Notes from the Vault

Larry D. Wall
November 2014

The financial crisis highlighted that distress at nonbank financial firms such as Bear Stearns, Lehman Brothers, and AIG can have a negative impact on financial stability. In order to reduce the risk that nonbank financial firms pose to future stability, the Financial Stability Board and Financial Services Oversight Council (FSOC) have been identifying systemically important nonbank firms. These nonbank financial firms are then subject to heightened prudential regulation.

A recent conference hosted by the Atlanta Fed brought together researchers from academia and regulatory agencies to discuss a variety of issues on the topic of Nonbank Financial Firms and Financial Stability. The issues discussed included how to think about how nonbank financial firms affect financial stability, how to identify systemically important firms, and how to manage the risk posed by these nonbank financial firms.1

Impact of nonbank financial firms on financial stability
The conference began with a survey paper by Thorvald Grung Moe of the Norges Bank, "Shadow Banking: Policy Challenges for Central Banks." Moe's paper makes the important point that it is not necessarily nonbank financial institutions per se that pose a threat to financial stability. Rather, it is the role of these institutions in key financial markets that poses a threat.

Sebastian Infante of the Fed's Board of Governors highlighted the need to have a detailed understanding of how markets work, especially in creating liquid liabilities, in his paper "Money for Nothing: The Consequences of Repo Rehypothecation." This paper showed how dealers were able to rehypothecate (that is, use for their own purposes) collateral obtained from hedge funds and in the process obtain "free" funding. The key is that the hedge funds were subject to a larger haircut on the collateral they provided to the dealers than the dealers took on that same collateral used to obtain funds from other investors (such as money market funds). The large haircut on the hedge funds' collateral largely eliminated the dealer's creditor exposure to the hedge fund, but the rehypothecation exposed hedge funds to credit risk. The result was that during the crisis, hedge funds withdrew their assets to protect themselves from credit risk but in doing so exposed dealers to liquidity risk.

Moving to a bigger-picture analysis, I presented the paper "Stricter Microprudential Supervision Versus Macroprudential Supervision." This paper emphasizes the benefits of end-to-end quantitative and qualitative analysis in systemically important markets.

An example of detailed quantitative analysis of a specific financial market was provided in the paper "The Microstructure of the Reinsurance Network among US Property-Casualty Insurers and Its Effect on Insurers' Performance," by Hua Chen, J. David Cummins, Tao Sun, and Mary A. Weiss, all with Temple University. This paper used detailed data on reinsurance relationships to evaluate the ability of the reinsurance network to withstand simulated defaults by one or more of the strategically networked reinsurers.

Along with the discussion of how to analyze the risks within a single financial market, also important is an understanding of how a shock that originated in one market can propagate through multiple markets due to the initial shock's impact on bank and nonbank financial firms. Mark Paddrik of the Office of Financial Research presented a methodology for tracing such propagation with the paper "An Agent-Based Model for Financial Vulnerability." Coauthors are Rick Bookstaber, also of the Office of Financial Research, and Brian Tivnan of MITRE Corporation.

Identification of individual systemically important nonbank firms
Although the above papers highlighted the importance of understanding financial markets, existing prudential supervisory mechanisms are largely targeted at specific institutions. For example, although the Dodd-Frank Wall Street Reform and Consumer Protection Act gives the FSOC responsibility to "monitor the financial services marketplace in order to identify threat to … financial stability," most of the public focus has been on the FSOC's responsibility of designating specific financial firms as being a threat to financial stability.

A variety of quantitative measures have been developed to help identify which firms are the most systemically important. Some measures focus on the stock returns of specific firms at times of extreme negative returns in the stock market. The paper "Taking the Risk out of Systemic Risk Measurement" questions the systemic risk measurement ability of two of these measures: conditional value at risk and marginal expected shortfall. The paper by Levent Guntay of the Federal Deposit Insurance Corporation and Paul Kupiec of the American Enterprise Institute observed that these measures are not based on formal statistical inference. They also presented evidence that these measures confound systemic and systematic risk and poorly measure tail dependence in stock returns.

Two papers considered the systemic importance of particular types of nonbank financial firms. Craig Pirrong of the University of Houston presented a paper on "The Systemic Risk of Commodity Trading Firms". Pirrong's conclusions are that: (a) no single commodity trading firm is big enough to pose a systemic risk to the broader financial system, (b) the nature of these firms' business model provides some natural (partial) hedges against a financial crisis, and (c) the types of transformations they make are less systemically risky.

Nicola Cetorelli of the New York Fed made a presentation on "Asset Management Firms as Financial Intermediaries." Cetorelli found that some aspects of asset management firms' operations can provide risky transformations that could break down during a systemic crisis.

Disciplining nonbank financial firms
While the Dodd-Frank Act called for the designation of systemically important nonbank financial firms and financial market utilities, that is only the first step in mitigating their systemic risk. The essential next step is to determine whether and what regulatory actions can reduce the risk.

The first place to look for market discipline is from other financial market participants and a firm's own governance. David Mayes of the University of Auckland discussed the discipline provided by consumers and firm governance in his paper "Regulation and Governance in the Non-Bank Financial Sector: Lessons from New Zealand." Mayes observed that New Zealand had both banks and less regulated nonbank financial firms providing deposit services. He found that neither consumers nor the firms' governance proved to be adequate substitutes for the reduced regulation of the nonbank firms.

Although consumers and internal governance may not be very effective, it is nevertheless possible that other sophisticated financial market participants can provide some discipline. Evidence of such discipline in the form of the pricing default risk was found in the paper "Systemic Risk in Clearing Houses: Evidence from the European Repo Market" by Charles Boissel, François Derrien, Evren Örs, and David Thesmar, all with HEC Paris. While these results are supportive of the potential for market discipline, they are also somewhat troubling. The central counterparty (CCP) of a clearinghouse plays a critical role in the functioning of many financial markets with the consequence that the failure of a CCP would, by itself, likely constitute a systemic event. Ideally, clearinghouses would be financed in such a way that failure is almost impossible.

Whether and to what extent market discipline exists depends in part on government guarantees. The paper "Do Bond Investors Price Tail Risk Exposures of Financial Institutions?" finds that investors are less likely to price risk that they perceive as borne by the government, including the risks for depository institutions, large institutions, government-sponsored enterprises, and politically connected institutions. The paper is by Sudheer Chava and Rohan Ganduri of the Georgia Institute of Technology and Vijay Yerramilli of the University of Houston. The authors also found that while investors price an institution's risk of failure, they do not seem to price the risk of a systemic collapse.

The extraordinary support provided to American International Group (AIG) is a reminder that nonbank financial firms also benefit to at least some degree from the federal safety net. The loss of financial value at AIG at the time of its rescue is detailed by the paper "AIG in Hindsight" by the Chicago Fed's Anna Paulson and Northwestern University's Robert McDonald. The paper also analyzes the postcrisis performance of AIG's portfolio of troubled securities and shows these securities ultimately suffer substantial write-downs.

Thus, market discipline may prove inadequate because retail customers are not very sophisticated, internal corporate governance will not necessarily prevent excessive risk taking, some institutions are deemed too important to be allowed to fail, and the existence of a government safety net mutes the disciplinary signals sent by even the most sophisticated investors. All this suggests a potential role for government prudential regulation. The conference had a variety of presentations related to such regulation.

The paper "Assessing the Adequacy of CCPs' Default Resources" by the Bank of England's Fergus Cumming and Joseph Noss gives an approach prudential supervisors could use to analyze the financial stability of a CCP. The paper proposes a top-down methodology using daily data on the exposure of the CCP's members.

Linda Allen of Baruch College and Yi Tang of Fordham University proposed a new regulatory requirement for contingent capital designed to reduce systemic risk while transferring more of the private risk of losses to the private sector. "What's the Contingency? A Proposal for Bank Contingent Capital Triggered by Systemic Risk" proposed that contingent capital conversion be subject to a dual trigger, based on the systemic risk of the financial system and the contribution to systemic risk by individual firms.2

The regulation of insurance companies was discussed by a panel consisting of Georgia State University's Robert W. Klein and Martin Grace and the Chicago Fed's Richard Rosen. The U.S. insurance industry has long been regulated at the state level, but the Dodd-Frank Act authorized regulation by the Federal Reserve of insurers designated as systemically important by the FSOC. Klein discussed the current status of insurance solvency regulation as conducted by the states and the proposed changes that are due in part to standards being set by international bodies in presenting the paper "Insurance Solvency Regulation: A New World Order?" The paper was cowritten by Elizabeth F. Brown, also of Georgia State. Klein noted that existing state insurance capital requirements are far below the levels of capital being held by the largest insurers. Nevertheless, insurance failures are relatively rare events, with AIG's collapse being an outlier on more than one dimension, which suggests that insurance buyers may have been imposing some effective discipline on the insurance firms.

Rosen highlighted some fundamental differences between the goals of state insurance regulators and the Federal Reserve's regulation of designated insurance companies. The state insurance regulators are primarily concerned with protecting the policyholders in their state from the failure of insurance companies chartered to operate in that state. In contrast, the Federal Reserve's mandate is to protect the financial stability of the United States from the risks posed by the entire insurance group, including its parent and noninsurance operations. This difference in emphasis may lead to some tricky issues about how to coordinate their different regulatory operations.

Grace, the session chair, offered some thoughts in response to Klein and Rosen. Among his concerns was how federal regulation would work in practice.

In addition to the discussions of how to regulate nonbank financial firms for financial stability purposes, the conference also heard two presentations on how regulation can drive financial activity out of entities subject to prudential regulation and into the "shadows." The paper "Banks, Shadow Banking, and Fragility" by Stephan Luck of Princeton University and Paul Schempp of the University of Bonn develops a model in which both banks and nonbank financial firms can provide maturity transformation services. The relative market shares of the banks and shadow banks depend in part on the relative benefit banks have due to their direct access to the safety net (lender of last resort) and the relative cost disadvantage banks have from being subject to greater regulation. Luck and Schempp's analysis allows banks to sponsor nonbank financial firms as a way of extending the safety net. Such sponsorship increases financial system resilience to smaller shocks but increases the cost of the safety net in the event of a large shock.

The conclusions of Luck and Schempp's theoretical paper were supported by an empirical paper titled "How Capital Regulation and Other Factors Drive the Role of Shadow Banking in Funding Short-Term Business Credit " by John Duca of the Dallas Fed. Duca finds that banks' share of intermediation depends in part on a variety of regulatory factors, including the cost of meeting reserve requirements and complying with higher capital requirements.

Concluding thoughts
One takeaway from the conference is that to varying degrees the private sector and the government both take some of the risk and provide some of the discipline to nonbank financial firms. Given these overlapping roles, one cannot make blanket statements in either direction: that more government involvement always promotes financial stability or less government involvement will always promote stability. Rather, what is needed is a clear understanding of how the current financial system works and some imaginative analysis of the way that market participants would respond to changes in government involvement. The presentations and panel at this workshop provided some valuable contributions along both of these dimensions.

Larry D. Wall is the executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Paula Tkac for helpful comments on the paper. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please e-mail


1 The conference was sponsored by the Atlanta Fed’s Center for Financial Innovation and Stability and the Center for the Economic Analysis of Risk at Georgia State University. It was organized by Glenn Harrison and Martin Grace of Georgia State University, Iftekhar Hasan of Fordham University, and Larry Wall of the Atlanta Fed.

2 Allen and Tang’s proposal focuses on contingent capital issues made by banks, but the proposal could also be applied to systemically important nonbank financial firms.