2023 Financial Markets Conference - Old Challenges in New Clothes: Outfitting Finance, Technology, and Regulation for the Mid-2020s

Policy Session 2: Opportunities, Risks as Nonbank Financial Institutions Grow

Nonbank financial institutions have assumed a larger role in the provision of some key services, taking substantial market share from banks. After welcoming remarks from Atlanta Fed president Raphael Bostic, moderator Andreas Lehnert and panelists Stijn Claessens, Meghan Neenan, Philipp Schnabl, and Dennis Kelleher discuss whether the increased role of nonbanks is socially desirable as it increases competition or not as they may be less able to handle adverse market conditions.


Raphael Bostic: Good morning, everyone. All right, that was a little better than yesterday. It's good to see you all. I hope everyone had a restful evening and enjoyed breakfast. We're going to kick off the second day of the conference, a full day. I'm still reflecting on our keynotes yesterday from Lord King, from Gary Gensler, and from Charles Calomiris, particularly Charles's discussion yesterday. I have to say, for me, one of my takeaways is now I've got to make sure that I do not do anything that causes me to be the topic of a conference dinner about real estate bubbles and fraud. Clearly, one of my predecessors failed to have that in his head as he was doing what he did, so I want to make sure that I don't make that error.

I'm really excited about today's sessions. We have a full schedule. We're going to hear a discussion of nonbank financial institutions and the opportunities and challenges that they present to us. We're going to dig into web3. I honestly have no idea what that is so I'm really looking forward to that. What they've told me here in my notes is that one headline is that it has the potential to help bring about an era of decentralized finance, or "DeFi," and I'm really looking forward to learning about that.

We'll also explore financial stability in a world of appropriately restrictive monetary policy. Clearly, given what's happened in the last several months, that's something we all need to pay attention to. We're going to close today with a treat. I'll get to share the stage with Chicago Fed president Austan Goolsbee. I've known Austan for a while, but it's the first time we will be on stage together, talking and conversing. It will be a very interesting conversation around policy and our outlooks, and I'm looking forward to the questions and discussion on that.

That's what our day will be, but now I am going to turn this over to Andreas Lehnert, who is director of the Division of Financial Stability at the Board of Governors, who will moderate our first policy session this morning.

Andreas, it's all yours.

Andreas Lehnert: Thank you very much, President Bostic, and thank you, as ever, to the organizers of this conference, both for the invitation and for the usual first-rate organization of the conference. I'll briefly introduce the panelists, I'll say a couple of words about nonbank financial institutions, and then I'll turn it over to them. They've each prepared about 10-12 minutes of prepared remarks, and then we'll go to Q&A. I'll be sure to let you know when you're running out of time.

I'll introduce our panelists in the order in which they're going to present, which is slightly different from the one in your program. Leading off, Stijn Claessens is at the Bank for International Settlements, where he's deputy head of the Monetary Economic Department and head of Financial Stability Policy. Second, we'll have Meghan Neenan from Fitch, where she is managing director and head of Nonbank Financial Institutions. Then, Philipp Schnabl, the Martin J. Gruber Professor in Asset Management at the Stern School of Business at NYU. Batting cleanup, Dennis Kelleher, the cofounder, president and chief executive officer of Better Markets.

Let me just briefly note a few baseline facts about nonbank financial institutions, and their role in the US economy and globally. First, people are often surprised that nonbanks are really the dominant player in the regular credit allocation and decisions for the household and business sector. Nonbanks fund two-thirds of both nonfinancial business loans and household credit. That's been stable for 25 years. Through various different dislocations and evolutions over the last 25 years, that's been fairly steady.

Some nonbanks have well-known fragilities. The nonbank sector benefited from a number of Federal Reserve emergency lending facilities that got set up in very difficult circumstances in March of 2020. At the same time, nonbanks have pretty deep connections to the banking system. There's a chart in the Fed's Financial Stability Report that shows the banking systems' lines of credit to various nonbank financial institutions. We refer to it as the "rainbow chart" because there's just such a plethora of different kinds of institutions that are getting committed lines of credit from the banking system.

Of course, the connections are deeper than simply lines of credit. The dealer subsidiaries of banks, or bank holding companies, facilitate a large amount of bond issuance and mortgage-backed security issuance, and so forth. With that background, let's begin with Stijn.

Stijn Claessens: Well, thanks very much. Thanks very much for inviting me to this conference. I've really enjoyed it. I'm going to give you the international perspective on nonbanks, to sketch the plot of the issues to be discussed. Nonbanks. Sometimes we call them "shadow banks." This was a title that we used to use after the financial crisis. We've now moved away from it, at least in Basel. We call them nonbank financial institutions. That's still a very general coverage, because you have insurance companies, pension funds, money market funds, et cetera. Personally, I prefer the term "market-based finances" taking a slice of that nonbank, so a little bit more about how they finance within markets and across markets. That brings in the links with the commercial banks, of course.

Those markets have really expanded a lot around the world. The growth that we already knew in the US was always there. The US is more or less 50-50 when you think of nonbanks versus banks. When you look at other countries, they were not there yet, but the growth at the margin, this increase in terms of flow so to speak, has been tremendous. Europe is sometimes even more than 50 percent, in the last decade or so. That reflects a combination of factors. Obviously, there has been a demand for this type of financing, so you can see it both in some sense on the investor side, but also on the final demand in terms of the firms and households that are needing that kind of financing.

It has also been driven by regulatory issues, of course. We have tightened the regulation on banks, so the nonbanks often stepped in to provide that financing. That trend, like I said, has been everywhere, and very strong. That also brings out this complementarity between the two. The two, banks and nonbanks, work together, and Andreas has already mentioned the credit lines that you have, but it's more general that you need both, in some sense, for a good financial system, because the nonbank's often the source of financing. I think of CDs and CPs, even financial institutions, for that matter. We need to start thinking about repo markets and other collateral markets. Obviously, the two are very closely linked, to the hip almost.

That does raise a number of issues in terms of the benefits and the risks of this kind of development growth in the nonbanks. If you look at the cross-country evidence that I studied a few years ago, and a lot of people are continuously looking at that, you really have to think of the growth in terms of what does it help in terms of economic type of financing, so it's really the demand side, in some sense for these types of services, what those nonbanks do. One of the important components of the nonbanks is the diversity and the type of financing that they offer. We don't get the same financing from the banks, of course, in terms of particularly on the equity side. That's not the dominant form of financing, necessarily, on the nonbank side. Nevertheless, they add quite a bit, and that is really an important growth factor.

I didn't use my slides. I thought maybe I would overwhelm you, but if you look at what you do on a cross-country basis, if you look at the contribution of banks to the marginal increase in growth ... take a dollar of bank financing relative to GDP, and take a dollar of equity financing or a dollar of nonbank financing, and ask every time: if you are at a certain level of financial development already, what does an extra dollar, or extra euro or whatever it is, do in terms of growth? What you see is at the commercial bank, it starts to taper off. At some point, the margin of contribution to the extra financing is getting less and less. Whereas, for the moment at least, you see that the contribution of the equity and the nonbank financing is still quite positive, and you see actually an increase in financial debt. In that dimension, you get a higher growth impact.

The diversity element is important to keep in mind after these nonbanks, although they come with issues and typically we stress the issues being, at least myself, on the regulatory side. They are always a little bit more pessimistic and say, "Okay, let's make sure that things work for the greater good, but we shouldn't ignore that element of it."

Talking specifically about financial stability: the reasoning that Alan Greenspan and others have put out a long time ago on the spare tire still applies very much to this segment of the financial system. Having a well-developed nonbank system across a number of crises and across a number of stress periods does help you recover quickly and quicker. It is particularly true if you have a banking crisis, particularly if it's a real estate-driven banking crisis. If you have the nonbanks, you see the recovery coming much better on the real side. It's not just that the financial system is a little bit more strong, but also that the recovery from the recession that typically comes along with it is going much faster.

There is a clear benefit there as well. But are there risks, too? One is kind of a procyclicality. It happens to be the case that the nonbank system is more procyclical being more asset-price driven. That's almost by definition, I would argue. It's also the case that the banks in market-based systems tend to act more procyclical so there is this adverse impact of being a more market-based system on how the banks themselves act as well. That's not a major shift, but it's still at the margin. If you were to draw a line, in some sense, it's slightly more upward sloping in terms of the procyclicality of the financial system.

That's something that we have to keep in mind, particularly when we discuss these complementarities. The complementarities also shift over time. When I tried to do a cross-country comparison, the complementarities were there even more and stronger, historically. Maybe at the margin they are starting to diminish a little bit. They are still there, but the perverse part and the benefit part are starting to offset each other. It may be in this equilibrium that these things are not obviously a gain anymore of having a better nonbank system for the overall interaction.

What we have seen recently, in some sense, are just manifestations of that. We have a few cases, unfortunately, in the last year or two where we have seen the nonbanks really acting perversely. We already had the cases in 2008, 2009. The money market funds. We have done a lot to reform those, so in that sense they were not the culprit this time around, but we have seen some impacts as well. There's no point belaboring the gilt crisis. Everybody knows that there was a perverse interaction. But we have seen other ones, dash for cash, even in the commodity markets last year. These are case studies because it's hard to do this, again, on a systematic basis. But clearly, in the stress period when things are really getting bad, you really have to watch out for those spikes where you see the spillovers happening, also back in the banking system.

Lastly, what are the solutions? Well, in Basel we debate these things in many ways. We have the Financial Stability Board, there's the Basel Committee on Banking Supervision, there's the Committee on Payments and Market Infrastructure. There are many debates, unfortunately sometimes in parallel, because this issue really deserves an overall arching perspective, because the ties between these various components are important. Nevertheless, to give you a quick snapshot by individual regulators: for the Basel Committee, clearly, we have done a lot on the Basel III. The shadow banking risk that used to exist, they are largely gone. Never say no, of course, but we have done quite a bit to tighten supervision as well.

Where we have made good progress, as I mentioned, is on the money market fund on a global level. We have thought about it harder, what kind of funds we would like, but also the conditions in which they operate. We're working now on the open-ended funds, slightly more difficult, and we're working on some things like margining practices in CCP. That's still a work in progress. It's hard to put everybody on the same level, of course, but it's nevertheless important.

It's also key to shift the approach a little bit. The approach has often been security market regulators. That's understandable, and they push for investor protection, disclosure, transparency, and the like. That's very good, but it's a very micro prudential perspective. To balance that from a system point of view, you really need to have a little bit more overall macro prudential kind of a view. That is tough in the sense that the regulators themselves don't think like that, but also that the tools that we have at the moment don't allow us to intervene in the macro prudential sense.

We have done that quite well on the banking side. We've done it quite well on the borrower side, if you think of housing markets. For example, loan-to-value ratios in those, et cetera, but there is still a big agenda to be covered there, to have a little more of a systemwide view on the risk that exists in that sector. I'll stop here, just to give the big overview, and I'm probably going to come back to some specifics in the next round.

Lehnert: Absolutely, yes. Okay, Meghan.

Meghan Neenan: Okay. I was going to talk a little bit about the private credit market, because it's a sector that we get a lot of questions on, so I thought I'd run through some slides to help support some of the commentary, really talking about the growth in private credit since the GFC, how the private lenders have performed over the last 15 years, and the state of the market today, just given the recent banking crisis but also rising interest rates.

Maybe just kicking out to size of the market, there's certainly a lot of numbers. Based on some data from Preqin, the FDIC, and the Fed, we size the private credit space at about $800 million in the US. It's up about fourfold over the last 12 years, but still accounts for a relatively small part of GDP at just over 3 percent. The private credit space includes a lot of different things, as you can see on the right-hand side of the slide, but direct lending is the biggest proportion of private credit and has grown the most significantly in recent years.

This used to be much more heavily a distressed kind of bucket in private credit, but there really hasn't been a distress cycle in a long period of time so you can see that that's contracted pretty meaningfully. Howard Marks, who is the founder of Oaktree, was out with some commentary recently. They have a distress fence, and he was talking a little bit about perhaps coming into a credit cycle that will be a bit more distressed in the coming months, coming quarters and years.

Who's benefiting from private credit, or who's leading the charge? Certainly, alternative investment managers are benefiting. Here, you see just the fee earning assets under management for Blackstone's credit segment. It accounts for about 28 percent of their total fee earning assets under management in the first quarter, and the growth is even more stark if you go back to 2010 when they had about $25 billion in their credit business. You'd see a similar trend with other alt managers as well. Apollo and Ares, in particular, are very big in the credit space. Their insurance relationships are certainly driving some of this growth.

We've seen a lot of different tieups. Certainly, insurance companies are LPs to alternative investment managers, but we've also seen now alternative investment managers take minority stakes in insurance companies, as is the case for Blackstone and Carlyle. You've also seen some alt managers just buy insurance companies outright, Apollo and KKR. The alt managers are really providing and structuring products specifically for the insurance companies, who are looking for yields and who are looking for rated paper.

On the right side, you see business development companies. Fitch rates 19 of these. They've had significant growth in this sector, and a lot of these firms are managed by the alt managers and so are certainly helping support the growth of their AUM. Here are the three largest platforms, Ares, Owl Rock, and Blackstone. Blackstone, you can see, popped up in 2021. They introduced a new structure of BDC [business development company]. It's called the "perpetual private BDC," which is a little bit different. They're raising money on a monthly basis from the retail channel, and oftentimes that capital initially is invested into the liquid market. Eventually, as they have middle market opportunities, they'll redeploy that capital.

While it's in the liquid market, it certainly adds some more valuation volatility on their books, so that's something that has to be carefully managed. The other thing is these BDC structures have redemption risk, so there's a lot of headline risk that people saw in the fourth quarter. Blackstone's perpetual private BREIT had a lot of redemptions, a meaningful uptick. Blackstone Private Credit certainly had some contagion as well, so they popped to 5 percent redemption in the fourth quarter. That has since come down, but we're seeing a lot of perpetual private BDCs get started, and so we don't really know the normal state redemption risk, but that's something else that they have to manage, certainly carefully. It could lead to some liquidity issues and disruption in the sector if we start to see some "for sales."

What drove some of the growth in private credit? Certainly, regulation coming out of the GFC, and leverage limits of six times on leverage loans. Here you see some underlying statistics for Ares Capital's BDC. You can see leverage ticking up pretty steadily, and their weighted average, even of their portfolio, is nearly $300 million in the first quarter. They and other BDCs have certainly moved up market, starting to compete head on with the syndicated space. That's because sponsors and borrowers have become much more comfortable with private credit solutions. They can deal with one lender, one set of documents, and there's certainty around their pricing.

A lot of that has led to some significant competition. Certainly, heading into the COVID pandemic, and coming out of it immediately as well, lots of pressure on EBITDA adjustments, leverage ticking up, pricing coming down. Here you see covenants as well, being an issue and being sacrificed. It is certainly still lower than the broadly syndicated market, but the good news is starting in the second half of 2022 things moved more in the lenders' favor. We saw spreads widen, leverage start to come down, and a lot of private lenders are saying, "Hey, this is the best underwriting environment we've seen since 2009 and 2010." But the issue is, there's just not a lot of M&A activity, so most of these portfolios are still heavily weighted towards 2020 to first half of 2022 vintages which, generally speaking, have a little bit weaker fundamentals.

How durable is private credit during a recession or a typical credit cycle? I don't have the answer for you, unfortunately, but just to look at a couple of examples that might be informative, one is for BDCs in particular. Here you see BDC 1.0. This is three BDCs that we rated in June of 2008, none of which exist today. They were all bought coming out of the crisis. BDC 2.0 is the 19 BDCs that we rate today. You can see there's a considerable amount of improvement in terms of some of the structures. Back in 2008, some of these BDCs were mini-buyout shops. They had equity investments accounting for 35 percent of their book, lots of valuation volatility. When Lehman hit, they immediately breached covenants. Now you see equity exposure at 15 percent. It's not just individual investments in companies, it's equity stakes in specialty finance businesses, and joint ventures which, the underlying assets are a diversified portfolio, firstly. Less valuation volatility, certainly.

Non-accruals are looking better heading into a more challenging macroeconomic picture, and you also have a better funding structure. The bank facilities are much longer duration, and most of the BDCs are under the cadence of kind of amending and extending on an annual basis. Leverage is certainly up. The passage of the Small Business Credit Availability Act (SBCAA) in 2018 allows BDCs to lever higher than they had before, but the asset coverage cushion has improved, and that's the amount of valuation hit a BDC can take before breaching their asset coverage cushion, which is required by the Investment Company Act of 1940. That's a better cushion to have, certainly today. They're paid-in-kind interest, or their noncash income, has come down, and their coverage of dividends, just from regular spread income and fees, is significantly improved.

All that to say: BDCs are structured much better today than they were heading into the last crisis. That's certainly a good thing. The other test that we've seen is COVID. We can all agree that wasn't a credit stress. It was a valuation and liquidity stress. Here, you saw BDCs took some meaningful valuation hits on their portfolio in the first quarter of 2020. That did reverse in 2Q and 3Q, for a variety of reasons, but they were able to absorb those movements pretty easily. The other thing that they had to deal with was revolver draws. They do extend revolvers to their borrowers. In normal times, utilization is around 20-25 percent on those revolvers. That popped in the pandemic to about 65 to 70 percent. Most were able to handle that from a leverage and liquidity perspective. That being said, most of the BDCs were just legging into a new leverage target following the SBCAA.

Today, most BDCs are fully levered at their new target, so probably less cushion to absorb some meaningful uptick in revolver utilization, at least from a leverage perspective. I won't go through all of this, but we did include this chart in a recent report that we published on private credit, just some good things and bad things. Obviously, it hasn't been tested through a cycle, but most of these guys have moved off the capital structure into first lien, and equity cushions are significant. LTVs [loan-to-value ratios], in general, even if you don't believe the Vs: 40-50 percent. There's a significant amount of equity cushion backing up some of these loans that are being extended.

The other thing, just in terms of transparency. There's not a lot of transparency, obviously, in the private credit space. BDCs uniquely do have to publish every investment that they have in their portfolio, the maturity date, the pricing, the industry, so relatively speaking there's a bit more there. The connection for the banking sector is something that we'd also have to think about, because they're extending revolving facilities to the BDCs and to other credit funds. We have heard, at least anecdotally, that banks are certainly getting more selective about where and when they're extending credit to the sector.

Just in terms of where we're at today, we do have a deteriorating sector outlook for BDCs, because we have some more concerns about where they're going to go from a credit perspective in a rising rate environment. Here you can see Ares Capital again. They're definitely benefiting from the rise in rates, from an earnings perspective. The majority of the BDC portfolios are floating rate, so earnings is increasing. That's a good thing, because it does help build a cushion to offset some disruption on the credit side. On the right-hand side of the slide, you just see interest coverage ratios, which have steadily come down.

There's certainly a portion of BDC portfolios that have interest coverage below 1. That doesn't account for some cash on the balance sheet or revolver capacity, but the good news is, here you see dry powder in private equity buyout funds. During the pandemic, we did see private equity sponsors step up and support their companies. If you believe the forward curve, there's maybe some light at the end of the tunnel when it comes to rates. We don't expect private equity firms to throw good money after bad, but if they do see some valuation uptick or realizations over the near term they will step in and help support their companies.

Non-accruals: we have seen some deterioration year over year. First quarter results are all out at this point, not seeing any meaningful deterioration. The other thing we're keeping an eye on is just paying any kind of interest, or noncash interest, which gets capitalized to the principle of the loan. Some of this is already elevated still, just coming out of the pandemic, because it was a tool that a lot of the lenders were using to get their borrowers through a tough time and conserve liquidity. We'll start to see this tick up a little bit again as we continue to move through a more challenging macroeconomic time.

Maturities: we do start to see some walls coming; 2023 is looking pretty good, but definitely in '24, '25, the maturities start to pick up. On the BDC funding side, really manageable in '23 in terms of maturities because we saw a lot of opportunistic issuance during the pandemic. No real walls there, meaningfully, until 2026, but certainly it's going to continue to tick up.

Just wrapping up, the fundraising is pretty significant. There is a lot of capacity to help deal with some of those maturity walls. I would just say, we did see the Financial Stability Report come out last week. They did talk about private credit and risk being limited, but it is something that we're certainly keeping an eye on. Thank you.

Lehnert: Thank you, Meghan, and thank you for the plug for the FSR. Philipp.

Philipp Schnabl: Thanks a lot for having me here. It's a big pleasure to be part of this distinguished panel. Thanks a lot to the organizers for inviting me. I've been asked to talk about interest rate risk, and banks and nonbanks. As you will see, I will start talking about the banks, especially given recent events. It's important to understand the banking terminal first, so I'll give you my perspective. I will highlight where the nonbanks come in, in particular money market funds but also other nonbanks who compete as private lenders with banks but don't finance themselves with deposits.

Any discussion of the banking turmoil has to start with thinking about the bank asset losses. Here, I give you my number. As we all know, I don't have to tell this audience, the Fed raised the short rate to now around 5 percent since 2021. That means long rates, which just reflect the expected future short rates, maybe plus the term premium, are up around 2.5 percent.

What does that mean for the value of bank assets? Banks hold roughly $17 trillion in long-term loans and securities. Average duration estimate is around four years, so the implied loss is you just take the change in the long rate, 2.5 percent, multiplied with the duration, the size of the balance sheet, and you get a number of roughly $1.7 trillion for the banking sector wall.

Two points about this number. First of all, it's not hidden or complicated. It's different from credit risk. It's a different situation than in 2008. Interest rate risk we understand. We can calculate this number with simple bond math. Second, this number is very large. It's the same order of magnitude as bank equity. If this is all there is to banks, banks should actually be, overall, insolvent. The stock market tells us that's not quite true. If you look at the stock market, here I'm plotting it from mid-'21 up to April '23, bank stocks have been holding up well as the Fed was raising rates, until February of this year.

For the longest time it didn't seem to have any effect on bank stocks, and now bank stocks are down roughly 30 percent, but by no means the stock market is telling us that banks are insolvent, so something is going on. The missing piece here is the deposit franchise. I would argue what makes banks special, among other things but in particular, is that they issue deposits, and deposits are valued by depositors for their convenience and their safety. They're expensive for banks to provide, but it also means that depositors are willing to accept very low deposit rates.

What that means is when rates go up, deposits become much more profitable for banks. A historical estimate of what we call deposit beta is 0.4. What that means is that, on average, when the fed funds rate goes up 1 percent, the banks raise deposit rates 0.4 percent. The flip side of that is that the bank's going to keep 0.6 percent for themselves.

Now, how did that play out during the ongoing cycle here? I'm giving you the latest deposit rates I could find from the FDIC website. They go through March '23. Some of the repricing we've seen in the market is not in here yet. I will come back to that later. If you just look through March '23, what you see is that basically the interest rate on interest checking hasn't moved, that's the green line. The red line is savings deposits, the main category of deposits, that went to like 50 basis points, so it barely moved, and then CDs. They are higher now, but at the time was 1.5 percentage points.

That spread between the fed funds rate in black and these colored lines, that's the spread the bank is earning. Another way to get that is you can just look at the big four banks. I did this calculation using the latest available call reports, so those are available up through March '23. You can see that yes, banks have been raising their rates, so these are the average deposit rates you see here. There's actually quite a bit of difference in business models, so JPMorgan, Bank of America, Wells Fargo ... they all raised around 1 percent. Citi actually has more wholesale funding, so they had to raise more.

These imply betas are actually pretty low by historical standards. Now, they're going to rise going forward, but this is a beta of like 0.2, actually less than what we have seen historically. This is the distribution of historical bank deposit betas around 0.4, but you see there's quite a bit of variation. It depends on the business model. Some banks are more like Citi. They have a higher deposit beta. Some banks have a lower deposit beta. In some sense, in order to get to where we have been historically, there's still quite a bit of ways to go. In case you're interested, this is estimated from data from 1984 to 2022, and actually posted on my website if you want to look up bank level deposit betas.

Now, why are they so important? Well, because from the bank's perspective, they consider deposits to be their hedge against rising interest rates. Quantitatively, what does that mean? Roughly, banks have deposits on the order of $17.5 trillion. If you take the historical beta of 0.4, that means they're going to earn a deposit spread of 0.6. If you multiply the current fed funds rate with 0.6, that means a spread of 3 percent. If you multiply that with total deposits, roughly what that means is that banks' income is going to increase by $525 billion. That's per year. If banks are able to hold on to the deposits, this is enough to offset the losses over three or four years going forward.

Another way to think about that is the deposit franchise value went from being very unprofitable, because you have the cost and you didn't get any income at the zero lower bound, to extremely profitable. Now, the baseline estimate using historical numbers is that, on average, for the banking sector wall, they get that sort of right. There's a full offset, and that can explain why bank stocks didn't fall through February '23. One way you can see that in the data of whether the banks get that right, whether they get the asset liability management right: it should generate a stable net interest margin. The repricing of the asset should match the repricing of the deposits.

Just to emphasize that this is not something new, this is how banks have been operating. One way to see that is if you look at the net interest margin as interest rates change. Here, I'm plotting in red the net interest margin, this is going back to 1955, and what you see is that interest rates, in black, moved around a lot. Somebody mentioned yesterday, in the '70s, we had even larger increases in interest rates. What you find is that the bank interest margin, the net interest margin, barely budges when interest rates go up. This is really the business model of banks and has been for a long time. Now, if you look at this cycle, the same so far is playing out. If anything, the net interest margin actually went up. Now, it's projected to come down as deposits reprice. but for the sector wall it looks like banks got the matching roughly right.

Now, that doesn't mean that there are no risks. I just want to talk about three risks. The first risk, which is obvious now—maybe it wasn't that obvious back in February—is that deposit hedge only works if there's no run. I mean, that point was obvious, but we didn't really necessarily think that we're going to have runs. A lot of us had blind spots there. Clearly, once there's a run that's going to destroy the deposit franchise, the hedge is going to fail, and at this point the bank may be insolvent. We have seen, clearly, that regional lenders with a lot of uninsured deposits are particularly at risk to these runs.

The second risk, which maybe is a little bit less obvious, is the deposits paid that may reset. Whether it's a regional bank or not, some of the uninsured depositors, maybe even some of the insured depositors, are going to wake up, if you so want, and say, "Maybe I don't want to pay that much for my liquidity service, the deposit spread is too high. Let me move it to a higher-paying alternative outside of the banking sector." The first one which comes to mind, which also came up yesterday, is a nonbank, namely money market funds.

Then the third one, it's less of a risk but it has to be distinguished, conceptually, is the regular monetary policy transmission mechanism, what I would call the deposit channel. Even setting aside what happened in March ... this has been going on before March, in general, and we see that for every cycle ... price-sensitive depositors are going to move out as deposits become more expensive. These betas are set by the banks in response to what they see in terms of outflows, and usually when rates are going up, you see some outfalls.

Let me just give you a very short perspective, looking forward where we are with respect to these three risks. The first one is, do we see outflows from the regional banks to the large banks? One way to assess that is just to look at deposit growth of large banks versus small and midsize banks. I'm plotting this here from FRED. What you see is, basically, there were large outflows right after the SVB failure. A lot of them went from the smaller banks or midsize banks to the large banks. That seems to have stopped.

Now, we don't yet have good data on rates. My understanding is that it stopped partly because the small banks have to pay significantly higher deposit rates, so in some sense it's good news that it's stopped, but there is a level effect in the sense that they have to replace these price-insensitive deposits with something more expensive. We will still see that working for the system, and so potentially be a pullback in terms of lending. We already see some of that. It also creates opportunities for nonbank lenders who compete, in particular with respect to small business lending and those in commercial real estate.

The second risk is that depositors just move en masse to money market funds. Here, I'm just plotting total money market funds as one measure. You can see roughly $500-550 billion moved right after the SVB failure in those weeks. My understanding from talking to banks is a lot of this is the corporate cash accounts that were in checking or savings. Every self-respecting CFO does not have their uninsured deposits at a smaller bank anymore. They're either at a large bank, or they moved to money market funds, or they're doing both. It's interesting to note that it looks like most of this was institutional money. There really wasn't that much in terms of retail moves. Again, it looks like a level effect, so in a sense this could affect the lending as well. Clearly that's not good news for the smaller banks. For the large banks, it's a bit unclear, because on one hand, some money moved to money market funds. On the other hand, the inflows coming from the smaller banks on net, it's a little less clear how it works out for the larger banks. We'll see that soon.

My last point is, what about the deposit channel? What about monetary policy? Here, I'm just plotting this on our retail money market funds. That's in blue. If you calculate, on average, which were the flows pre-SVB failure, from the time you started raising rates, up to February, on average, I would say there were roughly $20 billion outflows per week. If you look over the last five or six weeks, I did the calculation yesterday, you're back to $20 billion per week. That looks like, in some sense, the deposit channels continue to be at work. It's sort of different, because presumably that's the intended effect of monetary policy tightening: reducing bank lending, and therefore affecting aggregate demand.

My summary: it looks like the deposit channel is back at work. We still have to understand how the resetting of deposit pricing is going to seep through to the lending, especially among the smaller banks. We'll learn more about that as more data on lending and deposit rate is coming in over the next weeks and months. Thank you.

Lehnert: Okay, thank you very much, Philipp. Batting cleanup is Dennis Kelleher.

Dennis Kelleher: Good morning. First, let me say thank you to President Bostic and his team for inviting me here, and for this terrific conference. It's an honor to be here. Second, I wanted to start by saying to those of you who don't know who Better Markets is, it's a nonpartisan, independent 501(c)(3), a nonprofit based in Washington, DC. We've got a team of experts in banking, securities, commodities, derivatives and consumer protection. We were founded shortly after the 2008 crisis to promote the public interest in the financial and economic policymaking process in Washington, DC, and we're active across all the regulatory agencies in Congress, the executive branch, the courts, and the media. We've participated actually in more than 300 rulemakings across those agencies, where we're often the only nonindustry organization participating. We've also been involved in dozens of lawsuits related to many of those rules. I come to these issues as a practitioner and a public interest advocate, and to some extent a consumer of the products that you all produce, particularly the academics.

As for nonbank risks, I want to make five points. First, let's look at the financial system as a whole. Banks are the most highly regulated, supervised, and transparent part of our financial system. There are hundreds of bank regulators, and thousands of bank supervisors, and yet, regardless of why, they seem to fail fairly often. Yes, recently we've got Silicon Valley Bank, Signature Bank, and First Republic, but also let's look at Wells Fargo. Years of failure upon failure, and of course, the conduct in the years before the 2008 financial crash. Again, regulation and supervision failure for years.

Now, I don't say any of this to bash bank regulators, but if such risks can materialize in the most regulated, supervised, and transparent part of the financial system, just imagine what the unknown, unregulated risks in the nontransparent, nonbank part of the system are. It's surprising how little we actually know about the nonbank financial system. The Fed's recent (May) Financial Stability Report illustrates this. Almost every time they talk about a nonbank activity or risk, it says, "Of course, we don't really know because we have hardly any information." Put differently: if we can have very big and consequential systemic surprises in the banking sector, we need to be very, very worried about all that we don't know about the risks in the nonbank sector.

Second, this isn't the way it was supposed to be. As everyone knows, the 2008 crash was caused by reckless risk-taking, if not worse, in the banking and nonbanking sector. Both were bailed out by the Fed, the FDIC, and American taxpayers. The Dodd-Frank Act actually addressed both of those sectors with the intent of focusing on systemically significant financial institutions, regardless of form or function. The Fed was directed to regulate systemically significant banks directly, and the FSOC was created to identify risks in the nonbank sector, and designate systemically significant nonbank risks, which were then supposed to be subject to regulation by the Fed. The intent was to ensure that systemically significant banks and nonbanks were similarly regulated, based on their risk profiles. But then, that didn't happen.

Today, according to FSOC, there is not one systemically significant nonbank in the United States. Not one is designated as such, not one is regulated by the Fed, or really anyone else for that matter. Attempts? Yes. Partial? Yes. Really? No. That's true, even in light of the facts previously mentioned. The nonbank sector is now way bigger than it was in 2008, and bigger than it was in 2020.

Remember, like 2008: nonbanks were bailed out again in 2020. Yes, it was due to the pandemic and it's not anyone's fault, but the pandemic shock was the first live stress test of the entire post-Dodd-Frank financial architecture and it failed. People forget that not only did the Fed take rates to zero and engage in massive QE, it also revived every single one of the 2008 rescue programs, for money market funds, commercial paper, asset-backed securities, mutual funds. It even added a few new ones: junk bonds, PE, and more. Now, people can argue whether all of that was right or wrong, necessary or not. Regardless, it vividly highlights the ongoing vulnerabilities, fragilities, and risks in the nonbank sector.

That brings me to my third point, which is that "too big to fail" is alive and well and getting worse. It should be no surprise that too big to fail was at the core of the most recent bank crisis, not just because non-G-SIB [Global Systemically Important Banks] banks were systemic. We've been saying that for years, that the G-SIB focus is too narrow. Too big to fail includes what we call D-SIBs, domestic systemically significant banks, and Better Markets, along with former Fed vice chair and governor Lael Brainard, and former director, now chair, of the FDIC Marty Gruenberg have repeatedly pointed this out in dozens and dozens of rulemakings, speeches, public statements, testimony, predominantly after 2017, but even before. Bailed out, or if you prefer "rescued," D-SIBs is not the only place too big to fail distorts the financial system. The depositor flight that Philipp just talked about happened because too big to fail firms or activities were there to take those deposits. The bottom line is too big to fail is alive, well, and getting worse.

My fourth point is: how to change that isn't a mystery. Kristin Forbes made this point yesterday. Sometimes it's not so much trying to come up with new clothes to deal with old challenges. The old clothes were actually pretty good. Not actually the ones in her slide, but others. I don't know how to run the metaphor out here, but people just didn't wear them right, maybe.

As I said earlier, FSOC has to do what it was created and empowered to do. With OFR, it needs to get all the information necessary to evaluate the risks in the nonbank sector so that the future Financial Stability Reports won't say we don't have the information. Then, FSOC has to identify and designate nonbank SIFI [systemically important financial institution] risks. The Fed then has to regulate them in a way that's similar to bank SIFIs: based on their unique risk profile. No, not one size fits all, not cookie cutter based on their unique risk profiles.

Of course, regulating systemic risks once identified isn't a mystery, either. Building on a great deal of prior work, Better Markets released a policy brief just last week, summarizing the 10 actions that need to be taken to reduce systemic risks. No one will be surprised because they're all well-known. They're old clothes if you will. More and better capital and liquidity, actually stressful stress testing with public consequences, resolution plans that work and enable certainly D-SIBs, if not G-SIBS and systemically significant nonbanks, to be resolved in bankruptcy in an orderly fashion that doesn't involve government bailouts and support like every other company in America, and as required by the foundational rules of capitalism.

None of this is radical, or frankly, all that complicated. Most importantly, we need regulators to take action as decisively and quickly to prevent the next crash as they do when trying to stop an ongoing crash. Again, read the Fed's May Financial Stability Report. They repeatedly talk about how decisively—favorite word! and I'm not making fun of them, it's an accurate word—they acted regarding Signature Bank and Silicon Valley Bank, but they only otherwise identify all the ongoing risks without really proposing to do a darn thing about them. That's upside down.

I know that's not the purpose of the stability report, but the stability report is supposed to be consumed by somebody who then does something, and it's time to act decisively to prevent crashes now. To act as decisively now to prevent the next one as they're willing to act once one happens. One way to do that would be to enact now a variety of interim final rules, which would be effective upon publication. There's an ample basis to do that across the board on a number of these reforms, if you want to call them that.

Fifth and finally, everyone has to remember the stakes are very, very high. This is about much more, with all due respect to Lord King, much more than models, regulation, deregulation, crashes, bailouts, rinse and repeat. While studying them is academic, these are not academic issues. The impact on the lives and livelihoods of all Americans is quite dramatic. We're a chart-deficient table over here, but I did have one chart that I wanted to bring up.

When I say they impact the lives and livelihoods of all Americans, this chart is the unemployment caused by the 2008 crash judged by the U-6 rate. It illustrates how bad it can be. You can see that it actually reached 17 percent, which is about 27 million Americans who are out of work. By the way, it peaked in early 2010. You might remember that in early 2010, at the exact same time, Wall Street paid itself $20 billion in bonuses, according to the objective facts.

There was no bailout for Main Street families. They saw that, they felt that, they lived that, and yes look at the polls: they remember that. They see echoes of that with what just happened. You have to remember, even a so-called soft landing is still going to land very, very hard on millions of Americans, families, and communities. Sure, a low unemployment rate is much better than a high one but remember that the unemployment rate for each one of those millions of Americans who are unemployed is 100 percent. Those are the dire consequences that result.

That's not all: these issues also directly impact our democracy, the faith, trust and confidence of the American people in their government, the legal system, and government officials. That's what's actually at stake in the issues that this conference is talking about. Bailouts and favorable treatment for the wealthy and well-connected destroy confidence and trust, not just in regulators but the entire government and, yes, democracy itself.

I don't have the time to talk about it at the length it deserves, but I urge you all to read Martin Wolf's new book called The Crisis of Democratic Capitalism. I don't agree with everything he says, and I don't expect you will either, but he starkly illustrates what's at stake when special interests, including especially from too big to fail banks and nonbanks, are put above the interests of everybody else. Let's look at the opportunities nonbanks may create for financial markets, but remember that the cost and consequences of not properly regulating bank and nonbank risks aren't just crashes and crises. It's much deeper than that. Thank you.

Lehnert: Thank you, Dennis. I'm going to exert moderator privilege and ask a couple of questions to kick us off. I encourage all of you to use the Reddit-style system that they've set up here, and bonus points if you put your name on it, and don't hide behind anonymity when you ask it. Meghan said when discussing the outlook for the sector that the rates are stressful, but if you believe the forward rate curve, there is hope. I'm not putting words in your mouth, I hope.

It occurred to me: Jan Hatzius yesterday argued that there's at least a risk that the market, the forward rate curve, is wrong, and that we might be in an environment of increasing rates, certainly at the medium end of the curve. I guess a question for the panelists, and I might actually ask all of you for your view on this, but what if we are in an environment of just structurally higher and more volatile interest rates for a few years here? What's your view about how that feeds through to the fragilities of the nonbank sector, but also some of the opportunities that the nonbank sector has? I imagine that you all have something to say on this, so maybe we'll just go in the order in which you presented. Stijn?

Claessens: We're going to have the expected effects, in some sense the desirable effects, from high interest rates. We want to slow down the economy, and we do that through increasing the debt service for borrowers. That will have an effect, of course, including on nonperforming assets. We should expect those to rise. We may have been a little bit clouded by the COVID experience. We didn't see many bankruptcies during that period. Of course, there was massive support, so we shouldn't take that as a norm. We should go back to the pre-COVID experience. On that basis, we cannot expect some higher performing assets. The banking system on the capital side is able to deal with that very well, except for the interest rate risk, but we can talk about it more.

It's normal, and in some sense we should budget for it and have the buffers. I do, however, think there's a little bit of a risk part of it, and it goes back to what Philipp presented, and what we all have been discussing) We see in the banking system, of course, that we can get these runs. It's really the liquidity part of it that we don't understand very well, with the higher interest rates and particularly in the context of these growing nonbanks.

Is the gilt crisis that we saw in the UK really an exception? It was, in the end, that nonbanks are the natural place where you would want interest rate risk to reside, because their duration on the asset side is shorter than on the liability side so they benefit from an increase in interest rates. They have these liquidity issues, which is where the hedging comes into play, sometimes as a perverse factor because you have the margin goals and what have you. I would see that part of it.

Some of you mentioned that the data are very poor on the nonbank side, but if we work back from the mechanisms that we have observed now, and we can see some repeats, then the data are not necessarily that bad. You have to think a little bit more, not "let's look for all the data that we want, and then we're going to do this gigantic computer, whatever, identification of the risk," let's say, "what are the mechanisms by which we can see unexpected things, or things like that to happen?" Margin calls, because of hedging, are one where we have the data to some extent much more, and we can start to map some of those risks.

Kelleher: Certainly we have more data, but the gilt episode illustrates the big, big gaps. It comes out as a big surprise, nobody saw it, and all of a sudden "Shocking, what do we do?" It wasn't like it was buried underground, that nobody could find until it appeared. It was laying in plain sight. Frankly, Silicon Valley Bank was the same thing. A short said in January of this year that Silicon Valley Bank was a time bomb sitting in plain sight.

The same thing with uninsured deposits. We keep getting surprised in ways that you really have to scratch your head and say, "How could we possibly be surprised by these things?" There's no question that we've got slightly better data in the nonbank system than we used to have, but do we have anywhere near what we should have? No. Does it give us anywhere near the ability to assess the risks? No.

In terms of interest rate policy, Better Markets put out a report recently called the Federal Reserve Policies and Systemic Instability, and what it did is it really tracked the decoupling of asset pricing from underlying risks due to Fed policy starting in the Great Financial Crisis of 2008. If you look over that 15-year span, you can see the instability that those policies have caused, embedded and often unseen until too late, in the financial system.

It's one of the reasons that the siloing of monetary policy and financial stability and regulation is handcuffing regulators in the vision with which people are thinking about the financial system, which is what leads to these surprises. There really should be a much more conscious relationship, an inverse relationship, with monetary policy and financial regulation. When you're tightening policy, you ought to be looking at the regulatory side to ensure that the known time bombs that happen when you're trying to achieve a different policy objective, don't overwhelm that policy objective in a way that actually interferes with achieving the policy objective. That's kind of the approach that we come at it from.

Lehnert: Good. Meghan?

Neenan: Yes, I probably just have a more granular perspective. We cover a lot of different subsectors within the nonbank space, and so some are going to react differently to different interest rate environments. Some can pass on costs. One of the things that we're focused on, though, is just that, in the second half of 2020 and in all of 2021, really, the capital markets were so strong, we saw a lot of opportunistic debt issuance.

Now you have a lot of companies just sitting on the sidelines, waiting for rationalization and pricing. At some point, you're going to hit some maturity walls and you're going to have to start issuing, and your funding costs are just going to go up and you might not have had the same repricing speed on the asset side. You're going to see reductions in profitability in a lot of different subsectors.

Then the question is, what happens to the share prices? Then, do they start to do things that are more shareholder-friendly from purchases, and what happens to your leverage profiles? Then, are you ready to deal with tougher conditions? We certainly think about that. The nonbank mortgage space in particular is one that's had a meaningful surge in the years leading up to the pandemic. We saw lots of private equity money in the space, lots of SPAC [special purpose acquisition company] IPOs. Some of those guys issued unsecured bonds in the high yield space, which they probably wouldn't have been able to do before.

Now all of those companies are scrambling, their originations are hard to find, and so they're trying to right-size costs. If rates stay higher for longer, the question is can they survive, and then what's the capacity of the nonbank space for mortgage origination? You see some guys that are stronger right now picking up some of the smaller players that just aren't going to survive, but at some point there's going to be pressure on the bigger nonbank folks as well because they're going to be relying on access to the market to refinance some of their maturities as well. Lots of different pieces to think about.

Lehnert: Thanks, and thanks for mentioning nonbank mortgage servicers. Philipp?

Schnabl: What are the risks and opportunities? I already talked a bit about the risks for the banking sector. What's important to keep in mind is, it's a different situation than 2008. All the uncertainty was about the asset side. This time around, all the uncertainty is about the deposit side. We will learn more. Our banks are holding up. I was giving a perspective that so far it looks like the sector wall is looking fine, although individual banks may still face difficulties going forward.

We will learn more, as we go along. Let me highlight one opportunity. Maybe it's a risk for the banking sector, an opportunity for the money market funds. If I was a banking executive, maybe that's what would keep me up at night. If I look at my MBA students, who want to start a new business, who want to find an opportunity: one place where potentially they could make a difference is, as I showed you, there weren't large movements of retail depositors to money market funds yet, as far as I can tell.

What's missing, from the consumer perspective, is a money market fund which maybe invests in T-bills or reserves, for that matter. It's very safe. Charges are spread, potentially, but has the same look and feel as a bank. If you are able to invest in a money market fund, had the same app maybe the cooperation of a bank, or maybe a tech company, who are able to tap into a branch network, that could really change how young people use banking services.

The regular constraints of why you can't do that: also, in terms of the cost, it's difficult because we underestimate often the cost of providing the services. If a young student came out and put that together, a young entrepreneur, that could really change the sectors. That's where I see an opportunity for money market funds, and maybe a risk for the banking sector in the medium run.

Lehnert: Good. We're having a session on web3 later today, Philipp. It's going to be very germane. There's a couple of questions here. Let me try wrapping them up into one kind of uber-question, and then maybe we can dig down into some of the specifics. We have articulated a vision where there is the banking system and there is this kind of nonbank system. Different countries have a different weighting between the two, but they are clearly intimately linked in a kind of financial ecosystem that is evolving in part due to technological change, as Philipp articulated, and in part due to the rate environment.

The big thing in the United States is that regional bank stress has the potential to change the dynamics of the ecosystem as well, so let me just ask our panelists: where do you see the major shifts? I don't know who is the predator and who is the prey in this analogy, but there's the liability side with deposits and money funds competing. There's the asset side with loans but also competition from direct lenders, and of course there's the international dimension. Just thoughts on your views on the outlook for the ecosystem as a whole.

Claessens: It's a tough one because the system is evolving very quickly, of course. There is also no universal answer here. Going back to basics, it is often important to step back a little bit. What do we want to get out of the financial system to the extent that we as public authorities or whatever can try to influence that? It's going to be at the margin, I suspect. The markets largely drive debt.

My biggest issue is, still make sure that we have the level playing field, that Dennis also pointed towards, but then be careful. Not only go for activity-based regulation, but also have in mind an entity component to it, which can sometimes be the systemic entity that you shouldn't ignore. When you think about infrastructure to support an overall financial system, digitalization is moving things very rapidly. We'll talk about web3, I guess, in the afternoon, a bit later, but nevertheless, as regulatory authorities, including central banks, we have a role in making that digitalization not only addressing the risk part of it, which is the faster one, but also making sure that we have the services.

For example, to some extent the interest in crypto is maybe a deficiency of the existing financial system in terms of digitalization and the services that it provides. Then the authorities should try to do fast payments. FedNow is one answer to that, but there are many more where we can leverage what we already have in the system there. A big component, which is, frankly, probably outside of many of our regulatory remit, is thinking about data. If it were to be one area where we need to put our minds together is how we're going to govern the data that is used for financial services. It is accessible by big tech. It is, to some extent, accessible by banks, but there the "level" playing field is very, very uneven. This could be a break issue going forward if you don't get the right solution in place.

Lehnert: We certainly heard thoughts along those lines from Gary, Chair Gensler, yesterday. Very good. Dennis?

Kelleher: When you think about the shifts that are coming, obviously there are going to be market opportunities. Technology is going to drive a fair amount of it, but let's not forget, regulation is going to drive a lot of it, and where it is and where it isn't, and what its cost is and what its cost isn't, and what its cost is perceived to be. You know, we don't have a level playing field today. We don't have fair competition today. We have subsidized "too big to fail" activities. Talk about money market funds as an opportunity. They've failed abysmally twice now, been bailed out twice, completely and entirely.

You want to talk about runnable risks, there's no better place to talk. When you think about how the ecosystem or the macro-financial system, however you divide it up with banks, nonbanks, shadow banks, or narrow banks, whatever you want to call them, it's going to be driven continually by regulatory arbitrage, where the activities are going to go where they can naturally and acceptably profit maximize, and that means cost minimize. To the extent you don't have a level playing field, particularly at the SIFI level, you're going to see the migration of risk from the more regulated banking sector to the more unregulated nonbanking sector.

This is not wildly controversial. It's well known, and we see it every day. When you see the ecosystem develop, it's not difficult to see how it's developing and what the drivers are. I did an op-ed, actually with the CEO of the American Banking Association for CNBC to talk about the need for a level playing field so that we actually get fair competition, which will better serve the American people in terms of products and services that they want and need, so that they can benefit from the technological changes to come and the market opportunities to come. The drivers, the fundamental underlying drivers, have to be addressed if what you want to ultimately get to is a level playing field.

Neenan: The interconnectedness is something that we certainly focus on. We've heard, I mentioned anecdotally, that some of the banks are talking about rationalizing who they're doing business with. Nonbanks, even though we've seen an uptick in unsecured issuance, they're still heavily reliant on the banks for financing. To the extent that they're starting to pull back, that's something that could constrain the nonbank sector, for sure. That with the structure of a lot of those vehicles, in the private credit space in particular, the advanced rates are attractive.

Lots of these nonbanks are affiliated with alt managers who are paying massive Wall Street fees to the banks, and so they're going to be there for some of their funds, but some of the smaller players may not be so lucky, and maybe kind of competed out if they're being a bit more selective about that. In the private credit space, too, banks are so heavily involved in providing revolvers to those companies. I don't think the nonbanks are set up to do that so much. We've seen some interesting structures in the securitization market where you can kind of finance CLOs, but there's not a huge investor base there. There's still going to be that interconnection because I don't think nonbanks could ever separate themselves completely because they need banks as partners, and they need banks to provide what they can provide still, for the company that they're lending to.

Lehnert: There's a good question on that coming up here, but let's go to Philipp.

Schnabl: Maybe let me just pick up on a few points which were made earlier. Stijn said nonbanks tend to be procyclical. Meghan said we have to be careful about the interconnectedness with respect to the credit lines. I would take these points and incorporate them when I think about to what extent the monetary policy mechanism, or deposit channel more generally, is going to work going forward, because to the extent that it affects lending the question is are other lenders stepping in and maybe picking up the slack? We are looking at this very carefully, now, with respect to small business lending, but also to serial lending.

One word on that: we haven't talked about that, but the residential mortgage market is obviously a very big market, and sometimes there's the sense in which the banks are not that important anymore because Quicken, until recently, was the largest mortgage originator. When you think about the cost of capital of mortgages, it misses that the banks, to a large extent, are still one of the main buyers of agency MBS.

What we have seen is now with quantitative tightening, and the banks at the same time pulling back because of the deposit channel, both of these buyers are stepping out of the agency MBS market. Others have to pick up the slack, and you see that spread between Treasuries and agency MBS opening up. The cost of mortgages goes up because Quicken relies primarily on synchronizations and credit lines from banks for the warehousing. Trying to understand this mechanism and how it will play out as we're raising rates, that's an interesting aspect to look at going forward.

Lehnert: Excellent. Question from Krishna about the channels, the kind of systemic risk channels or potential contagion from private credit, private equity, more broadly into public markets, into the banking system. Meghan, how do you think about what if there's severe difficulties in this private credit world? How do you think about that spilling over?

Neenan: The banks are still very senior in the capital structure, and the nonbanks have kind of stepped in to take that over. As I said, Blackstone's BDC, for example, is 98 percent, 99 percent first lien, but they don't want to do the revolvers and so the banks are involved and still providing that as a service. In some ways, the banks are going to just continue to pull back. The hung deals that they had at the end of 2022, that just created even more opportunity for the private credit space to expand. You see alternative investment managers who are doing now their own capital markets activities, so they have all the deals already. They're starting to cut even the Wall Street banks out of some of those things as well.

In terms of the private credit space, they provide revolvers, certainly, to a lot of them. They provide subscription facilities, which was something that came up with the failure of Signature Bank and SVB. They were big subscription facility providers. Is there a place to fill that, and who needs to step in to do that? They're going to continue just to rationalize their exposure to the private credit lenders who are focused on the biggest guys in terms of providing revolvers. We haven't seen really much change in the structure there, even with the passage of the SBCAA in 2018, which allowed BDCs to double their leverage, there hasn't really been a meaningful change in the terms of the bank facilities. We had to take a look, too, and say, "Okay, does that just mean everybody gets downgraded because your leverage is going higher?" It was the same with the banks, that they were doing the same analysis, but really the covenants stayed the same, the pricing stayed the same, so they were comfortable, too.

Ultimately, what the Financial Stability Report found, too, is that most of these private credit funds are relatively lowly levered. The average they quoted was 1.27, and most BDCs are levered at 1.25 times or below. So relative to banks, who are 10 times, or other finance and leasing companies that are 6, 7, 8 times, a lot of the private credit funds are still relatively conservatively managed. I do think one of the things we think about is, the Financial Stability Report mentioned redemption risk being relatively limited, you are seeing some creation of new vehicles which are trying to provide liquid solutions because retail investors are interested and alternative managers get a lot of fees for those funds. If they can provide and transform some of these investments into what they deem to be liquid, you have some redemption rates associated with the funds. That part of the market is going to continue to grow. We've seen it with the perpetual BDCs. Blackstone was a first mover with $53 billion of assets in two years, but lots of others are following suit. Just redemption risk in the private credit space is certainly going to increase.

Lehnert: What do you make of this argument that Emil Siriwardane ... I don't want to put words in his mouth, but let's just say that some people have looked at this and they've had the view that the dry powder that's on the sidelines, whatever the retirement fund or the endowment may not be that sophisticated, may not understand that they have a contingent liability and that they've agreed to put in a lot of money if called upon by the general partner of the structure. Is this something that fits into your thinking?

Neenan: Yes. We've seen this, really, for a while. It's punitive though, if they're not funding their on-call capital commitments so they could lose their investment in the fund that they've had to date. When things start to pick up again, and private equity fundraising eventually becomes much more attractive again, we're certainly dealing with some denominator effects on being overexposed. You're not having a lot of realizations, so the cash flows that are coming back from legacy funds aren't there to help support their new investments in the next vintage fund. It's a much more challenging time for private equity fundraising. Once that comes back, endowments, pensions want to make sure that they're well positioned with those large alternative investment managers to make sure that they get what they want to get, the size of commitment they want to get in those funds. There's a lot of reputational risk around the LPs as well and making sure that they can fund those commitments because they could be cut out of the next fund.

As they think really long-term about what their investment horizon is, they have to do that. We cover some of the Canadian pension funds as well, who are big investors in alternative managers. Some of those guys are huge, and they still have a significant amount of liquidity. I do think you're going to see, over time, some shift into more and more illiquid assets. Some of the big Canadian guys have talked about 20-25 percent, and certainly longer term if the alts get their way that will continue to tick up.

The biggest untapped place really is retail investors, and that's certainly a huge focus, and as I mentioned, insurance companies as well. There's a lot of dry powder, for sure. As we look, historically, there's only a couple of cases really where LPs did not make good on their commitments, so there is a really strong track record around that. As you see, subscription facilities, too. Banks are extending those, and they're taking a look at LPs and saying they're counting on LPs to make good on those commitments, because the pricing on those facilities is really attractive as well.

Lehnert: We have some other questions here, but let me just ask, when it comes down to systemic risk from this sector, whether the other panelists, any of you other guys, have anything to say on this?

Claessens: You mean systemic risk, and that the nonbanks have to better regulate it. On the private equity and the private debt, I'm less in tune with the current thinking in the US, at least. But if you asked me the broader question, I think of it as always, can we have better and bigger buffers in the sector in the first place? That's always a question about the business model, right? How far do you push that without making, let's say the money market funds or the open-ended funds, no longer viable relative to the competitors? We also don't want to, in the process, basically regulate them in exactly the same way as we regulate banks, because then we're back to the same model that we had before.

The second set of regulations we need to think much harder about is the ex post. Faced with a situation of stress, whether we can do better in terms of redemption issues. Is it gates, is it swing pricing? Is it other forms where we put in a little bit of sand in the wheel to slow down the process in the most acute point in time, so that we don't have these liquidity issues anymore? We may want to look a little bit at the ETFs there. It's interesting that in the ETF sector, we haven't seen the same stresses sometimes. Although they hold the underlying corporates often, which in principle are not so liquid in the first place. But nevertheless, the ETF sector itself... maybe there is a mechanism there that we can replicate in some other parts as well.

The last thing we need to think hard about, but it's not something where we want to go, is the ex post liquidity facilities that we do offer. Do we have the excess rules properly set up, to the extent we want that in the first place? Is that a quid pro quo that we are looking for, in terms of the behavior ex ante, so that when we intervene ex post, we have the right balance there? There's a lot still there to be done. We need to budget principles for the nonbanks, like we have done for the banks. I don't think it's the scheme that Mervyn laid out yesterday, to answer that question, but maybe we want to go back to that at the end.

Lehnert: Yes, "the pawnbroker for all seasons." Okay, so we have a question about commercial real estate. You're essentially making the point that there's $3.5 trillion of commercial real estate debt out there. Two-thirds of it is held in the banking system, two-thirds of that is held at smaller institutions. The question doesn't ask this, but roughly speaking, a third of the total, in terms of the holders, is office buildings and downtown retail establishments. The industry is facing some fallout from the pandemic. There are a lot of concerns around the value of downtown office space in a work-from-home environment. Of course, the regional banking system is facing some stresses. Given that constellation of facts, the question is: is there a role for the nonbank sector in what has traditionally been a bank-dominated market? I don't know if someone has a view on CRE.

Neenan: Well, I would say based on that, a third of CRE is already probably in the nonbank space, right? Mortgage rates we rate, they certainly are involved. The alternative investment managers, they're involved in everything. Blackstone, Brookfield are the 800-pound gorillas in the CRE space, real estate space. Brookfield, interestingly, is more exposed to office properties in retail, and put out a white paper several years ago about just the future of office and felt a little bit more confident about it. I don't know that they would still have the same opinion today just given where everything has trended.

Generally, office is a small part of Blackstone's portfolio. Certainly, they moved more into logistics and multifamily and things like that, so they're certainly competing head on. The mortgage rates that we rate, generally speaking, have modest exposure to office, but they're looking to grow as well over time. There'll be bigger players in the CRE space, too. Lots of different funding structures, though. Some have some unsecured funding, and some are doing securitizations of those facilities. They'll continue to grow, and that's just another part of the market that will get more and more interest from the nonbank side.

Lehnert: One of the things that Stijn said, and a kind of a persistent criticism, is that the nonbank sector tends to be more procyclical, in particular the CMBS market. I guess there's a question of having seen issuance dry up, in the face of broader bond market stress in the past, if we're in a higher volatility environment do you think that that's a durable or stable funding source?

Claessens: The nonbanks, in the particular case of the CRE, could be the spare tire that you're looking for. We don't want to go there, necessarily, but to the extent we have a deep recession, we've seen in the past that these defunct assets are then bought up by a variety of investors. That is an outlet that you should push for at that point in time. For the cyclicality point, it's a little subtle in the sense that it's more the stress periods that we want to avoid. We have what looks like a stable period, and then we have these spikes, and that's a little bit more on the market-based financing of how we have structured the liquidity and other issues. That's a separate agenda.

Lehnert: This is a very technical question, Philipp, but essentially the point is: Once we get past the debt ceiling and Treasury resumes issuing bills, do you think there's a particular risk that that might attract deposits, draw deposits out of the banking system? That could be a risk event. You would normally think of that as being risk-reducing.

Schnabl: Yes, that's a great question. It came up yesterday. It's a risk and opportunity. I was mentioning money market funds before, actually to Dennis' earlier point. I've written about the risk of money market funds, especially prime funds, and there's been significant changes, but I've been careful to point out when I was making my example, that you invest in T-bills or reserves. We do think that's liquid and safe.

Definitely the money market funds would want to invest in those, and that would draw deposits away from the banks. Clearly a risk for the banking sector along the lines I outlined, meaning that the betas probably would be higher, which means that's going to affect the capital and therefore the lending. On the other hand, if you want to have another opportunity for banks to compete with outsiders, if you think the market power of banks is getting too large, that's exactly what you want. You want other intermediaries stepping in, offering liquidity services. You can look at this issue from both sides, and we'll see how it plays out. If it doesn't go too fast, I don't see major financial stability concerns. That's definitely something to watch.

Lehnert: We have a question about macro prudential policies in the nonbank sector, a subject near and dear to my heart. There are two species of these sorts of policies. There is a kind of European style of policy, where there are loan-to-value caps, or minimum margin requirements that affect either wholesale or retail terms, in people's acquisition of debt. There's that cluster of macro prudential policymaking. Then there's the more crisis management or ex post financial stability, macro prudential policymaking, where I would put Mervyn King's "pawnbroker for all seasons."

I went back last night and I looked up the relevant parts of his book, and that book is very much an excellent book, strongly recommended. He focuses on what he refers to as alchemy, which is the conversion of the straw of long-term illiquid assets into the gold of highly liquid, short-maturity liabilities, mainly in the banking system but of course we know that that's also very much the business of the nonbank system as well.

If one were to have a pawnbroker for all seasons, one could imagine setting up a lending facility for nonbanks, an emergency lending facility, that would, let's say, take some of the risk off the table that's inherent in that kind of structure. Maybe we'll just run down the panel and see your thoughts on either these kinds of ex ante, borrower-level restrictions, or ex post pawnbroker for all seasons, and macro prudential policymaking in the nonbank sector.

Claessens: I would add a third category. Of course, you mentioned the LTVs, et cetera. Those are more of what I call borrower-based micro prudential tools, but we definitely also need the lender-based micro prudential tools. We know them in the banking system, we have the CCyB [countercyclical capital buffer], but actually the systemic surcharge for large banks would include that as well as an important micro prudential tool.

I question on the ex post part of it: the bond-maker of last resort, or lender of last resort. It's okay for the banks, of course, because we have done that and it is just, in some sense, a twist—maybe a specific application, in the case of the UK. When it comes to nonbanks, we then need to regulate them also, of course, in the same way, because otherwise we're going to unlevel the playing field. Do we really want to go there to regulate the nonbanks? There was another question, too: what is so special about nonbanks? They provide some efficiency gains.

It goes back to my first point. If you regulate them as banks, then you defeat the goal in the first place. We need to tailor that a little bit more specific to their issues, so the points I mentioned before about these redemption gates and the like: they're more meaningful. That's probably only applicable to the market-based finance, where we have the high-frequency shocks that we need to manage. For a little bit longer gestation shocks, which is the cycle that evolves over a year or two, that's going to be a little bit difficult to think of a countercyclical component for the nonbanks. I don't think we're going to probably ever going to get there.

The one thing I would encourage is to look at systemic entities within the nonbanks. There are some. Dennis, you may have the names in mind, but they arguably could be regulated, and should be regulated.

Kelleher: You know, the interesting thing about Lord King's approach is that, regardless of how you feel about the pawnbroker for all seasons, the real debate is: do we want to be dealing with these? How do we deal with these, ex ante, or ex post? I would hope we'd all agree, ex ante is better than ex post. To the extent that we're talking and thinking about how to deal with them ex ante, then it's an important contribution whether you agree with the details or not.

It's true that you don't want to have one size fits all, some cookie cutter that says regardless of what you're doing here are your five rules, or whatever the mix is. It's important when you want to talk about opportunities or claim deficiencies that they get actually balanced and weighted with what the risks are. Without having the information, knowing what the risks are, understanding the transmission channels, understanding the contagion risks, and all the other well-known risks between banks and nonbanks, you're somewhat regulating in the dark.

You are inevitably going to be in the ex post world, not the ex ante world. When you're thinking about macro prudential regulation, and we all agree at the SIFI level we ought to be way ahead of the game on the ex ante side, maybe less so on the non-SIFI level. We also have to pay attention that we do need, and we all benefit from, diversity in both the bank and the nonbank sector. One of the things we need to be careful of, whether it's ex ante or ex post, is the impact on diversity in the sense of whether or not you're driving consolidation, whether or not you're making too big to fail too much bigger, which we just saw in First Republic.

That gets to ex ante, too, which is to say that regulators having panicky weekends about what to do with a non-SIFI bank, frankly, should be a shocking, unacceptable circumstance in today's event. A failing bank is not a surprise. It's going to happen, it's happened, it's going to happen again. Why we don't already have in place war-gamed, alternate financing vehicles and financing players to come in and deal with that and be at the table in an effective, compelling way, rather than have a too big to fail bank come in with a balance sheet that's so big that they can always underbid by $1 so they can almost always guarantee to be the least-cost alternative. There are a whole variety of ways that we should be driving to the ex ante arena, to minimize the macro prudential implications of the ex post conduct of regulators. Market participants: get them to the table ex ante rather than ex post.

Lehnert: Interesting. Meghan?

Keenan: Just taking a narrower view, about just transformation of the illiquid into liquid. With the alts in particular, we've heard a lot about just suitability of different investment products for different types of investors, and a lot of the alt managers are looking at retail investors as the holy grail. Thinking about BDCs, retail investors can get access to that BDC just by buying the stock. It's liquid, they can get in, they can get out. Yes, they might lose money, but at least they can get out quickly. Then you have this new form of BDC that's launched, perpetual private. It is for accredited investors, but ultimately it's subject to limits on redemption. There is redemption there, but it is largely illiquid assets.

There's a lot of trying to get to the retail investors, but what alts do primarily is illiquid asset. Trying to find wrappers that can provide some access to the retail investors and provide a little bit of liquidity, it just feels like there's certainly the potential for some contagion there. We saw it already with the BREIT issues in the end of last year and early this year. Investors, these were the parameters and then there was a lot of headlines around gating, but I don't even know that it's a gate. That was really what was outlined: "Hey, your max is 5 percent," but then that leads to contagion to other Blackstone vehicles. Once we get larger with some of these other vehicles that have redemption risk, it's just much more contagion potentially, which could lead to some forced selling of assets and lots of valuation declines that affects lots of different markets. It's something that is really starting to change right now, and we need to really keep an eye on it.

Lehnert: Yes. Okay. A well-taken point, Meghan, actually. Philipp, this should be ... let me give you the last word, actually.

Schnabl: I will be brief. On nonbanks, I completely agree. If you have facilities and some kind of support, we have to think about the ex ante incentives that creates it. That's first order. On the pawnbroker, it's very interesting. I went back as well to look at this. I have some new academic work where we look at basically optimal liquidity and interest rate risk management, given the business model of banks I described. The problem you run into is as interest rates go up, as I described—and let's set aside runs by uninsured depositors—the deposit franchise value becomes a larger share of the firm's value.

If you have a pawnbroker where you say, "Well, you can borrow against my securities and my loans." They went down in value. In some sense, if you wanted to keep the same amount of borrowing capacity, you would have to lend against the franchise value. Otherwise, you're going to naturally have the collateral available to borrow at the pawnbroker. It's going to go down.

In some sense, you can interpret the facility which the Fed set up, where you're lending against par value—it's basically a negative haircut—as lending to some extent against the franchise value. That's the issue you run into with the pawnbroker. That's something one has to figure out. It wouldn't be a perfect solution, at least in the model we wrote down.

Lehnert: Okay. Good, excellent. Very thoughtful responses from everyone. Let's thank the panel here for the thoughtful comments. Thank you, guys.