Alternative Reference Rates: Meeting the Challenges

Guest post by Richard Berner, Executive-in-Residence (Center for Global Economy and Business) and Adjunct Professor, NYU Stern School of Business

In response to the fragility of LIBOR and other interest-rate benchmarks, regulators globally are working with industry to identify sturdy alternatives. Despite significant progress, concerns persist that the transition to these new reference rates will be disruptive.

While these concerns are legitimate (see Eclipsing LIBOR), both U.S. and global authorities and market participants have begun to address them in ways that should go a long way to managing the risks. In this post, we review why LIBOR’s persistent fragility makes reform critical, and examine progress on some of the ongoing reforms....

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Money Funds -- The Empire Strikes Back?

Shortly after Lehman failed in 2008, investors began to flee from money market mutual funds (MMMFs). To halt the run, the U.S. Treasury guaranteed all $3.8 trillion in outstanding MMMF liabilities. That rescue created enduring moral hazard: the expectation that a future crisis will lead to another bailout.

Aside from their legal form as mutual funds, MMMFs functioned much like banks engaged in the transformation of liquidity, credit and (to some extent) maturity. Similar to banks that redeem deposits at face value, they promised investors a fixed share value of $1 (a “buck”) on demand. Unlike depositories, however, MMMFs had no capital, no deposit insurance, and—at least officially—no access to the lender of last resort. So, when the Reserve Primary Fund “broke the buck” (by failing to redeem at the $1 par value) in September 2008, MMMF investors panicked.

Somewhat surprisingly, it took until 2014 for the Securities and Exchange Commission (SEC) to resolve political conflicts and introduce significant rule changes for MMMFs (see our earlier posts here and here). The SEC now requires that institutional prime MMMFs—which (like Reserve Primary) frequently invest in short-term corporate liabilities—operate like other mutual funds with a floating net asset value (NAV). The same rule applies to institutional municipal MMMFs. Retail MMMFs, as well as those investing in federal government (and agency) securities, are exempt.

In light of a recent legislative proposal to water it down, in this post we review the impact of the SEC’s 2014 reform. To highlight our conclusions: (1) it did not go far enough to reduce run risk; (2) aside from temporary dislocations, it has not raised nonfinancial sector funding costs by more than would be accounted for by reducing the implicit taxpayer guarantee for MMMFs; and (3) reversing the floating-NAV requirement would weaken the safety of the U.S. financial system....

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In Defense of Regulatory Diversity

Guest post by Lawrence J. White, Robert Kavesh Professor in Economics, NYU Stern School of Business

The U.S. regulatory landscape--especially with regard to financial regulation—is maddeningly complex.  It is easy to make a case for a drastic simplification, and the authors of this blog have done so here. But there is value in diversity—including regulatory diversity. Consequently, with regard to the regulatory framework, as is true of most other areas of political economy, we need to consider the costs as well as the benefits of any proposed changes.

Let’s start with the undeniable complexity of U.S. financial regulation: Consider the following array of agencies and jurisdictions (an alphabet-soup glossary appears at the end)...

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An Open Letter to the Honorable Randal K. Quarles

Dear Mr. Quarles,

Congratulations on your nomination as the first Vice Chairman for Supervision on the Board of Governors of the Federal Reserve System. We are pleased that President Trump has chosen someone so qualified, and we are equally pleased that you are willing to serve.

Assuming everything goes according to plan, you will be assuming your position just as we mark the 10th anniversary of the start of the global financial crisis. As a direct consequence of numerous reforms, the U.S. financial system—both institutions and markets—is meaningfully stronger than it was in 2007. Among many other things, today banks finance a larger portion of their lending with equity, devote more of their portfolios to high-quality, liquid assets, and clear a large fraction of derivatives through central counterparties.

That said, in our view, the system is not yet strong enough. In your new role, it will be your job to continue to fortify the financial system to make it sufficiently resilient.

With that task in mind, we humbly propose some key agenda items for the first few years of your term in office. We divide our suggestions into five broad categories (admittedly with significant overlap): capital and communications, stress testing, too big to fail, resolution, and regulation by economic function....

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Too Big to Fail: MetLife v. FSOC

Last week, a Federal District Court overturned the Financial Stability Oversight Council’s (FSOC) designation of MetLife—the nation’s largest insurer by assets—as a systemically important financial intermediary (SIFI). Until the Court unseals this decision, we won’t know why. If the ruling is based on narrow grounds that the FSOC can readily address, it will have little impact on long-run prospects for U.S. financial stability.

However, if the Court has materially raised the hurdle to SIFI designation—and if its ruling holds up on appeal—“too big to fail” nonbanks could again loom large in future financial crises, making them both more likely and more damaging...

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