i.e., the $1.00 NAV) minus the market impact that the redemptions have on the fund. Thus, during a period of declared illiquidity, a shareholder who insists upon making a large redemption of its shares would receive less than the full amount of its shares’ NAV. As soon as the declaration is withdrawn at the end of the period of illiquidity, money market funds would no longer be permitted to impose a redemption fee on redeeming shareholders and, once again, share transactions would occur at the $1.00 NAV.

I can’t say I’m very impressed with the redemption fee argument. Most importantly, it implies breaking the buck in all but name – there’s no insurance aspect to it, as there is with a capital buffer, or guarantees from a credible counterparty.

Update, 2011-12-23: Bloomberg’s editors suggest:

To add another level of security, regulators should consider one other change the industry has proposed: Allow funds to quickly close the door on redemptions when management deems it necessary. Hedge funds routinely used this lifesaver during the financial crisis. Few failed as a result. We would prefer that, instead of the industry deciding whether to shut the gate, which could leave millions of small investors in a cash crunch, the SEC make that decision in consultation with the Fed and the Treasury.

I don’t buy it. As soon as one MMF locks its doors, there will be a run on all the others. Additionally, there will be very grave effects on holders who need the money and to whom $0.98 now is worth a lot more than (maybe) $1.00 in two weeks.