SEC

Making Unelected Power Legitimate

Through what administrative means should a democratic society in an advanced economy implement regulation? In practice, democratic governments opt for a variety of solutions to this challenge. Historically, these approaches earned their legitimacy by allocating power to elected officials who make the laws or directly oversee their agents.

Increasingly, however, governments have chosen to implement policy through agencies with varying degrees of independence from both the legislature and the executive. Under what circumstances does it make sense in a democracy to delegate powers to the unelected officials of independent agencies (IA) who are shielded from political influence? How should those powers be allocated to ensure both legitimacy and sustainability?

These are the critical issues that Paul Tucker addresses in his ambitious and broad-ranging book, Unelected Power. In addition to suggesting areas where delegation has gone too far, Tucker highlights others—such as the maintenance of financial resilience (FR)—where agencies may be insufficiently shielded from political influence to ensure effective governance. His analysis raises important questions about the regulatory framework in the United States.

In this post, we discuss Tucker’s principles for delegating authority to an IA. A key premise—that we share with Tucker—is that better governance can help substitute where simple policy rules are insufficient for optimal decisions….

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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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Treasury Round II: The Capital Markets Report

Earlier this month, the U.S. Treasury published the second of four planned reports designed to implement the core principles for regulating the U.S. financial system announced in President Trump’s February 2017 Executive Order. This report focuses on capital markets. We wrote about the first report—regarding depository institutions—in June (see here). Future reports are slated to address “the asset management and insurance industries, and retail and institutional investment products and vehicles” and “nonbank financial institutions, financial technology, and financial innovation.”

A central motivation for all this work is to review the extensive regulatory reforms enacted in the aftermath of the 2007-09 financial crisis. President Trump’s stated principles provide an attractive basis for evaluating the effectiveness of Dodd-Frank in making the financial system both more cost-effective and safer. Where have the reforms gone too far? Where have they not gone far enough?

Much of the capital markets report focuses on ways to reduce the regulatory burden, and many of the proposals—which address issues ranging from initial public offerings (IPOs) to securitizations to financial market utilities (FMUs)—could improve market function. However, while they would involve a large number of changes—most of which can be implemented without new legislation (see table)—none of the 100-plus recommendations seem terribly dramatic, nor are they likely to have much impact on the goal of promoting economic growth.

Our overall reaction is that Treasury’s predispositions—which were more clearly evident in the earlier report—encourage doubts. To us, the numerous proposals look lopsided in favor of providing “regulatory relief” even where systemic concerns may persist....

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Regulating the Credit Rating Agencies? Less Would be More

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

The major credit rating agencies (CRAs)—Moody’s, Standard & Poor’s (S&P), and Fitch—contributed significantly to the financial crisis of 2007-09. Their excessively high initial ratings of residential mortgage-backed securities (RMBS) helped fuel the bubble of mortgage finance that ultimately burst, with near catastrophic consequences for the U.S. financial sector.

These disastrous failings motivated the post-crisis urge to tighten regulation of the CRAs. It’s not hard to share the (metaphorical) desire—reflected in the Dodd-Frank Act of 2010—to grab them by the lapels and shout “Do a better job!” 

There is, however, a better way, albeit one that is less intuitive and possibly less gratifying: namely, eliminate—or at least greatly reduce—the regulation of the CRAs. This would encourage entry into the credit rating business, stimulate innovation and, eventually, improve the efficiency of capital markets....

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The World of ETFs

The first U.S. exchange-traded fund (ETF)—the SPY based on the S&P500—began trading in 1993. Since then, the number of such funds has grown dramatically, so that by mid-2016 there were more than 1,600 ETFs on U.S. exchanges valued at roughly $2.2 trillion. This means that ETFs are now roughly one-sixth the size of open-end mutual funds. And, with this ETF growth has come a broadening in their scope and character. Today, there are ETFs that include less liquid assets such as corporate bonds and emerging market equities, and there are funds that provide inverse or leveraged exposure to the underlying assets.

Given these trends, it is no surprise that ETFs have attracted regulators’ attention (see, for example, here and here). Should they be concerned? Is this a consumer protection issue? Do ETFs contribute to systemic risk? Or, is their design stabilizing? Might financial stability even be served by the conversion of all open-end mutual funds into ETFs? ...

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Dodd-Frank: Five Years After

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (hereafter, DF), the most sweeping financial regulatory reform in the United States since the 1930s. DF explicitly aims to limit systemic risk, allow for the safe resolution of the largest intermediaries, submit risky nonbanks to greater scrutiny, and reform derivatives trading.

How to celebrate its fifth birthday? Well, if you are like us, it will be a sober affair, reflecting serious worries about the continued vulnerability of the financial system.

Let’s have a look at the most noteworthy accomplishments and the biggest failings so far. Starting with the successes, here are our top five:

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Making Finance Safe

Walter Wriston, Citicorp’s chief for nearly two decades until 1984, used to argue that banks’ didn’t need much, if any, capital. The global financial crisis put that view to rest. Today, we know that if banks are going to be able to absorb large unforeseen losses that would otherwise threaten financial stability, they need to finance themselves with equity, not just debt.

But how much capital do banks need to have to ensure the financial system is safe? Even after the financial crisis, answers to this question range widely, making it the single most contentious source of debate among bankers, regulators, and academics...

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In Search of Better Credit Assessments

July 21, 2014 was the fourth birthday of the Dodd–Frank Act (DFA). It is maturing faster than a human, but slower than a dog. Of the nearly 400 rules that DFA requires regulators to write, just over half have been completed. At the end of August, the SEC finished another one – regarding credit rating agencies (CRAs). The result makes us wonder what took so long...

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The SEC is in the Wrong Business

A recent open letter from an SEC Commissioner reminded us of several absurdities of the U.S. financial regulatory apparatus. The Commissioner railed against the Treasury Office of Financial Research (OFR) report on Asset Management and Financial Stability. At the request of the Financial Stability Oversight Council (FSOC), the OFR sought to analyze activities in the asset management industry that could pose risks to the broader financial system...
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