Regulation of Financial Institutions
Eric S. Rosengren
President & CEO
Federal Reserve Bank of Boston
Open Classroom
Northeastern University
Boston, MA
November 30, 2011
www.bostonfed.org
Why Do We Regulate Financial
Institutions?
 If everyone wants funds at the same time
cannot liquidate loans


Depositors want immediate access to funds
Borrowers want longer-term financing
 Financial intermediaries borrow short and
lend long – assume diversification reduces
risk from maturity mismatch
 Depression – bank runs – widespread bank
closures
2
Depression Era Solution
 Deposit Insurance – FDIC


Banks have special role – depositors get
limited government guarantee
Taxpayers at risk during failure



Banks limited in what risk they take
Banks have capital requirements – CAMELS
Regular bank exams
3
Problems Emerge
 Interest on deposits does not rise at weaker
banks


Weak banks have incentive to take more risk
Gains go to shareholders, losses go to
taxpayers
 Use financial institutions for other goals


Savings and Loans
GSEs
 Banks become larger and more complicated
4
Too Big to Fail
 International loans – assumption that
governments would not default
 Real estate loans – assumption real estate
values would not fall
 Real estate securities – assumption
securities with national pools of mortgages
would be protected since national housing
prices had not fallen
5
2007-2008
 Runs are not unique to banks




Investment banks – Bear Stearns, Lehman
Insurance – AIG
Money market funds – Reserve Primary Fund
Exotic structures – SIV
 International transmission of shocks – global
banks are global problems
6
Money Market Mutual Funds (MMMFs)
 Regulated by the SEC
 Must maintain significant liquidity ratios
 Limited in the duration and credit ratings of
instruments they can hold
 Not required to alter net value (NAV) to reflect
small movements in underlying asset values
 Like other mutual funds, not required to hold
any capital as protection
 This structure can generate shareholder “runs”
during times of financial stress
7
Importance of
Money Market Mutual Funds
 Critical players in short-term credit markets
 Significant buyers of CP, ABCP and CDs
 Important source of financing for organizations
dependent on wholesale financing
 Largest investor focused on high-quality, very
short-term paper
8
Figure 1
Total Money Market Mutual Fund
Assets Under Management
September 12, 2006 - September 6, 2011
Trillions of Dollars
4.0
3.5
3.0
2.5
2.0
12-Sep-06
11-Sep-07
Source: iMoneyNet
9-Sep-08
8-Sep-09
7-Sep-10
6-Sep-11
9
Figure 2
Total Money Market Mutual Fund
Assets Under Management by Type of Fund
September 12, 2006 - September 6, 2011
Trillions of Dollars
2.5
Prime
2.0
1.5
Lehman
Fails (Sep 15)
Government
1.0
Tax-Free
0.5
0.0
12-Sep-06
11-Sep-07
Source: iMoneyNet
9-Sep-08
8-Sep-09
7-Sep-10
6-Sep-11
10
Figure 3
Daily Changes in Assets Under Management
in Prime Money Market Mutual Funds
August 1, 2008 - October 7, 2008
Billions of Dollars
30
AMLF program commences (Sep 22).
0
Lehman fails
(Sep 15).
-30
Treasury announces
insurance for MMMFs
(Sep 19).
-60
The Reserve Primary
Fund breaks the buck
(Sep 16).
-90
Fed announces
AMLF program (Sep 19).
-120
-150
1-Aug-08
12-Aug-08
21-Aug-08
2-Sep-08
11-Sep-08
22-Sep-08
1-Oct-08
Note: Prime funds include both retail and institutional funds. Outflows at prime institutional funds
account for 90% of prime outflows since September 17.
Source: iMoneyNet
11
Response to the Rapid Withdrawals
 Treasury temporary insurance program
 Federal Reserve Bank of Boston administered
Fed lending facility
 Addressed short-term liquidity needs of MMMFs
 Helped stabilize short-term credit markets
disrupted by rapid liquidations
 Efforts proved successful at restoring stability,
avoiding further harm
 Balances have gradually declined (low rate
environment and corresponding returns)
12
Figure 4
Highest-Yielding Prime Funds
Average Gross and Net Yields
August 30, 2011
Funds
Average
7-Day Yield
Gross
(Basis Points)
Average
7-Day Yield
Net
(Basis Points)
Five
Highest-Yielding
Money Market Mutual
Funds
38.4
5.0
Next Five
Highest-Yielding
Money Market Mutual
Funds
33.8
2.6
Source: iMoneyNet
13
Figure 5
Foreign Exposure of Five Largest Prime
Money Market Mutual Funds
As of February 28, 2011 and August 31, 2011
Percent
80
as of February 28, 2011
as of August 31, 2011
60
Change (Percentage Point Difference)
40
20
0
-20
Total
Foreign
Europe
France
Source: Crane Data, Mutual Fund Company Websites
UK
Germany
Italy
14
Financial Stability and MMMFs
 Actions have been taken recently – improved
liquidity and monthly reporting of holdings
 Credit risk and MMMFs holdings
 Is the current structure appropriate given the
critical role of MMMFs to short-term credit
markets?
15
No One Proposal has been
Settled on – My Preferred Approach
 A meaningful capital-like buffer – perhaps 3%
 If violated, automatically leads to conversion to
a floating NAV
 If plan for a buffer isn’t produced and accepted,
require MMMFs to float NAV
16
Additional Actions
 A more proactive regulatory approach
 Reporting should be more frequent
 Reducing a fund’s maximum permissible
exposure to any one firm
 Many (but not all) MMMFs have been
significantly reducing exposure to troubled
institutions – but are assets of riskier firms
appropriate investments for MMMFs?
17
MMMFs are Intertwined with Another
Systemic Risk Issue
 Dependence of foreign branches and
agencies in the U.S. on short-term wholesale
funding
 Not able to get deposit insurance or FHLB
membership
 Issuing jumbo CDs, CP, and repurchase
agreements
 During times of stress, less stable than retail
deposits
18
Challenges from Europe
 Banks are large relative to their economies
 Global banks have significant operations in
the United States
 Many global banks have large exposures to
European sovereign debt
 Wholesale credit markets showing significant
stress
19
Figure 6
Bank Size Relative to Country Size:
Assets of Largest Bank as a Share of GDP
as of Year End 2010
Percent
300
Switzerland
250
Netherlands
200
Denmark
Sweden
Belgium
150
Spain
France
100
United
Kingdom
Germany
Italy
50
United
States
0
Note: Includes the U.S. and all European countries with a bank ranked in the top 50 worldwide as of year end 2010.
Source: Global Finance, IMF
20
Figure 7
Stock Prices of Largest Banks
in Europe and the United States
Largest Banks in
Groups of Five
Average Stock Prices:
Average
Index Level Dec 29, 2006 = 100
Bank Assets
Billion Dollars
Peak
sssssssssss
Dec 31, 2010 Dec 30, 2008 Nov 28, 2011 (Post 2006)
Average Percent Change
Year End
Peak to
2010 to
Nov 28, 2011 Nov 28, 2011
Five Largest Banks
2,456
33
30
110
-72
-37
Next Five Largest Banks
2,019
30
22
104
-79
-44
Next Five Largest Banks
1,470
41
30
111
-73
-41
Next Five Largest Banks
1,028
34
22
118
-81
-50
Source: Global Finance, Bloomberg
21
Final Thoughts
 Financial markets remain stressed
 Many global banks are experiencing
wholesale funding issues
 We are not insulated from European stress
 Political will in many countries is lagging for
directly addressing problems
22