In our forthcoming article, Regulating Ex Post: How Law Can Address the Inevitability of Financial Failure, 92 Texas Law Review (2013), we observe that, unlike many other areas of regulation, financial regulation operates in the context of a complex interdependent system. This, we argue, has implications for financial regulatory policy, especially the choice between ex ante regulation aimed at preventing financial failures and ex post regulation aimed at responding to those failures.

Our article begins by considering the nature of systems and the usefulness of systems analysis as a methodology for studying law. Law-related systems are systems in which the law is an integral element. The financial system can be viewed as a complex network in which financial firms interact directly and indirectly (through markets) against the background of legal rules.

…continue reading: How Law Can Address the Inevitability of Financial Failure

A critical policy question is the extent to which “systemic” banks provide value from an economic or social perspective. Much research has been mobilized to demonstrate this, as well as to counter these findings to argue that the biggest banks enjoy undue subsidies because they are so systemic as to be protected by taxpayers. Markets may indeed perceive some big banks as too big to fail (TBTF), but perception does not make reality. Thus, this paper assesses how a systemic financial institution can be differentiated from others to inform the debate over policy responses to TBTF and pending regulatory actions and U.S. legislation to govern the largest financial institutions. Quite simply, if there are no reliable, objective systemic criteria, then policy based on size thresholds or other “systemic” indicators will be at best ineffective antidotes to global financial crises even as they do unnecessary damage to banks and, more broadly, to financial-market efficiency and effectiveness.

In this paper, we assess the ability of regulators to define the criteria that characterize systemically-important financial institutions (SIFIs). The definition of systemic is critical since an array of rules predicated on the negative externalities of SIFIs is under active development. Further, allegations that “systemic” firms, most notably very large bank holding companies (BHCs), are TBTF have aroused calls for additional, generally punitive action for designated institutions.

…continue reading: A Critical Missing Reform Criterion: Regulating “Systemic” Banks

Today [June 5, 2013], the Commission considers amending the rules that govern money market funds to address potential systemic risks. Before I begin, I would like to recognize the efforts of the staff throughout the SEC, especially the Division of Investment Management and the Division of Risk, Strategy, and Financial Innovation. I acknowledge and appreciate the staff’s good work in examining the 2010 amendments to Rule 2a-7 and the staff’s report, which concluded that, among other things, the 2010 amendments would not have been adequate to prevent the systemic risks that we saw in 2008. This report has resulted in the much-improved proposal that is before us today.

The staff’s work is a testament as to why the SEC should take the helm of matters that are within its jurisdiction. I appreciate that the Financial Stability Oversight Council (“FSOC”) recently said as much in its 2013 Annual Report. [1] The SEC’s expertise brings a clear-eyed experience and practical knowledge that can target needed change, while being mindful of unintended consequences.

I am supportive of the staff’s recommendations and will first put the proposed amendments in context, and then highlight a few items.

…continue reading: Striving to Restructure Money Markets Funds to Address Potential Systemic Risk

On May 3, 2013, Federal Reserve Board Governor Daniel Tarullo delivered a speech outlining potential regulatory initiatives before the Peterson Institute for International Economics in Washington, D.C. In this speech, entitled “Evaluating Progress in Regulatory Reforms to Promote Financial Stability,” Governor Tarullo acknowledged that substantial progress has been made in achieving financial regulatory reform, but he maintains that much more is still needed. [1]

Even beyond the substantive impact of the reforms proposed by Governor Tarullo, his speech is particularly noteworthy for two reasons. First, Governor Tarullo oversees the Federal Reserve Board’s banking supervision and regulation function and was recently appointed as Chairman of the Financial Stability Board’s Standing Committee on Supervisory and Regulatory Cooperation. Second, in the past, Governor Tarullo has used similar speeches to forecast the Federal Reserve’s upcoming regulatory initiatives.

Governor Tarullo’s speech focuses on three general areas of increased regulatory scrutiny: (1) large financial institutions generally; (2) large financial institutions that rely on short-term wholesale funding; and (3) short-term wholesale funding markets, in particular those for securities financing transactions (SFTs). Governor Tarullo proposes a number of regulatory requirements to address what he perceives as the unfinished business of regulatory reform, including both macro- and micro-prudential requirements at an institution-specific level and market practice level.

…continue reading: Federal Reserve Board Governor Tarullo Outlines Potential Regulatory Initiatives

This post summarizes “The Dodd-Frank Act’s Maginot Line:  Clearinghouse Construction,” which will appear in the California Law Review later this year.

Regulatory reaction to the 2008–2009 financial crisis, following the failures of AIG, Bear Stearns, Lehman Brothers, and the Reserve Primary Fund, focused on complex financial instruments that deepened the crisis. A consensus emerged that these risky financial instruments should move through safe, strong clearinghouses, which would be bulwarks against systemic risk.

The consensus turned into law, via the Dodd-Frank Wall Street Reform Act, in which Congress instructed regulators to construct clearinghouses through which these risky financial instruments would trade and settle. Clearinghouses could repel financial risk, reduce contagion, and halt a local financial problem before it became an economy-wide crisis.

But clearinghouses are weaker bulwarks against financial contagion, financial panic, and systemic risk than is commonly thought. They may well be unable to defend the economy against financial stress such as that of the 2008–2009 crisis. Although they can be efficient financial platforms in ordinary times, they do little to reduce systemic risk in crisis times.

…continue reading: The Dodd-Frank Act’s Maginot Line: Clearinghouse Construction

Today [May 1, 2013], the Commission considers issuing a release proposing rules and interpretive guidance applicable to certain market intermediaries, participants, clearing agencies, data repositories, and trade execution facilities that are involved in cross-border transactions of security-based swaps. The proposed release is over 1,000 pages, contains over 2,000 footnotes, and requests comments on more than 630 questions with many subparts. Although the questions posed are many, they are intended to be balanced and fair to solicit views from all sides. This is a welcome approach, because it contributes to a healthy debate and dialogue that is vital to the Commission’s processes.

Today, the Commission also votes to reopen the comment period on the various outstanding rulemaking releases and policy statement concerning security-based swaps and market participants to allow the public additional time to analyze and provide comments in light of our cross-border release.

The length of the cross-border release and the reopening of the comment periods reflect the complexity and importance of the issues involved in securities-based swap transactions. In issuing today’s proposal and asking for comments on the Commission’s proposed approach to regulating the securities-based swap market, the Commission recognizes the interactions among many important rules in this area. It is important, therefore, that our rules avoid gaps and loopholes, and that they work together to provide the needed transparency, accountability, and protection to our economy, the markets, and, most importantly, to investors.

…continue reading: Proposed Rules for Global Derivatives Market

The recent financial crisis has rekindled interest in the relationship between the structure of the financial network and systemic risk. Two polar views on this relationship have been suggested in the academic literature and the policy world. The first maintains that the “incompleteness” of the financial network can be a source of instability, as individual banks are overly exposed to the liabilities of a handful of financial institutions. Thus, according to this argument, a more complete financial network, which limits the exposure of the banks to any one counterparty would be less prone to systemic failures. The second view, in stark contrast, hypothesizes that it is the highly interconnected nature of the financial system that contributes to its fragility, as it facilitates the spread of financial distress and solvency problems from one bank to the rest in an epidemic-like fashion.

In our recent NBER working paper, Systemic Risk and Stability in Financial Networks, my co-authors (Asuman Ozdaglar of MIT and Alireza Tahbaz-Salehi of Columbia Business School) and I provide a tractable theoretical framework for the study of the economic forces shaping the relationship between the structure of the financial network and systemic risk. We show that as long as the magnitude (or the number) of negative shocks is below a critical threshold, a more equal distribution of interbank obligations leads to less fragility. In particular, all else equal, the sparsely connected ring financial network (corresponding to a credit chain) is the most fragile of all configurations, whereas the highly interconnected complete financial network is the configuration least prone to contagion. In line with the observations made by Allen and Gale (2000), our results establish that, in the more complete networks, the losses of a distressed bank are passed to a larger number of counterparties, guaranteeing a more efficient use of the excess liquidity in the system in forestalling defaults.

…continue reading: Systemic Risk and Stability in Financial Networks

For the last four years, regulators and law makers have been focusing extraordinary efforts on ensuring that financial regulation is adequate to protect the financial system from risks emanating from the banking sector. However, it is only more recently that policy makers have turned their attention towards possible systemic risk related to entities which carry out similar functions to the banking sector or to which the banking sector is otherwise exposed. Such entities have, for convenience, been grouped under the heading of “shadow banks”, although no precise definition or description of shadow banking has yet been agreed upon by policy makers.

At their November 2010 Seoul Summit, the leaders of the G20 nations requested that the Financial Stability Board (FSB) develop recommendations to strengthen the oversight and regulation of the shadow banking system in collaboration with other international standard setting bodies, and in response to such request, the FSB formed a task force with the following objectives:

…continue reading: Out of the Shadows and Into the Light

There have been recent developments related to the Securities and Exchange Commission’s consideration of potential reform of money market funds that I would like to highlight.

On November 30, 2012, the SEC staff delivered to the Commission its report delving deeper into the causes of investor redemptions in 2008, the efficacy of the Commission’s 2010 amendments to strengthen Rule 2a-7 (the principal rule that governs money market funds), and the potential impacts of future reform on issuers and investors. This is a welcome development. As I previously stated, I have been requesting this analysis so that it could inform the dialogue as to any further money market fund reform. [1] The staff’s report is a response to a request made in mid-September by a majority of the Commission (Commissioners Aguilar, Paredes and Gallagher) that asked the Division of Risk, Strategy, and Financial Innovation to conduct a study to answer a series of questions intended to inform the continuing dialogue.

I look forward to the staff’s report being made public, so that the Commission can benefit from the public dialogue.

There have also been developments in the consideration of the potential impact of assets migrating from existing transparent, regulated money market funds to opaque, unregulated funds (sometimes referred to as Liquidity Funds) as a result of structural changes to money market funds.

…continue reading: Recent Developments in Money Market Funds

There is a sensible compromise to the debate over money market fund reform that regulators should seriously consider: requiring a fluctuating share price for some money market funds owned by institutional investors, but not for those owned by retail investors. Currently, all money market funds may use a fixed share price – known as the “net asset value”, or NAV – at one dollar per share, subject to strict conditions.

Regulators have argued that a fixed NAV creates systemic risk in the financial system and misleads investors into thinking their investment is guaranteed. They believe that money market funds should instead calculate their NAV daily based on the market value of their investments, as stock and bond mutual funds do – meaning that the NAV may fluctuate from day to day. However, the fund industry argues that a fluctuating NAV would drastically undermine the utility of money market funds. Most investors use money market funds as an alternative to bank deposits, so most investors require the convenience and liquidity of a fixed-dollar account. Additionally, the industry points out that only two money market funds – both institutional – have ever caused any investor losses by “breaking the buck”.

…continue reading: Not All Money Market Funds Are Equal