Regulation of Financial Institutions

1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Importance ofMoney 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

9. Figure 1Total Money Market Mutual Fund Assets Under Management September 12, 2006 - September 6, 2011 Source: iMoneyNet

10. Figure 2Total Money Market Mutual Fund Assets Under Management by Type of Fund September 12, 2006 - September 6, 2011 Source: iMoneyNet

11. Figure 3Daily Changes in Assets Under Management in Prime Money Market Mutual Funds August 1, 2008 - October 7, 2008 Source: iMoneyNet

12. 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)

13. Figure 4Highest-Yielding Prime Funds Average Gross and Net Yields August 30, 2011 Source: iMoneyNet

14. Figure 5Foreign Exposure of Five Largest Prime Money Market Mutual Funds As of February 28, 2011 and August 31, 2011 Source: Crane Data, Mutual Fund Company Websites

15. 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?

16. No One Proposal has beenSettled 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

17. 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?

18. 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

19. 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

20. Figure 6Bank Size Relative to Country Size:Assets of Largest Bank as a Share of GDP as of Year End 2010 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

21. Figure 7Stock Prices of Largest Banksin Europe and the United States Source: Global Finance, Bloomberg

22. 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