Our new in-depth analysis of the FRB’s qualified financial contract (QFC) rules shows how far-reaching they are for the biggest banks doing business in the U.S. I agree with the Fed – the rule does a lot to end TBTF banks. Now, what about all the other TBTF financial institutions? In the U.S., banks hold about 25 percent of national financial assets while insurance companies, pension funds, GSEs, and “shadow banks” control seventy percent of the financial system’s fuel. In the QFC standards, as in most of its rules, the Fed is confident that harnessing big-bank risk corrals the rest of the financial system. Here, though, the Fed is wrong, and dangerously so.
There has been a lot of talk about “shadow banks” since the Federal Reserve Bank of Chicago in 2014 asked me for a paper about what should worry the Fed. Since then, U.S. regulators acted on MMF risk, at least to the extent the SEC was willing to countenance. Regulators are also comforted that the crisis transformed U.S. securities markets into a big-BHC arena. Although Fed officials publicly muse about the need to do something more about “shadow banks,” the QFC rule continues a string of massive post-crisis changes posited on the increasingly fragile assumption that solving for big-bank risk insulates markets from systemic shock.
I have said many times before that the growing role of non-banks in market-critical areas such as repos is in large part due to the rules imposed on the largest banks. And, as before, I do not say this to urge go-easy on big banks. My point is to remind policy-makers that economic-capital allocation does not follow regulatory edict – it goes where the profit is greatest. As more capital and other rules squeeze the ability of banks to conduct certain activities, the supply of providers may drop and the cost to counterparties will rise, at least for a while. However, new suppliers will rush in even where barriers to entry seem large, quickly building on the already-sizeable players that now lead FRB-NY President Dudley and others to urge a Federal Reserve market-maker-of-last-resort liquidity facility for companies outside the regulated banking system. In short, if we can’t rescue non-banks, we’ll have to bail them out all over again.
Although most global central banks already stand ready to bail out non-banks, they are nonetheless far less sanguine about their ability to stabilize their financial systems should major shadow institutions falter. The Financial Stability Board has thus proposed an array of resolution protocols for insurance companies, asset managers, and financial-market utilities.
No sign of them here in the U.S., nor of any work even within the big-bank resolution context for handling affiliated insurance companies and securities firms. Big banks have done yeoman work on these fronts in their own resolution plans, but they are an increasingly small part of the systemic problem. What happens if a state insurance guarantee association tells a large insurer not to abide by a QFC automatic stay when a big-bank counterparty goes bust? And, what of the bank if an insurance company is its QFC counterparty and the insurance regulator quashes QFC stays? What will asset managers, especially foreign ones do? The Fed thinks it’s got all these non-banks in an iron contractual vise, but commenters outside the banking system raised far-reaching questions about just how enforceable the QFC stays will be with or without adherence to the ISDA protocols.
And, what happens if a CCP or financial-market utility encounters severe stress? The QFC rule continues the policy push to central clearing and infrastructure consolidation despite widespread, well-taken fears that these centralized transaction points are a source of profound structural instability. Most are well insulated against traditional counterparty risk, but it’s far less clear how they would fare under operational or contagion risk. That’s why the FSB has tried to posit resolution protocols for them, but progress is scant at best despite widespread recognition that risk is high and growing.
Although Congressional Republicans this week renewed their efforts to repeal OLA and Trump Administration willingness to use this resolution tool is at best uncertain, the Fed and FDIC rightly believe that OLA is a critical policy ending TBTF, not enshrining it as opponents continue to assert. To make this assertion true not just for big banks, U.S. regulators need quickly to turn to mapping out how an orderly resolution would occur for giant insurers, asset managers, GSEs, or payment-system fintech kingpins.
As I said, economic capital goes where the money is. QFC contracts will go where the early-termination rights are easiest just as surely as credit markets have become a non-bank business. And, when financial push comes to systemic shove, as someday surely it will, QFCs based on contractual commitments with big banks are only as good as the paper they are printed on if the person holding the paper cannot or does not want to abide by it.