Treasury has now released three of the four reports due under President Trump’s Executive Order on Core Principles for Regulating the United States Financial System. The first covered depository institutions. The latestreports address (1) capital markets and (2) asset management and insurancecompanies.
The next report will cover “nonbank financial institutions, financial technology, and financial innovation.” (Treasury will also issue separate reviews of Dodd-Frank’s Orderly Liquidation Authority and the Financial Stability Oversight Council’s systemic risk designation process, respectively.)
The core principles articulated in the reports are excellent, and all three reports recommend good policies consistent with those principles. Overall, then, the reports are very positive and show clear support for the types of beneficial reforms that have already passed the House.
Treasury should be commended for endorsing so many specific reform proposals to improve financial market regulations. (My brief review of the depository institution review is here). More broadly, the reports include position statements consistent with the administration’s core principles, thus offering support to other agencies and members of Congress seeking to fix regulatory problems.
The asset management report, for instance, states the following:
- Treasury’s position is that entity-based evaluations of systemic risk are generally not the best approach for mitigating risks arising in the asset management and insurance industries.
- Treasury also rejects the need for stress testing of asset management firms.
- Treasury supports current efforts at the Department of Labor (DOL) to reexamine the implications of the revised fiduciary rule and related exemptions adopted by the DOL in April 2016 (the Fiduciary Rule). A delay in full implementation of the Fiduciary Rule is appropriate until the relevant issues are evaluated and addressed to best serve retirement investors.
- When disruptive events occur in the asset management industry, significant redemptions at individual funds or fund complexes have not led to material market dislocations or longer term systemic consequences to the economy.
- Treasury rejects any highly prescriptive regulatory approach to liquidity risk management, such as the bucketing requirement. Instead, Treasury supports the SEC adopting a principles-based approach to liquidity risk management rulemaking and any associated bucketing requirements.
Similarly, the capital markets report includes many strong proposals, such as those that promote access to capital and that refocus securities regulation on disclosure of relevant material information. (My colleague, David Burton, is currently working on a full-length review of this report).
More generally, the report offers hope that the administration will support rolling back pieces of the wasteful overreaction – the 2010 Dodd-Frank Act – Congress enacted in the wake of the 2008 financial crisis. For example, the report explains:
Following its enactment in 2010, Dodd-Frank resulted in several significant changes to capital markets regulation, such as mandating risk retention for securitized products, mandating clearing of certain derivatives through central counterparties (CCPs), and authorizing the FSOC to designate systemically important financial market utilities (SIFMUs). More than seven years after Dodd-Frank’s enactment, it is important to reexamine these rules, both individually and in concert, guided by free-market principles and with an eye toward maximizing economic growth consistent with taxpayer protection.
Optimally, the administration will support ditching the derivatives rules (and Titles VII and VIII of Dodd-Frank) and the systemic risk designation process altogether, but Treasury has not gone that far yet. Ultimately, laws that centralize derivatives risk and require regulators to publicly identify the financial firms they view as too risky are inconsistent with free-market principles and taxpayer protection.
In fact, the entire concept of using government regulation to maintain financial stability is inconsistent with free-market principles because it ultimately requires the government to protect someone from losing money. Yet, page 165 of the capital markets report states:
As noted, Dodd-Frank provides that the Federal Reserve may authorize the Federal Reserve Banks to establish and maintain a central bank account for, and services to, each SIFMU [systemically important financial market utility]. The ability to deposit client margin at a Federal Reserve Bank is an important systemic risk mitigation tool. FMUs [financial market utilities] without such account access rely on a number of other alternatives for cash management, such as money market funds, repurchase agreements, and deposits at commercial banks. These private sources may be less reliable in times of market stress. … Federal Reserve Bank account access may also provide an economic advantage to SIFMUs due to the more favorable interest rate (currently 1.25%) which the Federal Reserve Banks may pay compared to that paid by commercial banks. [Emphasis added.]
There is no possible way that private sources can offer the same reliability as the Federal Reserve because only the Fed can provide credit with no consequence, and that’s really the problem.
This passage is an admission that the U.S. framework crowds out private financial companies for the sake of maintaining some sort of ill-defined safety or stability. It’s also an acknowledgment that the government is subsidizing the SIFMUs with above-market interest rates.
It would have been much better if Treasury had simply recommended ditching the new regulatory system, but the report is a good start because it recommends that the Federal Reserve review the framework.
Treasury also has not yet weighed in forcefully – in any of the reports – on the disastrous money market rules (known as the 2014 amendments) that went into effect in 2016.
To be fair, Treasury could still delve much deeper into this issue in the nonbank financial institution report. To be even fairer, money market funds are primarily regulated by the SEC, and any full analysis of those rules requires its own report.
Nonetheless, these rules, enacted in the name of financial stability, are just one of the many post-crisis regulations that increased incentives to hold federally backed debt, thus crowding out private markets. And Treasury’s last two reports make it very clear that the administration has studied the issue. Page 45 of the asset management report states:
In 2014, the SEC, following the issuance of proposed recommendations by the FSOC, under took additional reforms, the pillar of which requires “prime” (non-government) institutional MMMFs [money market mutual funds] to float the NAV of their shares instead of letting the funds maintain the stable $1 NAV per share. In addition, boards of directors were given discretion to lower “gates” on redemptions, or charge fees of up to 2% if market stress causes a fund’s weekly liquid assets to fall below 30%. Retail and government MMMFs were exempted from the rule. The compliance date for the floating NAV requirement and liquidity fees and gates was October 14, 2016.
By October 31, 2016, prime and tax-exempt MMMFs experienced a decrease in assets of $1 trillion since the beginning of the year, and government MMMFs saw an increase in assets of $968 billion during the same period.
So as these rules went into effect, nearly $1 trillion flowed out of prime and tax exempt money market funds. Consequently, private corporations and banks, as well as state and local municipalities, have experienced more difficulty funding their operations.
Treasury has acknowledged there is a problem but it hasn’t really taken a stand on this one. Incidentally, the Obama Treasury – using its new power from Section 120 of Dodd-Frank – was right in the middle of pressuring the SEC to issue these money market mutual fund rules, so it will be very interesting to see if the Trump administration (perhaps in the nonbank report) supports dumping them.
It would also be interesting to know if the administration supports H.R. 2319 and S. 117, sponsored by Rep. Keith Rothfus (R-Penn.) and Sen. Pat Toomey (R-Penn.), respectively. These bills would allow funds to revert to the rules in place prior to the 2014 amendments if they pledge they will accept no government financial support.
There is no good reason to oppose this approach, especially if one is in favor of regulation guided by free-market principles.
The 2014 amendments were put in place in the name of maintaining stability, but pretty much everyone involved in those markets warned that the new rules would cause investors to run straight to government-backed funds. And that’s exactly what happened. (For a brief overview of the events surrounding these rules, see this SEC report).
The administration already supports the CHOICE Act’s capital election, which allows banks to rid themselves of certain federal regulations if they choose to fund their operations with more equity. So it seems rather natural that the administration would support a similar idea for money market mutual funds: less regulation in return for explicitly agreeing to no federal bailouts.
Come to think of it, why not combine these two ideas in a new financial charter: Firms that use a higher equity ratio and agree that they will receive no federal assistance opt in to a lighter regulator regime. Makes sense to me.
This piece originally appeared in Forbes
