Yesterday, U.S. Securities & Exchange Commission Commissioner Dan Gallagher spoke on "The Philosophies of Capital Requirements," and discussed bank regulators' recent "disturbing fascination with imposing bank-theory capital requirements on non-bank institutions". He comments, "[T]here's been a great deal of attention paid to regulatory capital recently, including new Dodd-Frank requirements, Basel III implementation (or non-implementation) issues, and even bipartisan Congressional efforts to raise capital requirements for large banks. Almost all of that attention has naturally centered on the question of how much capital a financial institution should be required to hold. What's missing from the conversation, however -- and what I'd like to focus on today -- is a proper understanding of the theories behind capital requirements, both for banks and for non-bank financial institutions."

Gallagher explains, "Bank capital requirements serve as an important cushion against unexpected losses. They incentivize banks to operate in a prudent manner by placing the bank owners' equity at risk in the event of a failure. They serve, in short, to reduce risk and protect against failure, and they reduce the potential that taxpayers would be required to backstop the bank in a time of stress. Capital requirements for broker-dealers, however, serve a different purpose. In the capital markets, we want investors and institutions to take risks -- informed risks that they freely choose in pursuit of a return on their investments. Eliminate the risk of an investment, and you eliminate the opportunity for a return as well. Capital markets, in short, are predicated on risk."

He tells us, "These two models of capital requirements, in other words, differ in fundamental ways -- it's certainly not a matter of comparing apples to apples. Applying bank-based capital requirements to non-bank financial entities, in fact, is rather like trying to manage an orange grove using apple orchard techniques -- it's the equivalent of trying to determine how best to grow oranges to be used in orange pie, orangesauce, and, as a special treat, delicious caramel oranges on a stick.... In order to fully understand the danger of imposing bank capital requirements on non-bank institutions, it's helpful to take a bit of a detour to review the actions of the Federal Reserve during the height of the financial crisis, which leads us to that dreaded word: bailouts.... As you may recall me noting, I'm starkly against bailouts. But offering access to the discount window to illiquid, but not insolvent, banks against good collateral comports with the traditional role of a central bank as the lender of last resort and falls outside even an expansive definition of the dreaded concept of a bailout. Indeed, it falls squarely within the traditional understanding of a central bank's paramount purpose."

Gallagher continues, "So what does all of this have to do with capital? To answer that question requires a better understanding of the recent and disturbing fascination with imposing bank-theory capital requirements on non-bank institutions. Here, the recent FSOC intervention in the money market mutual fund space is quite instructive. In August 2012, a lack of consensus among the Commission on the best way to proceed with proposing reforms to our money market fund rules led to an ill-advised abdication of the issue to FSOC, which enthusiastically took up the cause, leading to an unprecedented -- albeit invited -- incursion into the regulatory purview of an independent regulator. The result was the issuance, in November 2012, of a report entitled "Proposed Recommendations Regarding Money Market Mutual Fund Reform," in which FSOC floated -- pun intended -- the concept of a "NAV buffer," that is, a capital requirement for money market funds."

He says, "As I delved into the issue of money market fund reform following my return to the SEC as a Commissioner, it quickly became apparent to me that, perhaps in the hopes of staving off more stringent regulation, the industry was coalescing behind a capital buffer requirement of approximately 50 basis points, to be phased in over a several year period. For the largest money market funds, this would have resulted in an approximately 1 to 200 ratio -- a $500 million buffer to support $100 billion in investments. This would amount to chicken feed in any serious capital adequacy determinations. The ostensible reasoning behind a capital buffer for money market funds is that it would serve to mitigate the risk of investor panic leading to a run on a fund. Common sense, however, belies this notion. Do we really believe that investor panic would be assuaged by the comforting knowledge that for every one dollar they had on deposit, the money market fund had set aside half a penny?"

Gallagher adds, "Common sense also leads to the conclusion that there is no reason to assume that this view of capital requirements as a panacea to mitigate run risk is limited to money market funds. Indeed, the now notorious "Asset Management and Financial Stability" report issued by Treasury's Office of Financial Research last September featured similar reasoning, as reflected in its implied support for "liquidity buffers" for asset managers. As I noted in my statement at last June's open meeting at which the Commission voted to propose reforms to our money market fund rules, which by the way thankfully did not include a capital buffer, "It became clear to me early on in this process that the only real purpose for the proposed buffer was to serve as the price of entry into an emergency lending facility that the Federal Reserve could construct during any future crisis -- in short, the "buffer" would provide additional collateral to facilitate a Fed bailout for troubled MMFs.""

He continues, "Indeed, some Fed officials and academics have suggested as much. In a speech delivered last February, New York Fed President Bill Dudley, while expressing support for the FSOC-proposed money market fund reform mechanisms of a NAV buffer and a "minimum balance at risk," explained his concern that "even after such reforms, we would still have a system in which a very significant share of financial intermediation activity vital to the economy takes place in markets and through institutions that have no direct access to an effective lender of last resort backstop." He went on to raise the possibility of expanding access to the lender of last resort to additional entities in exchange for "the right quid pro quo -- the commensurate expansion in the scope of prudential oversight." Arguing that "[s]ubstantial prudential regulation of entities -- such as broker-dealers -- that might gain access to an expanded lender of last resort would be required to mitigate moral hazard problems," he concluded, "Extension of discount window-type access to a set of nonbank institutions would therefore have to go hand-in-hand with prudential regulation of these institutions.""

Gallagher tells us, "Fed Governor Daniel Tarullo, on the other hand, indicated his discomfort with extending access to the discount window to non-bank entities in a speech last November, noting that he was "wary of any such extension of the government safety net." In the context of addressing the "vulnerabilities" of short-term wholesale funding, he stated that he "would prefer a regulatory approach that requires market actors using or extending short-term wholesale funding to internalize the social costs of those forms of funding" -- that is, an increased capital charge."

He states, "All of this adds up to a terribly muddled situation. Is the Fed seeking to impose bank-based capital charges on non-bank entities in conjunction with granting them access to the discount window at the cost of submitting to prudential regulation, as Mr. Dudley suggests? Or is the situation just the opposite, as Governor Tarullo implies -- would those additional capital charges be intended to prevent non-prudentially regulated financial entities from ever relying upon, as Governor Tarullo puts it, an extension of the "government safety net" the discount window provides? Put another way, is the goal to expand the Fed's role by making it the lender of last resort to non-bank entities such as money market funds and broker dealers, or is it to use its Bank Holding Company Act authority and its role in FSOC to dictate capital requirements to non-bank entities in order to prevent those entities from ever gaining access to the discount window?"

Gallagher adds, "These are more than purely semantic questions, although semantics play a role: one man's expansion of the Fed's role as the lender of last resort is another man's institutionalization of bailouts for failing financial institutions. In my opinion, both Governor Tarullo and Mr. Dudley raise very good points that warrant a healthy debate. The issues they raise, however, as well as the more general issue of how much capital is enough in the banking and capital markets, create a degree of confusion about the Fed's role as the lender of last resort. Should the Fed still perform that role? If so, when and for what entities? Does such lending, in fact, constitute a bailout? All of these questions require answers as we debate questions of capital adequacy. If we are to assume that the Fed will not, or cannot, expand its role as the lender of last resort to non-bank entities, including non-bank subsidiaries of bank holding companies, would it ever be possible to set capital requirements at a level that would guarantee avoidance of 2008-type scenarios? I think not, even if we were to impose capital requirements of 100%. To me, therefore, capital markets regulators simply cannot stray from the theory of capital as a tool to facilitate the unwinding of a failed firm with the goal of returning customer assets."

Finally, he comments, "[R]egulatory capital requirements play a tremendous role in incentivizing financial institutions' holdings. All the more important, therefore, that regulators use the right tool for the right job. We rightly take great pride in our capital markets, the deepest and safest in the world. We're an entrepreneurial nation, and taking risks, whether with respect to investments or otherwise, is as American as apple pie. Superimposing upon those markets a capital regime based on the safety-and-soundness banking paradigm, on the other hand, would be as sensible as orange pie."

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