Over the summer and fall shadow banking regulation moved forward on several fronts.
First, the SEC proposed rules that would reform the way money market funds operate "in order to make them less susceptible to runs that can harm investors". In keeping with previous guidance provided by the Financial Stability Board (FSB) and the Financial Stability Oversight Counsel (FSOC), the SEC proposal includes two principal alternatives that may be adopted alone or in combination. One alternative would require a floating net asset value (NAV) for prime institutional money market funds. (Note that government-debt funds are now to be excluded as it has become apparent that there had not been runs on these funds during the crisis). The other alternative would allow for the use of liquidity fees and redemption gates in times of stress.
The public comments on these proposals have been relatively predictable and in line with comments previously made in respect of the FSB and the FSOC proposals. Opposition to both the floating NAV and redemption fee alternatives remains strong. J.P Morgan Asset Management summarizes the views of MMF investors as follows:
"Specifically, MMF investors have indicated concern about changes to the basic tenets of money funds – stability of principal and daily liquidity. Both Alternatives 1 and 2 have the potential to significantly reduce these key benefits that MMFs provide today and the adoption of either alternative will reduce the use of MMFs. The extent of the impact appears to be dependent upon the details of the reforms adopted. The majority of these investors have stated that they would look to utilize bank deposits, direct money market securities, government MMFs and possibly look to outsource more internal investments to outside managers."
The one proposal which continues to be viewed as the least problematic is the imposition of redemption gates, which garners a certain degree of support from even such staunch opponents of the proposed reforms as the American Bankers Association and Melanie Fein. As indicated by the former "we do believe the ability to gate a fund could slow redemptions sufficiently to enable a board to assess the situation and take appropriate actions." If the regulator's real aim is to stop mass redemptions or runs, then only the imposition of a gate would be effective to accomplish this aim without significant collateral damage to the attractiveness of MMFs as an investment vehicle.
Second, the FSB finalized most of its policy recommendations regarding shadow banking risks in securities lending and repos. In hopes of helping reduce excess leverage and dampening pro-cyclicality, the FSB pushed forward on its proposals for minimum standards for calculating haircuts and a framework of numerical haircut floors. In addition, the FSB has proposed that entities should not be allowed to re-hypothecate client assets in order to finance activities for their own account and only entities subject to adequate regulation of liquidity risk should be allowed to engage in the re-hypothecation of client assets. Both the imposition of mandatory haircuts and restrictions on re-hypothecation are intended to decrease the "velocity" of the collateral or the amount of leveraging possible off of the assets.
At the same time the FSB issued a policy framework for strengthening oversight and regulation of shadow banking entities which essentially merely refined the previous work of identifying the economic functions conducted by these entities and presenting a menu of policy tools from which authorities can draw if necessary to mitigate the shadow banking risks inherent in each of the economic functions. In order to maintain consistency across jurisdictions in applying the policy framework and to detect new adaptions and innovations in financial markets, authorities are to set up an information-sharing process under the FSB.
According to the roadmap published in connection with the September G20 summit most of these and the other related shadow banking initiatives are to be largely completed and implemented by the member states sometime during 2014.
Finally, U.S. federal agencies issued a second notice of proposed rulemaking to implement the credit risk retention requirements of the Dodd-Frank Act. The proposed rule contains a number of changes from the original 2011 proposal, among the most significant being:
- The standard requirement to retain 5% of the credit risk has been modified to apply to the "fair value" (determined in accordance with GAAP) rather then the par value of the ABS interests issued in the securization.
- Due to the foregoing, the controversial original requirement to fund a premium capture cash reserve account has been eliminated.
- Rather than having to select from vertical, horizontal or "L-Shaped" options, sponsors are now permitted to satisfy their risk retention requirements by holding any combination of vertical and horizontal interests.
- The definition of "qualified residential mortgage" eligible for an exemption has been broadened to match the definition of "qualified mortgage" under consumer protection rules.
- Restrictions on hedging, pledging and transferring retained investments may be relaxed towards the end of a transaction.
- A sponsor may satisfy its risk retention requirements through the purchase and retention by a significant originator of no more than its pro rata share (based on the unpaid principal balance of underlying assets) of the eligible interests otherwise retained by the sponsor. The purchasing originator will be subject to the same restrictions on hedging, pledging and transferring its retained interests as the sponsor.
- In the case of ABCP conduits, a special option provides for the retention of the risk by the originator/seller of the ABS assets rather than the sponsor. The advantage of not having to retain the risk at the sponsor level will provide a strong incentive for ABCP conduits to be structured or restructured to comply with the eligibility requirements, the most notable of which is that the conduit can only purchase ABS as opposed to the underlying receivables. This will require the creation of an intermediate entity to purchase the receivables from the seller which will in turn issue the ABS to the ABCP conduit.
- The proposed rules maintain the safe harbor for certain foreign transactions involving non-U.S. sponsors selling no more than 10% of its ABS interests into the US, and which interests are not collateralized by more than 25% of U.S. assets.
Given the length of time that has passed since the original proposal, the agencies are apparently now keen to move to enactment. Only 40 days were provided for comments on the extensive re-proposal and several applications for extension were ignored. Nevertheless, a number of groups, including the Structured Finance Industry Group, the Securities Industry and Financial Markets Association and the American Bankers Association were after to pull together and submit lengthy and detailed commentary. However, given the evident rush of the agencies, the prognosis for acceptance of these comments would appear to be rather dim.
One comment letter worth mentioning due to its applicability to cross-border transactions in general, is that of the Association for Financial Markets in Europe (AFME). Although the EU has enacted its own risk retention regime, its provisions do not align with the proposed American rules, leaving issuers in the position of having to comply with both regimes, thus restricting cross-border liquidity. AFME has urged the American agencies to reassess the need for a mutual recognition process. (It should be noted here that Canadian authorizes have not as yet proposed any risk retention rules. In the continued absence of same, any mutual recognition process which may eventually be implemented would not be applicable to Canada-US cross border transactions.) If, however, the U.S. agencies decline to contemplate such a process, AFME has suggested that the proceeds trigger should be higher than 10%, considering 20% to be more appropriate.
Final Thoughts
As described by the FSB, the shadow banking rules are intended to dampen or mitigate the effect of runs. This is to be accomplished by, among other things, making participation in that system less attractive at the outset by the imposition of entry barriers (through increased capital requirements and risk retention rules), by reducing the velocity of collateral (through the imposition of margins) and by imposing costs (through the imposition of redemption fees) or erecting impediments (through redemption gates) to runs. These measures are perhaps best described as throwing sand in the gears of the run mechanism or imposing a governor to slow its momentum. Whether they will have the cumulative effect desired or advertised must await trial but we shouldn't be too surprised if they are never actually put to the test. This is primarily due to the fact that the restrictions placed on banks through capital and liquidity rules (assuming that proper enforcement is not undermined by the overly complex nature of Basel III: see comment by Paul Kupiec in November 14 Financial Post) combined with restrictions on proprietary trading should severely limit the appetite of the banks for the type of speculative and arbitrage-seeking behavior which contributed significantly to the formation of the asset bubble last time around. Hopefully, absent the all-in antics of banks, the remaining players will not be capable of creating an asset bubble the collapse of which could have systemic consequences. Indeed, this may well be another example of preparing for the last battle while a new and far more dangerous antagonist is allowed to marshall its forces in the wings.
The collapse of the shadow banking system resulted in a gaping hole in the monetary supply. Since the crisis this hole has been filled by greatly increased central bank reserves and government treasuries (through, in part, quantitative easing). Furthermore, the new rules have in many instances granted favorable treatment to government debt (see, for instance, the MMF rules cited earlier) thus further increasing demand. In addition, the fact that some of this collateral must be maintained by banks for liquidity purposes and that massive amounts of treasury bonds have been purchased and held by the Fed means they are essentially stranded and unable to satisfy the demands of the greater economy. This demand seems to dove-tail quite nicely with the ever increasing proclivity of governments to run massive deficits which have come to be justified as stimuli necessary to offset an "uncertain or sluggish recovery."
Economic stimulus was originally intended to counteract the otherwise harsh consequences of natural corrections to the economy, but it was generally accepted that they were to be removed once the crisis had passed. Now it seems that this limited application of stimulus has been deemed insufficient. Rather, the Fed seems to believe that it is able to, and thus should, manipulate the economic cycle to achieve constant growth. "NG-DP targeting, if it works, has the potential to make severe economic slumps a thing of the past" (Dylan Matthews, Washington Post). In service of this goal, short term interest rates have been reduced to and maintained at nearly zero per cent, promises have been made that these rates will remain low for the foreseeable future and huge amounts of money have been pumped into the system in order to influence long-term rates. At this point there does not seem to be any end of these policies in sight. When Ben Bernake merely broached the possibility that the Fed might begin tapering Q3, his comments so unsettled the financial markets that he quickly retreated.
But this constant growth is being fueled by an explosion of government debt which is sustainable only as long as the corresponding interest burden is controlled. As described by the Bank for International Settlements in its 2013 recent annual report:
"Continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system. After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change."
Sooner or later the ability to suppress interest rates will begin to be compromised by the increasing pressure brought to bear on the value of the U.S. Dollar and the eventual demand of holders of the debt for increased return to compensate for the debasing of the currency.
With such large amounts of debt being carried by governments, any significant increase to their debt service burden could have serious consequences. It is far from clear that the central bankers or indeed governments have the will or even the tools to respond but time may now be of the essence. According to Donald McKinnon in the Financial Post on October 29, it is time for the Fed to begin to slowly raise interest rates and phase out QE in order to get ahead of the problem. But to be successful, governments also need to take this problem seriously, and, notwithstanding the negative effect on growth and the associated political risks, to begin making significant reductions in their debt loads. (The work being done by the Canadian federal government to reduce the deficit is a good start and will help us weather the storm to come but must continue in order to reduce the overall debt.)
Some commentators believe it is already too late to avoid the uncontrolled growth, and the catastrophic consequences of the bursting, of the government debt bubble. Thus such adherents of the Austrian school of economics as David Stockman ("The Great Deformation"), Peter Schiff ("The Real Crash") and Detlev Schlichter ("Paper Money Collapse") take a fairly dim view of the prospects of avoiding a catastrophic crisis. In their view, the root of all modern economic evil is the creation of the Fed, its control over the money supply and its ever-increasing degree of activism in the use of this control to shape and guide economic performance. Part of the remedy, as they see it, is to pry the controls away from the Fed and to return to sound money, that is, the gold standard. These authors, like the editors of the Financial Post, tend to use the word 'Keynesian' as an expletive and in turn are characterized, along with Ron Paul, as libertarian cranks. Like the opposite sides of the climate debate, they all seem to talk past one another leaving no common ground on which to resolve differences or test their hypotheses or to earn for their discipline any consideration as a true science, dismal or otherwise. In any case, if I were to hazard a guess I would say that we are destined to find out whether the wizards at the Fed have really tamed the chaotic forces of the economy or whether their hubris will bring it all down around our ears sometime during the next decade or so. They promise to be, in the words of the ancient Chinese proverb, 'interesting times' so buckle up and keep safe!
Well that's it for me. I have had great fun writing these pieces and learning more about these complex and crucially important topics and I hope you have found it to be mildly diverting . Wishing everyone great holidays and Happy Trails.
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