Question

In recent years, the US banking system structure has changed how?

Answer 1

• The first recent change addresses potential disruptions coming from money market funding of shadow banks – money market mutual funds and other investment funds that are allowed to maintain a fixed $1 NAV should be required to have floating net asset values.
- The primary MMIs today are MMMFs and repos. Individuals, institutional investors, and nonfinancial companies are the primary holders of MMMF and other MMI funds with a fixed $1 NAV, which in turn are major investors in repos along with other financial companies.
- Some have suggested that MMMFs should be backed by government guarantees. We see no reason why the safety net should be extended and the taxpayer put at risk when other solutions are feasible. In addition, providing government guarantees would require prudential supervision to prevent excessive risk taking, but it would not be effective because of the ability of funds to rapidly shift their risk profiles.
- The runs during the crisis on MMMFs occurred because of concerns about the quality of their investments and because of the promise to maintain a $1 NAV. MMMF investment rules have been strengthened by increasing the minimum average quality and decreasing the maximum average maturity of their investments. However, because of the difficulty in calibrating these requirements, it is not clear that the vulnerability of MMMFs to runs in a systemic event would be significantly reduced as long as the fixed $1 NAV is maintained. We believe reliance on this source of short-term funding and the threat of disruptive runs would be greatly reduced by eliminating the fixed $1 NAV and requiring MMMFs to have floating NAVs.
• Critics of eliminating a $1 NAV for MMMFs argue that this limits cash management options for large corporations. However, MMMFs were first introduced to evade interest rate ceilings on deposits, and the only remaining Regulation Q deposit rate ceiling – the prohibition of paying interest on business transactions deposits – was eliminated by the Dodd-Frank Act. Some may be concerned that their deposits will be largely uninsured, but they are uninsured when invested in MMMFs. In addition, European MMMFs historically have mostly used floating NAVs. Although the percentage of fixed NAV European MMMFs has increased in recent years, the majority still have floating NAVs. However, because of the difficulty in calibrating these requirements, it is not clear that the vulnerability of MMMFs to runs in a systemic event would be significantly reduced as long as the fixed $1 NAV is maintained. We believe reliance on this source of short-term funding and the threat of disruptive runs would be greatly reduced by eliminating the fixed $1 NAV and requiring MMMFs to have floating NAVs.
The second change addresses potential disruptions stemming from the repo financing of shadow banks – the bankruptcy law for repurchase agreement collateral should be rolled back to the pre-2005 rules. By making this change, mortgage-related assets would no longer be exempt from the automatic stay in bankruptcy when a repo borrower defaults on its repurchase obligation.
- One reason for the runs on repos during the crisis was because of the prevalence of repo borrowers using subprime mortgage-related assets as collateral. Essentially, these borrowers funded long-term assets of relatively low quality with very short-term liabilities. The price volatility of subprime MBS rose sharply when subprime defaults started reducing MBS income flows. As a result, haircuts on subprime repos rose sharply or the repos were not rolled over.
- The eligibility of mortgage-related assets as collateral exempt from the automatic stay in bankruptcy in case of default by the borrower is relatively recent. The automatic stay exemption allows the lender to liquidate the collateral upon default as opposed to having to wait for the bankruptcy court to determine payouts to secured creditors.
- Prior to 2005, collateral in repo transactions eligible for the automatic stay exemption was limited to U.S. government and agency securities, bank certificates of deposits, and bankers’ acceptances. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 expanded the definition of repurchase agreements to include mortgage loans, mortgage-related securities, and interest from mortgage loans and mortgage-related securities. This meant that repos collateralized by MBS, CMOs, CMBS, and CDOs backed by mortgage-related assets became exempt from the automatic stay.
- We believe the problem of runs by repo lenders would be significantly reduced by rolling back the bankruptcy law for repurchase agreement collateral to the pre-2005 rules. The problem with the current bankruptcy law for repos is it provides special treatment – that is, it essentially subsidizes – short-term funding with mortgage-related collateral relative to other longer-term repo collateral or securities-based lending. As with the safety net for banks, the subsidy leads to the overuse of short-term repo funding, and therefore the overproduction of risky shadow banking activities.
• Overall, these two changes to the rules for money market funds and repo would increase the stability of the shadow banking system because term lending would be less dependent on “demandable” wholesale funding and more reliant on term funding. Fixed NAVs, like the just-noted problem with current repo bankruptcy law, provide special treatment and therefore subsidize short-term funding. These subsidies lead to an overreliance on short-term funding and excessive risk in shadow banking activities. With the recommended changes, shadow banks would rely less on short-term wholesale funding and more on term funding, which would continue to be provided by institutional investors such as mutual funds, pension funds, and life insurance companies. While this might increase the cost of funds and, therefore, the cost of mortgages and other consumer loans, it would be less risky and more reflective of the true cost.