In this entry I discuss two reforms of banking regulation proposed in Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation, which the Treasury Department issued on June 17 and which I'm calling the "Report." The first proposal is to vest the Federal Reserve with responsibility for regulating "systemic risk." (As usual, I define "banking" to include all financial intermediation--and this turns out to be particularly important in the present context.) The second proposal is to empower the Fed to regulate the compensation practices of firms that it classifies as potential sources of systemic risk; such firms are to be known as "Tier 1 Financial Holding Companies."
The Federal Reserve and the Federal Deposit Insurance Corporation between them exercise comprehensive authority over commercial banks, particularly (in the case of the Federal Reserve) banks that belong to the Federal Reserve System (but I'll ignore that detail). Runs on insured banks are rare, because depositors are insured; and while banks have uninsured creditors, the usual sequel to a bank failure is for the bank's liabilities as well as assets to be assumed by another bank. Member banks of the Federal Reserve System can moreover protect themselves from insolvency caused by lack of liquidity (which might occur because the bank could not liquidate assets fast enough to meet withdrawal demands) by borrowing from the Federal Reserve itself, which can increase the cash balance in a bank's account with the local federal reserve bank by a computer stroke. (This is called "borrowing at the discount window," an archaic phrase that confuses people about how the Federal Reserve System operates. There is no window and "discount" just means loan.) There is little concern that a string of commercial-bank failures would precipitate a recession or depression.
The crisis that engulfed the financial system last September primarily involved what is called the "shadow banking" system, which is to say the financial intermediaries that provide bank-like services (such as lending borrowed capital) but are not regulated as commercial banks. The shadow banking system provides in the aggregate more credit than commercial banks do.
An illustration of the perils of nonbank banking is provided by the commercial-paper market. Checkable money-market accounts are close substitutes for demand-deposit accounts in commercial banks, and they pay interest, which until 1986 commercial banks were not permitted to pay on demand deposits. To be able to pay interest, the money-market funds have to be able to earn interest with their depositors' money, which they do by using those deposits to buy debt, such as commercial paper. The term refers to short-term unsecured promissory notes issued by companies that have sterling credit records, such as Proctor & Gamble, to finance their day-to-day operations. Sometimes these notes are issued directly to money-market funds, but more commonly they are issued to broker-dealers (firms that either broker, or deal in--that is, buy and sell--financial instruments), such as the ill-fated Lehman Brothers. The broker-dealers issue their own commercial paper to the money-market funds, and the cash they receive in return (that is, the money they borrow from the funds, the commercial paper being their promise to repay) is what they use to buy commercial paper from, which is to say lend to, nonfinancial companies such as Proctor & Gamble. Lehman thus was a dealer in commercial paper--an intermediary between nonfinancial issuers of commercial paper and money-market funds. Because it had a lot of risky investments in other parts of its business, it defaulted on the commercial paper that it had issued to money-market funds, that is, failed to repay the money it had borrowed from them. This caused a run on those funds--because they were not insured--until the government stepped in and agreed to insure them. Since Lehman, broke, could no longer buy commercial paper, the nonfinancial issuers drew on the standby lines of credit that they had with banks, as a result of which the banks had less money to lend to the many firms that were clamoring for bank credit in the crisis atmosphere of last fall.
Lehman and the money-market funds were, for all practical purposes, acting as banks, which is to say lending borrowed capital, but their borrowed capital was not insured and they were not regulated by the banking authorities. The Report proposes that the Federal Reserve be authorized to designate a nonbank as a Tier 1 Financial Holding Company (FHC) and, having done so, to place restrictions on the bank's capital structure, management, and operations (including its compensation practices, which I discuss below) designed to prevent a repetition of the failure of Lehman Brothers and the near failure of other broker-dealers, such as Bear Stearns and Merrill Lynch. For example, the Fed could require a Tier 1 FHC to increase the amount of its capital or reduce its debt-equity ratio (leverage).
The basis for classifying a firm as a Tier 1 FHC would be that it poses a "systemic risk," meaning that its failure, like that of Lehman Brothers, could endanger the financial system, or the larger economy. Usually this would be because of the firm's web of direct and indirect relations with other participants in financial markets, such as, in Lehman's case, the money-market funds, the nonfinancial issuers of commercial paper, and the banks that had issued standby letters of credit to those issuers.
Another example of the problem of systemic risk involves what is called "prime brokerage." Some broker-dealers provide extensive financial services to other financial firms, such as hedge funds, notably by holding the hedge fund's money, much as a broker-dealer holds an individual's investment in a customer account, while the hedge fund is between investments and needs somewhere to park its money. When the broker-dealer, normally because of proprietary trading (that is, speculating, often with borrowed capital) or other risky activity, gets into financial trouble, the hedge fund will quickly withdraw its money from the broker-dealer. For like a person with a money-market account (before those accounts were insured), a hedge fund is merely an unsecured, uninsured creditor of the prime broker. A run by hedge funds seeking to withdraw their money before the prime broker declares bankruptcy can bring down the broke. And if because of the broker's insolvency the hedge fund in turn gets into financial trouble, this will precipitate demands for redemption by the hedge fund's investors, and thus another run, with the result that the hedge fund may collapse along with the prime broker.