Why Charles Plosser calls for simplicity in financial regulation (Part 3 of 9)
Regulatory arbitrage and the causality factor
Dr. Charles Plosser, President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia, spoke on “Simplicity, Transparency, and Market Discipline in Regulatory Reform” at a joint conference held at the Philadelphia Fed on April 8, 2014. Plosser provided a high-level perspective on financial regulations and financial stability. In his speech, he also discussed three broad principles that need to be considered for financial market stability.
- Simplicity in financial market regulations, which will help curb rising compliance and enforcement costs
- Transparency in financial instruments and markets, which will contribute to greater efficiency and awareness of risk exposures
- The role of market forces in effectively controlling risk-taking and enhancing supervision
The causality, or the chicken and egg factor, in structuring financial regulation
Which come first, evolving market structures or the rule-writing to regulate them? Even though both financial markets and regulations are becoming increasingly complex, markets can often evolve faster than the regulations, and with detailed rule-writing becoming obsolete with new market developments, the latter can often beget more rule-writing. On the other hand, firms often seek to create complex financial structures that aim to evade existing rules. Plosser cited several examples.
- Expansion of the shadow-banking system in order to bypass regulations placed on banking firms
- Subprime mortgage crisis, which occurred as a result of the use of bond ratings in setting capital requirements for securities holdings or in making eligible certain structured products for various investment purposes, created incentives to inflate ratings of collateralized debt obligations (or CDOs), and other structured products backed by subprime mortgages
- Bankruptcy rules exempting overnight swaps and repo agreements from the traditional stays when a company files for bankruptcy, which reduce the incentive for lenders to monitor counter-party risk and thus effectively lower the relative cost of using short-term funding to finance an intermediary’s or investment firm’s balance sheet
- The reliance on short-term funding from sources totally immune from counter-party risk can contribute to increasing risks of contagion and runs on financial institutions
What are shadow banks?
According to former Fed Chair Ben Bernanke, “Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions–but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper (or ABCP) conduits, money market mutual funds, markets for repurchase agreements (or repos), investment banks, and mortgage companies.”
Shadow banks can also include hedge funds, money market funds, structured investment vehicles (or SIVs), private equity funds, and ETFs. Examples of shadow banks include mortgage real estate investment trusts (or REITS) like Annaly Capital Management (NLY) and Investco Mortgage Capital (IVR). They also include investment banks like Goldman Sachs (GS), JP Morgan Chase (JPM), and Morgan Stanley (MS).
In Part 4 of this series, we’ll discuss why Plosser advocates for simplicity in drafting financial regulations. Read on to find out more.
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