Economists from the Federal Reserve Board of Governors recently published a paper in their "Finance and Economics Discussion Series," entitled, "Gates, Fees, and Preemptive Runs." (See our May 2 "Link of the Day" "More Reform Comments: Arnold and Porter's Freeman Writes for Federated," which is a response to this paper.) Written by Marco Cipriani, Antoine Martin, Patrick E. McCabe, and Bruno M. Parigi, its Abstract says, "We build a model of a financial intermediary, in the tradition of Diamond and Dybvig (1983), and show that allowing the intermediary to impose redemption fees or gates in a crisis -- a form of suspension of convertibility -- can lead to preemptive runs. In our model, a fraction of investors (depositors) can become informed about a shock to the return of the intermediary's assets. Later, the informed investors learn the realization of the shock and can choose their redemption behavior based on this information. We prove two results: First, there are situations in which informed investors would wait until the uncertainty is resolved before redeeming if redemption fees or gates cannot be imposed, but those same investors would redeem preemptively, if fees or gates are possible. Second, we show that for the intermediary, which maximizes expected utility of only its own investors, imposing gates or fees can be ex post optimal. These results have important policy implications for intermediaries that are vulnerable to runs, such as money market funds, because the preemptive runs that can be caused by the possibility of gates or fees may have damaging negative externalities."

The Fed staff working paper explains, "There is a longstanding view in the banking literature that the suspension of convertibility of deposits into cash can prevent self-fulfilling bank runs. However, this paper shows that the possibility that a bank might suspend convertibility can itself lead to preemptive runs. This result is relevant not only for an understanding of banking history and policy, but also for policy making in today's financial system. For example, recent regulatory proposals aimed at reducing the likelihood of runs on money market funds (MMFs) would give them the option to halt ("gate") redemptions or charge fees for redemptions when liquidity runs short, actions analogous to suspending the convertibility of deposits into cash at par. Our results show that the option to suspend convertibility has important drawbacks; a bank or MMF with the option to suspend convertibility may become more fragile and vulnerable to runs."

It continues, "Our focus is on preemptive runs that occur following a change in the economy's fundamentals, rather than because of a coordination failure. Hence, we build a model of a financial intermediary, in the tradition of Diamond and Dybvig (1983, hereafter "DD"). A fraction of investors become informed about an unexpected shock to the return of the investment technology, similar to that in Allen and Gale (2000). At first, informed investors only know that the return has become stochastic, but they later learn the exact realization of the shock. Our first result is that, when a gate or a fee can be imposed, informed investors may withdraw as soon as they learn about the shock, rather than waiting until they learn its exact realization. That is, they run preemptively. Our second result is that, for the intermediary that maximizes the expected utility of only its own investors, it can be ex-post optimal to impose gates or fees. To be sure, in a broader context that is beyond the scope of our model, the use of these instruments likely would not be socially optimal, as the intermediary would not weigh the negative externalities that might be associated with a preemptive run, such as increasing the likelihood of runs on other similar intermediaries. Hence, absent commitment, the intermediary will impose a gate or fee, justifying the beliefs of informed agents who run preemptively."

The economists write, "In the banking literature, suspension of convertibility of deposits into cash was long seen as a mechanism to prevent self-fulfilling bank runs because a suspension might eliminate the need to liquidate the investment technology. For example, in the DD model, where bank runs can occur in equilibrium as a result of a pure coordination failure, limiting withdrawals to the available liquidity is sufficient to eliminate investors' incentive to run. This suggests that the option to suspend convertibility could eliminate a centuries-old source of financial instability. However, several papers have challenged this notion."

They add, "Our paper is the first to show that the possibility of suspending convertibility, including the imposition of gates or fees for redemptions, can create runs that would not otherwise occur. This contrasts with the existing literature, which focuses on whether suspension of convertibility can prevent runs. In other words, we show that rather than being part of the solution, redemption fees and gates can be part of the problem."

Finally, the Fed paper says, "Our results, including our finding that restrictions on redemptions or withdrawals can be ex post optimal for the financial intermediary, provide a theoretical basis for understanding why such restrictions may have been forbidden. An intermediary's ability to impose restrictions can trigger preemptive runs with broader welfare costs that are not internalized by the intermediary or its investors. Of note, neither individual U.S. banks nor individual MMFs have had the legal option to suspend convertibility, although both types of intermediaries have done so, particularly in times of crisis. Subsequently, legislatures and courts struggled with whether and how to punish such transgressions without revoking banks' charters and forcing their liquidation after the crises had subsided (Gorton 2012)."

In other news, the Investment Company Institute published the "Viewpoint: Size by Itself Doesn’t Matter—Leverage Does". ICI's "Second in a series of Viewpoints postings on funds and financial stability," says, "The threshold set by the Financial Stability Board (FSB) for examining whether a regulated fund could pose risk to the financial system should be redrawn -- or better yet, withdrawn. The FSB's consultation puts size front and center, saying that funds with more than $100 billion in assets under management should automatically be reviewed as candidates for designation as global systemically important financial institutions, or global SIFIs. But size alone is not an accurate indicator of systemic risk. Regulators should instead prominently focus on balance-sheet leverage -- the essential fuel for financial crises."

ICI's Mike McNamee explains, "Leverage can tell a lot about a financial institution's capacity for systemic risk. In times of market stress, leverage helps turn small decreases in asset values into large losses, and spreads those losses across the financial system. Financial crises -- including the most recent meltdown -- generally stem from institutions whose losses were magnified by high amounts of leverage, and then spread throughout the financial system. Because banks are highly leveraged, focusing regulators' attention on the biggest banks makes sense. Outside the banking system, size alone is less useful as an indicator of risk. One must consider it along with leverage. Yet funds use virtually no leverage, so a threshold that concentrates only on assets under management as an indicator of possible risk is not appropriate."

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