Eric Miller

Center for Financial Policy and IMF co-host “Policy Roundtable on the Future of Financial Regulation”

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Apr 232012

Financial regulators, policymakers, academic researchers, private sector professionals, and IMF/World Bank country delegates gathered on April 17, 2012 to discuss the future of financial regulation. The roundtable, co-hosted by the Center for Financial Policy at the University of Maryland’s Robert H. Smith School of Business and the Monetary and Capital Markets Department of the International Monetary Fund (IMF), preceded the IMF-World Bank Spring Meetings in Washington, DC.

Christine Lagarde, Managing Director of the International Monetary Fund, opened the roundtable with a discussion of the relationship between financial regulation and growth and stability around the world. Ms. Lagarde spoke passionately about financial regulation and the important need for it to be on the agenda. “We need a more stable financial system, one that serves businesses and households rather than destabilizes the functioning of the real economy,” she said to the event guests. Although some progress has been made on capital and liquidity standards, Ms. Lagarde noted that “[policymakers] still need to complete the reform agenda and ensure that the new standards are implemented in a way that is consistent across countries.” José Viñals, Director of the IMF’s Monetary and Capital Markets Department, followed the Managing Director’s remarks by addressing the role IMF can play in financial regulation.

The first panel, “Framework and Best Practices,” was moderated by Jonathan Fiechter, Deputy Director of the Monetary and Capital Markets Department at the IMF. The panel discussed the progress national and international policymakers made in addressing the causes of the financial crisis since 2007. Additionally, they discussed ‘Too Big To Fail’ institutions, resolution frameworks, macro-prudential supervision and risks associated with shadow banking. Panelists included Nellie Liang, Director, Office of Financial Stability Policy and Research, Federal Reserve Board; Jason Cave, Deputy Director, Office of Complex Financial Institutions, FDIC; Russ Wermers, Associate Professor of Finance, University of Maryland; and Stijn Claessens, Assistant Director, Research, IMF.

Lemma Senbet, The William E. Mayer Chair Professor of Finance and Director, Center for Financial Policy, University of Maryland, moderated the second panel, “The Future of Financial Regulation.” The panel first discussed the movement towards a globally coordinated regulatory framework to monitor systemically important institutions that operate across national boundaries. Other topics included financial innovation; Dodd-Frank’s Orderly Liquidation Authority; regulating and monitoring systemic risks engendered by ETFs; corporate governance and executive compensation practices; and the future of capital regulation and cost of bank equity. Panelists included Donald Kohn, Former Vice Chairman, Federal Reserve Board and Senior Fellow, Brookings Institution; Craig Lewis, Chief Economist and Director, Division of Risk, Strategy, and Financial Innovation (RiskFin), US Securities and Exchange Commission; Charles Taylor, Deputy Comptroller for Capital and Regulatory Policy, Office of the Comptroller of the Currency; and Kathleen Hanley, Deputy Director and Deputy Chief Economist, Division of Risk, Strategy, and Financial Innovation (RiskFin), US Securities and Exchange Commission.

The roundtable participants enjoyed a luncheon keynote address from Darrell Duffie, Dean Witter Distinguished Professor of Finance at Stanford University. Professor Duffie went into the “plumbing” of the financial market, discussing the core interbank market, central bank liquidity, central bank swap lines, broad credit facilities, liquidity to financial market utilities, lending of last resort, and Tri-Party Repo Infrastructure Reform. Amadou N.R. Sy, Deputy Chief of the Monetary and Capital Markets Department at the IMF, concluded the day’s event by encouraging participants to use the information obtained at the roundtable to help refine the agenda on financial regulation in a forward looking manner.  He also mentioned that the program coordinators will produce a white paper as a follow-up to this roundtable.

About the Center for Financial Policy

The Center for Financial Policy leverages the Smith School’s world renowned faculty to lead research in a collaborative exchange of ideas and solutions on critical policy issues between business, government, and academia, while working to enhance and broaden the exposure of the next generation of business and government leaders to leading academics and practitioners in financial policy. For more on the center, please visit the CFP website.

About the Monetary and Capital Markets (MCM) Department of the International Monetary Fund

MCM’s mission is to provide intellectual leadership and expertise for the IMF’s work on capital markets, financial sectors and monetary and foreign exchange arrangements and operations. MCM’s surveillance role includes: identifying risks to global financial stability and their implications for the membership; assessing the soundness of individual members’ financial systems and their linkages with the macro-economy; assessing the effectiveness of the authorities’ oversight of these systems; and strengthening the Fund’s capability to provide early warning and help prevent or mitigate financial crises. MCM supports capacity-building in member countries, particularly with regard to the supervision and regulation of financial systems, central banking, monetary and exchange rate regimes, and asset and liability management. In delivering these services, MCM collaborates closely with regional and multilateral organizations and financial sector standards-setters.

Taking On the Notion of ‘Too Big To Fail’

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Apr 202012

By Phillip Swagel, CFP Academic Fellow and International Economics Professor at the University of Maryland School of Public Policy

This article originally was featured on on April 18, 2012.

The financial crisis left the biggest U.S. banks bigger, and amplified concerns that these banks are TBTF: “Too Big to Fail.” Calls for action to address TBTF were given considerable impetus by the recent annual report of the Federal Reserve Bank of Dallas, which asserted that “the vitality of our capitalist system” and “long-term prosperity” depend on eliminating TBTF. This in turn, according to the Dallas Fed, requires “breaking up the nation’s biggest banks into smaller units.”

The U.S. banking system is indeed dominated by six large firms accounting for more than half of bank assets. JPMorgan Chase and Bank of America had assets of more than $2 trillion each as of the end of 2011; Citigroup and Wells Fargo had more than $1 trillion each in assets; and Goldman Sachs and Morgan Stanley (formerly investment banks recast during the crisis as bank holding companies) weighed in at $950 and 800 billion, respectively. No other commercial bank comes close: the next largest has less than $400 billion in assets.

To be sure, there are many other large financial firms besides banks, including insurers and asset managers. But banks are special in that they intentionally undertake the risky activity of borrowing short-term money (deposits and other sources of funding) in order to invest in longer-term assets (such as making 30-year loans to homeowners). This maturity transformation at the heart of banking creates particular vulnerabilities to panics in which losses erode capital and confidence, and then funding vanishes and firms implode. This is a sadly familiar story, which too often during the recent financial crisis resulted in huge infusions of taxpayer money. The desire to end bailouts motivates many proposals to limit bank size.

Various provisions of the Dodd-Frank financial regulatory reform law and other regulatory initiatives such as the Basel III Accord impact large banks. Banks must hold more capital and ensure better access to liquidity. And then with the largest firms, those with assets of $50 billion or more, they’re subject to an enhanced supervisory regime that includes both additional capital charges and other aspects of increased regulatory scrutiny. These steps are meant to ensure that firms have an increased buffer against losses and a greater ability to survive the strains of a future crisis, and thus to provide increased protection for taxpayers. Banks further face restrictions on their activities, notably including a prohibition on proprietary trading under the Volcker Rule. These measures provide a disincentive against size, though not an outright limit.

While Dodd-Frank does not actively seek to break up large banks, the recent regulatory process appears cognizant of the potential dangers posed by large financial institutions. The Federal Reserve’s lengthy examination of the acquisition of ING Direct by Capital One, for example, suggested that regulators are wary of acquisitions that add bulk to already-large banks.

Still, the concern remains that policymakers will inevitably be forced to prop up a sufficiently large bank due to fear about the consequences of a failure. Hence the calls remain for further action to address TBTF.

What is sometimes overlooked in the discussion of TBTF is that the new orderly liquidation authority in Title II of Dodd-Frank fundamentally changes the way in which future problems at large financial institutions will be handled, and that this in turn has a profound impact even today, before a crisis. The Dodd-Frank resolution authority makes clear to bondholders and other creditors that they will take losses if a firm fails. Government money can be used to support a firm, but these funds must then be repaid by bondholders after shareholders are wiped out. Absent additional Congressional action (which is hard to imagine given the unpopularity of the TARP), a future failure of a large financial institution will involve losses for bondholders. This contrasts with what generally happened during the recent crisis, in which support for bondholders was the most common bailout.

While it is difficult to know in advance how the resolution authority will be used, it seems likely that the experience of the problems following Lehman’s demise will lead the FDIC, which will typically be in charge, to initially deploy government funds to keep a firm in operation in resolution. The FDIC might then arrange a debt-for-equity swap that recapitalizes the failing firm, with the former bondholders as the new owners.

This would be similar to a pre-packaged Chapter 11 reorganization under the bankruptcy code, though the Title II authorities would allow this to be done faster and with the government providing the equivalent of debtor-in-possession financing. Losses ultimately would be borne by bondholders.

The resolution authority provides government officials with an open checkbook to act through the troubled firm, with bondholders picking up the tab. The legislation seeks to narrow the scope of action for the FDIC in resolution by guaranteeing bondholders that they will receive as much in resolution as would have been the case under bankruptcy.  Of course this still gives worrisome scope for mischief on the part of policymakers.

The key reason while resolution authority gets at TBTF is that the near-certainty of taking losses translates into higher funding costs even in normal times (with no crisis). This reduces or even reverses the previous advantage of large firms reflecting the belief that bondholders would be bailed out. There will still be government action if large banks get into trouble: indeed, Dodd-Frank institutionalizes the intervention. But losses will be imposed. Ending the bailout of creditors such as bondholders removes a key problem of having institutions that are too big to fail.

The regulatory regime for large, complex financial institutions is in the process of a vast change from the system that prevailed before the financial crisis. Firms will be required to hold more capital, have more robust access to liquidity, receive increased regulatory scrutiny, and face restrictions on their activities. These changes will involve costs and benefits. Higher capital and liquidity requirements, for example, will affect lending activity and thus the overall economy, but the quantitative impact remains to be seen.

The Dodd-Frank legislation has many problems and omissions, and much is still uncertain about implementation. But the new liquidation authority provides for the possibility of making it so that future crises do not involve the bailouts of creditors that truly embodied the problem of having banks that are too big to fail.

Phillip Swagel is a non-resident scholar at the American Enterprise Institute and a professor at the University of Maryland’s School of Public Policy, where he teaches courses on international economics and is a faculty associate of the Center for Financial Policy at the Robert H. Smith School of Business.  He was Assistant Secretary for Economic Policy at the Treasury Department from December 2006 to January 2009. 

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Apr 182012

by Bill Longbrake, Executive-in-Residence, Center for Financial Policy

This is an excerpt of the April 2012 Longbrake Letter.  To read the letter in its entirety, click here.

Last month I referred to the economy’s strong start in 2011 and commented that once again optimism, like spring flowers, is blossoming. I posed the question whether 2012’s strong start might fade as the year progressed.

In pondering this question it is important not to lose sight of the severe damage the credit and housing bubbles inflicted on the economy. Healing is occurring but the patient remains in serious condition. While that is far better than being in critical condition, it means that the economy remains quite vulnerable to negative shocks.

U.S. March data reports have been somewhat weaker than January and February’s reports. The 120,000 increase in employment in March after six months averaging above 200,000 was a clear disappointment. While some might dismiss the weak employment report as a “bump in the road”, it is a reminder that the economy remains fragile and that the road to recovery is likely to be filled with many bumps and potholes. Or, put in economists’ language, recession is unlikely, but growth is likely to be feeble with the result that the large GDP output gap and sizeable level of unemployment will diminish only very gradually.

As often happens when data reports don’t meet expectations, the initial response of many market participants is to try to explain them away and discount their significance. This denial process started almost immediately after release of the employment report on April 6, 2012. However, denial cannot persist if other reports corroborate the initial surprise. The release of the monthly National Federal of Small Business (NFIB) report on April 10, 2012 was surprisingly negative and corroborated renewed labor market weakness. Generally, the market does not pay much attention to this survey. But, the NFIB overall index fell from 94.3 in February to 92.5 in March. It was expected to rise to 95. Details were grim. All ten sub-indices worsened. While small businesses increased employment an average of .22 workers per firm in March, up from zero in January, plans to increase hiring in the future fell from 4% to zero. This was followed by an unexpected rise in the weekly unemployment claims number.

In Europe, as expected, recession is developing. And, as feared, early indications are that the recession will be more severe than official forecasts. In recent days, Spain’s auction of sovereign debt was not well received. Yields on Spanish 10-year debt have climbed 115 basis points to 5.92% since the recent low in February. European bank stock prices have declined 14% in recent days, including a 4.6% drop on April 10, although there has been a modest rebound since then.

Read more…

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Mar 262012

by Bill Longbrake, Executive-in-Residence, Center for Financial Policy

This is an excerpt of the March 2012 Longbrake Letter.  To read the letter in its entirety, click here.

Imbalances in the Chinese economy continue to grow. An increasing share of Chinese GDP comes from investment in infrastructure. And a massive property bubble is unwinding. The question is whether the necessary transition will be managed and orderly or whether it will be disorderly and disruptive. What we know from past experience is that the longer these imbalances continue to build, the greater will be the correction whenever it eventually occurs. There is evidence that China is in the early stages of attempting to manage an orderly transition. Because the Chinese economy relies heavily on exports slowing global growth will have immediate consequences. In this regard a strengthening U.S. economy and the improvement in Europe’s near-term outlook is a welcome development.

Acknowledging these developments China officially lowered its 2012 growth target to 7.5%. This does not mean it expects growth to fall to this level. It has always been China’s policy to announce a target growth rate that it expects to be able to exceed. However, the importance of the announcement is the recognition that as the Chinese economy matures and transforms from an export-infrastructure economy to a consumer economy, the rate of growth, while still high, is likely to be lower than in recent years.

With the exception of oil the recent softening in commodity prices may be an indicator of slowing Chinese growth. There are many stories of unutilized infrastructure projects and there is anecdotal commentary that while infrastructure projects in progress are being completed, few new projects are being initiated.

While many believe that China continues to manipulate the value of the yuan to support its export-based economic strategy, recent currency market forward contracts suggest this may no longer be the case. Forwards are actually predicting depreciation in the yuan in coming months rather than appreciation. Supporting evidence is a shrinkage in China’s trade surplus and foreign exchange reserves. A shrinkage in foreign exchange reserves suggests China may be trying to support the value of the yuan rather than increase it.

Could it be that Chinese growth has been impacted to a greater extent by the global growth slowdown and the unwinding of its property bubble than market participants believe?

One analyst posed a speculative analysis which, if correct, portends a deeper slowdown in Chinese growth during 2012. The analysis begins with an assumption that real estate investment accounts for approximately 10% of GDP. Apparently, there is basis for this to be a reasonably accurate figure. Then, if one assumes that real estate investment grew 30% in 2011 but falls to 0% in 2012 and all other economic activity grows at the same rate in both years, GDP would fall from 8.5% for 2011 to 5.5% in 2012. This is simple math and may be wrong but it illustrates the vulnerability of Chinese growth to an outsized reliance on real estate investment and a crash in that activity. There is plenty of evidence that real estate activity has slowed dramatically but Chinese data are not transparent, so it is difficult to discern whether the consequences will be as great at the thought experiment above suggests they might be.

Read more…

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Multi-billion Dollar Hedge Fund Manager Speaks at Smith

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Mar 152012

by Rachel Hester, Marketing and Communications Coordinator, Office of Marketing Communications

Bruce Richards knows a thing or two about making a hedge fund stand out from the crowd. Richards, co-managing partner and CEO of top-50 hedge fund Marathon Asset Management, spoke at the Robert H. Smith School of Business to an audience of students, faculty, staff and alumni eager to learn his tricks of the trade.

The program, “An Insider’s View of How to Manage a Multi-billion Dollar Hedge Fund,” was sponsored by the Center for Financial Policy, and took place on Monday, March 12, 2012, in Van Munching Hall.

Richards, who grew up in Greenbelt, Md., graduated from Tulane with a bachelor’s degree in economics in 1982. He got his first job as a trader’s assistant on Wall Street, gaining valuable experience as the debt securitization market was beginning to be established. After 15 years of working in debt securities, Richards co-founded Marathon Asset Management with Louis Hanover in 1998 with $17 million in start-up funds from a small group of investors.

Richards is now responsible for the general oversight of Marathon’s more than $10 billion in capital. Marathon focuses its efforts on non-investment grade debt, mainly structured, corporate junk and emerging markets. For example, Marathon invested in American Airlines during its recent bankruptcy and restructuring, and in Argentina’s default and debt restructuring in 2002.

“We see good opportunities in distressed and restructuring entities. If you buy at the fulcrum point or above, these investments can be very profitable,” Richards explained.

To up-and-comers, Richards indicated the importance of being a vigilant reader of everything on financial analysis, especially on the macro level. Over the years, it will make it easy to form views on market issues of the day. However, he stressed to take the John Maynard Keynes quote, ‘When the facts change, I change my mind. What do you do, sir,’ to heart.

“You can be wrong about anything you think you know. The trick is in knowing how wrong you can be and how to protect yourself against that,” Richards said.

Before the night ended, Richards presented the audience with his advice for managing hedge funds:

  • Start small. You need a strong infrastructure to support your traders. Without the proper organizational structure, you cannot survive changing market situations.
  • Hedge funds charge big fees, so you must make people money somewhat consistently. Only Bernie Madoff produced complete consistency.
  • Being the No. 1 hedge fund is not a goal, but always being excellent is.
  • The point is to provide your clients with great service and make their money work for them. Focus on this and the rest will follow.