Non-Bank Financial Institutions and Systemic Risk

July 14th, 2011 by under Faculty Commentary. 3 Comments.

Center for Financial Policy (CFP) Director Lemma Senbet and CFP faculty associates, Russ Wermers and Ethan Cohen-Cole, recently had a dialogue with Michael Tae, Senior Policy Advisor of the Financial Stability Oversight Council (FSOC).  FSOC reached out to the Center to get an academic perspective on the newly proposed rules for the “systemically critical” designation of non-bank financial institutions.

The dialogue focused on the systemic risk designation of investment funds and the role of compensation incentives in systemic risk, as well as academic basis for quantitative metrics, such as leverage, interconnectedness, liquidity and maturity structure.  It was emphasized in the dialogue that there should be no over-reliance on size.  Institutions of modest size (e.g., Long-Term Capital Management) can be systemically critical by virtue of interconnectedness resulting from shared risk exposure or linked risk exposure.   It is important to distinguish between these two connections because they imply different policy implications.

On the investment fund management arena, the rules are not clear as to whether the designation pertains to institutions engaged in investment management advisory or the investment funds, but we think both should be considered. Although the assets of investment advisors are segregated from investment funds, their business is affected by how well these funds perform, given the linkage between asset size and fees. Moreover, the viability of investment advisors could have a negative spillover, since it could lead to massive redemptions. However, there should be a differentiation in terms of regulatory intensity between investment funds and other non-bank institutions, since the former are already subject to strong SEC scrutiny as a result of the Investment Advisors Act of 1940.

Finally, the proposed rules have no mention of global exposure of the US-based non-bank institutions. There should be due consideration to the global dimension so as not to distort the systemic designation. On the other hand, such companies may also be subject to global regulation, which should have an impact on the need for systemic risk designation. The designation that is devoid of global considerations opens to competitive disadvantage and regulatory arbitrage.

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steve malphrus  on July 14th, 2011

Good analysis and very well articulated

Arbitrage  on August 5th, 2011

Any ideas of how the EURO crisis will affect these instituitions in the near futere?

Michelle Lui  on August 22nd, 2011

Response from Ethan Cohen-Cole:

The euro crisis creates a set of complex issues for US regulators and the designation of SIFIs. Our view is that US and European banks are sufficiently interconnected and the financial systems of both have proven to be sensitive to the shocks on the other continents. As a result, we believe that exposure to other financial institutions, US or global, should lead to a designation. The rule is relatively non-specific about this issue, leaving regulators some latitude in making decisions. Our perception is that this issue is at the top of regulator’s agenda. The Fed’s recent flagging of Euro bank holding of dollar assets in US institutions is a good example – as is the recent announcement that a Euro bank drew on the Fed dollar swap line.

Overall, we believe that the Euro-crisis elevates the level of risk in the system (for all banks) and banks that have increased euro exposure are more likely to designated at SIFI.

We will be updating our original commentary to consider the Euro crisis issue shortly.