Stanley Fischer: Nonbank financial intermediation, financial stability, and
the road forward
Speech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve
System, at the "Central Banking in the Shadows: Monetary Policy and Financial Stability
Postcrisis" 20th Annual Financial Markets Conference, sponsored by the Federal Reserve Bank
of Atlanta, Stone Mountain, Georgia, 30 March 2015.
* * *
It is an honor to speak at the Federal Reserve Bank of Atlanta's 20th Financial Markets
Conference, and I am grateful to President Lockhart and the organizers for inviting me to do
so.1 This evening I would like to take stock of progress on financial reforms in the nonbank
financial sector and highlight some principles for approaching prudential regulation of this
sector to further strengthen financial stability.
The nonbank sector includes firms with diverse business models and practices, many of which
differ greatly from those of banks. Even so, nonbank firms and activities can pose the same key
vulnerabilities as banks, including high leverage, excessive maturity transformation, and
complexity, all of which can lead to financial instability. The reforms undertaken to date reflect
both the differences and similarities between the nonbank and bank sectors.
While there has been progress on the financial reform front, we should not be complacent
about the stability of the financial system. Regulation often creates incentives for activity to
move outside the regulatory perimeter, and market participants respond to incentives. Thus we
should expect that further reforms will certainly be needed down the road.
The nonbank sector was an important source of vulnerability in the crisis
As you know, the nonbank financial sector in the United States is larger, and plays a more
important role, than it does in most other countries. In recent years, about two-thirds of
nonfinancial credit market debt has been held by nonbanks, which includes market-based
funding by securitization vehicles and mutual funds as well as by institutions such as insurance
companies and finance companies. Nonbanks are involved in many activities within the
financial system as well, such as securities lending. The nonbank sector has produced material
benefits: increased market liquidity, greater diversity of funding sources, and - it is often
claimed - a more efficient allocation of risk to investors. However, threats to the stability of the
overall financial system have also increased, as was evident in the recent financial crisis.
It is now eight years since major cracks in the financial system that led to the Global Financial
Crisis first appeared in nonbank entities and activities. While the causes of the crisis were
complex, I will start by telling part of the tale of how nonbank distress was transmitted to the
broader financial system. The story begins with nonbank mortgage companies, which were
important originators of subprime and prime mortgage loans, typically securitizing them or
selling them to investment banks to be securitized. Rumors of troubles among these firms were
circulating in 2006 as house prices started to decline, and a large firm filed for bankruptcy in
December 2006.2 Then New Century, at one point the second largest subprime lender, filed for
bankruptcy in April 2007 because its funding had disappeared as a result of fears about losses.
Many more followed in 2007 and 2008. Replacement of nonbank lenders' capacity to process
mortgage applications and to fund mortgage loans occurred only partially and slowly.
Next step: The distress in mortgage markets was amplified in the broader financial system in
several ways, including something similar to a bank run but which instead occurred on
assetbacked commercial paper (ABCP) vehicles. These vehicles invested in private-label mortgage
securitizations and other long-term debt securities but were funded with short-term commercial
paper. Buyers of the commercial paper issued by the ABCP vehicles withdrew funding starting
in the late summer of 2007. The volume of assets in the vehicles was large, about $700 billion,
and after the run, the ability of the financial system to fund credit through many types of
assetbacked securities became constrained.3 The runs on ABCP also put considerable pressure on
the banking system because of the liquidity backstops that banks had provided to the vehicles.4
Some of the guarantors also insured mortgage-backed securities, and when doubts arose
about the ability of the guarantors to pay claims on mortgage-backed securities, the credibility
of their guarantees of municipal securities was also reduced. Municipalities then found it more
difficult and costly to issue debt even though their activities were otherwise unrelated to
subprime mortgages.5
Next, the crisis spread to nonbank finance companies, which made a substantial fraction of
consumer loans in the United States - for example, auto and credit card loans. As the crisis
went on, the ability of such lenders to fund themselves through securitizations and commercial
paper became increasingly constrained. For a period after the failure of Lehman Brothers,
many investors were unwilling to buy commercial paper and asset-backed securities at any
price, and, as a result, finance companies faced tight funding constraints. In turn, the finance
companies cut credit availability, which sharply depressed purchases of consumer durables,
including automobiles.
These examples highlight five lessons. One is that the recent crisis first manifested itself in the
nonbank sector and was worse for the nonbank sector than for banks. Almost all the examples
of financial distress mentioned so far occurred before stress in the commercial banking system
became acute, and in most cases well before. For example, only three commercial banks failed
in the United States in 2007, and commercial bank distress did not peak until the end of 2008
and later.
A second lesson is that nonbank distress can harm the real economy. Mortgages, auto loans,
and credit through securities issuance became harder to obtain. Some of the slack was taken
up by commercial banks, but credit contracted sharply, and millions of Americans suffered.
Third lesson: Many of the problems at nonbanks were similar to the problems that plagued
banks. These problems included insolvency, illiquidity (by which I mean the loss of access to
funding even if the nonbank was solvent), and a general loss of confidence, in which
counterparties of all kinds became reluctant to deal with some nonbanks.
Fourth lesson: The Federal Deposit Insurance Corporation (FDIC) can handle a bank
insolvency by keeping the bank's functions running while it pays off depositors and finds buyers
for the bank's assets. The Federal Reserve, as a central bank, can address bank illiquidity
using its lender-of-last-resort authority. Bank supervisory agencies can address a loss of
confidence by actions such as the stress tests conducted in the spring of 2009. However the
lack of such powers for nonbanks made it much more difficult for the authorities to address the
distress of nonbanks and its influence on the financial system. Before the crisis, the authorities
had few policy levers to provide liquidity or to resolve failures of nonbanks in a way that would
avoid serious spillovers. Liquidity was ultimately provided to some nonbank markets, such as
the markets for securities backed by consumer and business assets, but the facilities were far
from simple and took substantial time to create and implement.6
Finally, nonbank distress can transmit to the banking sector through many channels, such as
counterparty relationships, disruptions in funding markets, and knock-on effects of asset fire
sales. The failure of Lehman provides a good example. It was a nonbank, and its failure both
imposed direct losses on its many types of counterparties and disrupted many markets with
negative effects on banks.
Principles for prudential regulation of nonbank intermediaries and activities
It is widely understood that any regulation of nonbanks should fit their activities and the
vulnerabilities they pose, which implies that not every nonbank financial institution or activity
necessarily needs to be regulated. The two key principles for prudential regulation of nonbanks
when it is warranted, are simple: First, we should be attentive to solvency and liquidity; second,
we should recognize that the financial system will change over time, and thus close monitoring
and analysis of the system are essential.
Insolvency and illiquidity are classic financial stability concerns. And as mentioned, they were
common themes of the distress at nonbanks that we observed during the crisis. Thus, we will
not go far wrong if we begin by considering how to promote solvency and liquidity, taking into
account the unique structures and activities of each type of nonbank.
Liquidity challenges vary across nonbank firms and activities. In some, the issue is whether a
firm can fund itself in a distressed situation. For example, a broker-dealer that relies heavily on
short-term wholesale funding may find its funding evaporating at the first sign of trouble - a
situation that could force the sale of assets at fire sale prices. One way to mitigate such
problems is by having direct restrictions on the structure of liabilities, such as on their duration
or on the use of wholesale funding. Analogously with banks, one could also imagine requiring
some nonbanks to maintain buffers of highly liquid assets that are sized according to the risk
that their liabilities will run off quickly in a stress situation.
In other nonbanks, withdrawable liabilities are part of the structure of the entity or activity, and
what varies is the degree of mismatch between the liquidity of assets and liabilities. For
example, some open-ended mutual funds offer daily withdrawal privileges but invest in assets
that take longer to sell and settle, giving investors an incentive to withdraw quickly when
distress arises. The fire sales of assets that may result can depress asset prices and increase
volatility, with knock-on effects on other institutions and markets. Concerns have grown about
this liquidity mismatch as the aggregate value of less liquid assets in such funds has grown. In
part because of this concern, in a December Federal Register notice last year, the Financial
Stability Oversight Council (FSOC) requested public comment on potential systemic risks
posed by asset manager activities and products.
To promote solvency, one could impose ratio-type capital requirements, such as leverage ratio
requirements or risk-based requirements. An alternative is to require that firms perform regular
stress tests to demonstrate that they can remain solvent and continue to lend even under
stress. In the Fed's case, it has chosen to impose all of these requirements on banks, but these
requirements cannot simply be applied, as is, to nonbanks.
It is well known that solvency and liquidity can be difficult to separate during stress periods
because fears about solvency, even if unfounded, can prompt a run. Thus, one could also
imagine promoting both solvency and liquidity at some nonbanks by imposing restrictions on
their structure or activities in ways that reduce the likelihood of runs. An example of this is
recent changes by the Securities and Exchange Commission (SEC) in regulations for prime
money market mutual funds. Starting in 2016, prime institutional money funds will be required
to publish a floating net asset value rather than a stable value of $1 per unit. Stable-value
funds, as we saw during the crisis, can be vulnerable to an unexpected "break the buck" event
that leads to a run. Under the new rules, funds can also impose limitations on withdrawals of
liabilities and can impose liability redemption fees. The SEC considered requiring money
market funds to hold some capital but chose not to do so. Only time will tell whether the
adopted reforms have the intended run-damping effects, but if they do, capital will be much less
necessary.
Some may raise concerns that increased regulation of nonbanks will only increase moral
hazard and increase risk to the system on net. But moral hazard may already be present. Over
the past 20 years and more, governments have sometimes acted to contain damage from
distress at nonbanks because of the economic damage that might have resulted from a failure
to act. We should always be mindful of moral hazard incentives and seek to contain them, but
well-designed regulation might reduce rather than increase moral hazard. In the banking sector,
bank regulators have focused on improving resolution planning at banks and enhancing the
ability of the FDIC to manage the resolution of a systemically important firm in a way that
mitigates spillovers to the economy. For example, proposals are now under consideration to
require the largest and most interconnected banks to maintain a buffer of debt that could be
converted to equity or that could otherwise absorb losses upon failure. Such proposals could be
viewed as a form of solvency regulation and this form of loss-absorbing capital might be
appropriate for some of the largest and most interconnected nonbanks as well.
In addition, nonbank intermediation often involves complex chains of activity encompassing
many entities and markets. Such chains tend to increase the web of interconnections in the
financial system that, in some circumstances, can increase the likelihood or severity of systemic
stress. For example, movements in collateral values can trigger margin calls and fire sales of
assets, and thus activities that depend on market-valued collateral can be vulnerable. The
Financial Stability Board is currently considering reforms for margins on securities financing
transactions. Other interconnections involve exposures to counterparty default. The new
regulatory regime for derivatives, which I will discuss in a moment, seeks to mitigate
counterparty risk.
It is often said that stronger regulation of the banking sector will cause activity to move outside
the perimeter of regulation. This evolution also could lead to greater complexity, such as longer
chains of interconnections, which makes it more difficult for market participants to understand
the risks arising from their exposures. Examples of migration that have already occurred
include the movement of many loans made to large corporations from banks to collateralized
loan obligations, the securitization of many credit card receivables, and the securitization of
mortgages. This kind of migration makes close monitoring by regulators particularly important.
Authorities should monitor for changes that may arise in response to the new regulations or to
changing economic and financial conditions. They will need information to do so, but for many
nonbank entities, the flow of information is currently nonexistent or very limited and informal.
Another force for evolution in the nonbank sector is the demand for safe money-like assets.
Some argue that this demand for private money creation prompted the growth in "shadow
banking" prior to the crisis.7 Indeed, whenever shortages develop, we might expect the nonbank
financial system to create assets that appear safe but that could in certain circumstances pose
systemic risks.
Progress to date
We have seen some progress in improving the regulation of the nonbank financial sector. Let
me mention four areas of reform. The first is the Dodd-Frank Act's creation of the FSOC and
the power it was given to designate individual nonbank firms as systemically important and thus
subject to prudential regulation by the Federal Reserve. The FSOC has designated four
nonbank firms as systemically important.8 The FSOC is also a useful venue for regulators to
collaborate on identifying emerging threats. And it is an important mechanism through which
agencies can cooperate in responding to practices or firms that migrate outside of traditional
regulatory perimeters.
Second: securitization reform. A regulation that is now in the process of implementation
requires securitizers to retain some of the risk of the securities that they create. That should
incentivize them to structure securitizations in ways that better protect the holders of senior
tranches from credit risk, although qualifying residential mortgages are exempt from the
requirement.
A third area is derivative reforms. To reduce complexity and pro-cyclicality, these reforms
include moving standardized derivatives to central counterparties (CCPs) and requiring initial
and variation margin for noncleared derivatives. Relatedly, as CCPs have gained prominence,
regulators have become more focused on and concerned with their resilience, recovery, and
resolution. In addition, regulators are working to improve the quality and standardization of data
reported to swap data repositories, and are actively participating in international efforts to
develop uniform identification standards to facilitate the aggregation of such data.9 A key issue
is to understand how and to what extent market participants who use derivatives are exposed
to each other.
Besides the new money market mutual fund rules that I have already mentioned, a fourth
example is additional data collection on specific holdings of money funds, which has enhanced
stability by providing investors with more information to better evaluate risks. In addition, the
Dodd-Frank Act mandated the establishment of the Office of Financial Research in order to
help promote financial stability through the measurement and analysis of risks, the conduct of
essential research, and the collection and standardization of financial data. Data collection has
begun for hedge funds and progress is being made in collecting data on repurchase
agreements and securities lending. Nevertheless, some nonbank firms and activities - including
concerning the volume and uses of derivatives - are still opaque.
To sum up, much has been done to strengthen prudential regulation and supervision of the
nonbank financial system, but more will need to be done. We must remain vigilant for changes
in the system that increase systemic risk, and we should make appropriate changes to
regulation and the structure of regulation as necessary. Recent regulatory changes, including a
macroprudential approach on the part of U.S. regulators, should help us to do that.10 But we
should never forget the International Monetary Fund's all-purpose warning whenever it has
been tempted to give an economy a clean bill of health: Complacency must be avoided.