U.S. Securities and Exchange Commission Commissioner Daniel M. Gallagher took another opportunity to blast capital requirements and banking regulations for investment funds, and warn of the threat of FSOC, at "Remarks Given at the Institute of International Bankers 25th Annual Washington Conference Monday. He didn't say much on pending money fund regulations, but comments, "Before I begin, I'd like to point out that two years ago, I spoke at this conference and discussed the Financial Stability Oversight Council, or FSOC, in great detail. I spoke about the inherently political nature of FSOC, how it had been vested with tremendous power, and how it could threaten our capital markets. So, given everything that has happened since then, I have to say: I told you so." (See also, our Jan. 16 Crane Data News, "SEC Commissioner Gallagher Blasts Capital, Banking Paradigm for Mkts".)
Gallagher continues, "Today, I'd like to share some thoughts about regulatory capital requirements. I've spoken before about the significant differences between bank capital and broker-dealer capital, because I fear that these distinctions are all too often overlooked in the debates over regulatory capital.... In the capital markets, there is no opportunity without risk -- and that means real risk, with a real potential for losses. Whereas bank capital requirements are based on the reduction of risk and the avoidance of failure, broker-dealer capital requirements are designed to manage risk -- and the corresponding potential for failure -- by providing enough of a cushion to ensure that a failed broker-dealer can liquidate in an orderly manner, allowing for the transfer of customer assets to another broker-dealer."
He says, "As I said, it's counterintuitive, but the possibility -- and the reality -- of failure is part of our capital markets.... A safety-and-soundness bank-based capital regime simply doesn't work in the context of capital markets. To put it another way, when you deposit a dollar into a bank account, you expect to get that dollar back, plus a bit of interest.... When you invest a dollar through a broker-dealer account, however, the market determines how much you get back. You could break even, you could double your investment, or, of course, you could lose part or all of that initial investment. The point is that when we make a bank deposit, we expect, at a minimum, to receive the entirety of our principal back, while when we make an investment, we expect the market to dictate what we receive in return. It stands to reason, therefore, that the capital requirements for broker-dealers must be tailored accordingly."
Gallagher explains, "I'm sure you didn't need an SEC Commissioner to explain to you the difference between a deposit and an investment. And yet, when it comes to setting capital requirements, bank regulators seem increasingly determined to seek a one-size-fits-all regulatory construct for financial institutions. In addition, as noted by my friend Peter Wallison in an important recent op-ed in The Hill, both the Dodd-Frank-created FSOC and the G-20-created -- and bank regulator dominated -- Financial Stability Board seem intent on applying the bank regulatory model to all financial institutions they deem to be systemically important."
Gallagher tells us, "The recent FSOC intervention in the money market mutual fund space shined a spotlight on this newly expansive vision of the role of banking regulators. The money market mutual fund reform debates that raged through 2012 focused in large part on the concept of a "NAV buffer," which effectively is a capital requirement for money market funds. This debate culminated in the November 2012 issuance of a report by FSOC which incorporated the concept of a so-called "NAV buffer."
He adds, "The reasoning behind capital buffer requirements for money market funds is that they would serve to mitigate the risk of investor panic leading to a run on a fund. The figures under discussion, however, were far too low to promise any serious effect on panic, while the imposition of real, bank- or even broker-dealer-like capital requirements in this space, on the other hand, would simply kill the market for money market mutual funds. A 50 basis point buffer, to be phased in over a several year period, would hardly stem investor panic, unless one believes that investors would be comforted by the knowledge that for every dollar they had on deposit, the money market fund had set aside half a penny as a capital buffer."
Gallagher says, "Crucially, as I've noted before, there is no limiting principle to the application of this bank-based view of capital -- indeed, last September, Treasury's Office of Financial Research issued a fatally-flawed "Asset Management and Financial Stability" report featuring similar reasoning, as reflected in its implied support for "liquidity buffers" for asset managers. It remains unclear as to whether the Fed is indeed 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 -- or whether it is instead proposing those additional capital charges in order to prevent non-prudentially regulated financial entities from ever relying upon the "government safety net" provided by the discount window."
He continues, "Bank regulators and their wide-eyed admirers have spoken at length about the risks of "shadow banking," which they define broadly to include the types of "securities funding transactions," such as repo and reverse repo, securities lending and borrowing, and securities margin lending, used by both banks and broker-dealers for short-term funding. The loaded term "shadow banking" isn't exactly used as an honorific, and I find it concerning that so many bank regulators routinely use the term to describe the day-to-day transactions so crucial to ensuring the ongoing operations of our capital markets."
The Commissioner states, "To be clear, I respect the Fed's concerns about capital requirements for bank affiliated non-bank financial institutions, notwithstanding my fears as to the steps the Fed might take to address those concerns. Our financial institutions are interconnected as never before, increasing the importance of taking a holistic view of those institutions, subsidiaries and all. In doing so, however, it is crucial that we bring to bear the specialized experience and expertise of the regulators with primary oversight responsibility over the constituent parts of those institutions. In the case of broker-dealers, this means the Commission, with its nearly eight decades of experiences in this regulatory space."
Finally, he comments, "It's my hope that the bank regulators constructively participate in this dialogue as well. The last thing anyone wants is the old Washington cliche of a "turf war." For one thing, we'd lose -- the SEC will never have the resources of the banking agencies -- after all, it's hard to outspend agencies that can print their own money. More to the point, however, we'd never want to "win" -- not only are we busy enough as it is, with approximately sixty Dodd-Frank mandated rules yet to be completed along with the day-to-day, blocking-and-tackling work that's so critical to the agency's mission, but we recognize that the banking regulators are best situated to regulate banks. When it comes to the broker-dealer subsidiaries of banks, however, we stand ready to work with the Fed and other banking regulators to ensure that any new rules applicable to those entities are enhancements to our existing regime, not duplicative, contradictory or counterproductive regulations inspired by a regulatory paradigm designed for wholly different entities."
