Sunday, May 13, 2012

UK Central Bank Official Says Shadow Funds Sponsored by Banks Should Be Consolidated on Bank Balance Sheets; and MMFs Must Choose VNAV or CNAV

Shadow banking vehicles or funds that are sponsored or operated by banks should be consolidated on to bank balance sheet, emphasized Paul Tucker, Deputy Governor of the Bank of England. In remarks at a European Commission seminar, he also said that money market funds should be required to choose between being Variable Net Asset Value (NAV) funds or Constant NAV funds.

The definition of shadow banking employed by the Financial Stability Board and the Commission is credit intermediation, involving leverage and maturity transformation, that occurs outside or partly outside the banking system. In addition to leverage and maturity transformation, Mr. Tucker would include monetary services in that definition.

Shadow banking comes in many forms, he noted. The liquidity offered by some shadow banks relies almost entirely and openly on committed lines of credit from commercial banks. In these cases, the liquidity insurance offered by the shadow bank is derivative.

But for other shadow banks, liquidity services are offered without such back-up, making claims on the shadow bank effectively a monetary asset. Examples of the latter would include money market mutual funds and an element of the prime brokerage services offered by securities dealers to leveraged funds

The deputy governor posits that shadow banking vehicles sponsored or operated by banks are effectively part of their parent bank, including structured investment vehicles, conduits, and money market funds. Many benefitted from the financial support of their parent during the financial crisis. Thus, he recommends that shadow banking vehicles or funds that are sponsored or operated by banks should be consolidated on to bank balance sheets. While acknowledging that consolidation might require changes in accounting rules, which could take time, the senior official maintains that these vehicles and funds should be treated as consolidated in the application of Basel 3 regulatory capital requirements.

Even where a shadow bank is not de facto or de jure part of a banking group, he continued, many are fundamentally dependent on banks through committed lines of credit. The central banker believes that providing committed lines to shadow banks is riskier than providing such lines to non-bank businesses, since shadow banks are liable to call on their lines just when the banking system is coming under liquidity pressure itself.

Noting that this should be reflected in regulations on banks’ liquidity exposures, Mr. Tucker suggested that the draw-down rate assumed in the Basel 3 Liquidity Coverage Ratio should be higher for committed lines to financial companies than for lines to non-financial companies. This would result in banks holding more liquid assets against such exposures.

Claims on money funds have, in effect, become monetary assets in the hands of savers, noted the official and, in parts of the world, especially the US, they are treated like current accounts. Given the restrictions on their asset holdings, he said, they resemble narrow banks in mutual-fund clothing.

For a normal open-end mutual fund, he noted,  the value of investments in it fluctuates with the value of the vehicle’s asset portfolio. By contrast, most money funds hold themselves out as offering par under any circumstances; when they break the buck, they must unwind. Their investors run at that prospect, said Mr. Tucker, and so the funds themselves are flighty investors.

Compared to most types of shadow banking, money funds do not borrow in the usual sense. But by promising par, they are in effect incurring debt-like obligations, he reasoned, and can be exposed to leverage. Thus, he recommends that money market funds be required to choose between being Variable Net Asset Value (NAV) funds or Constant NAV funds, with any remaining CNAV funds subjected to capital requirements of some kind. Moreover, they all should be subject to gates or other measures that can be used to delay withdrawals in order to make runs less likely.

There must be a globally consistent approach to regulating money funds, he emphasized, and the US is crucial in this regard since the largest money-fund industry in the world is based in the US. Further, the US money market fund industry is internationally active; lending to banks, corporations and sovereigns around the world. This fact underlines the importance of the outcome of the deliberations of the SEC and of the Financial Stability Oversight Counsel in this area.

While hopeful that US authorities will take action, observed the UK official, if they do not, the EU and other global authorities will need to determine what if any measures they could sensibly take to make the financial system more resilient to the fault line that the money fund industry currently represents. One possibility would be for bank regulators to limit the extent to which banks could fund themselves short-term from US money funds and from other fragile and flighty sources, including CNAV money funds domiciled elsewhere.

The Deputy Governor emphasized that such a policy need not be targeted at US funds per se. Rather, it could be cast in terms of the liability structure and sources of funding of the banking system. The Basel 3 Net Stable Funding Ratio could be employed. He also noted that on some fronts, notably transparency, the EU should aim to catch up with the progress the US has already made.

Some shadow banks are businesses, such as securities dealers and finance companies, and not funds or vehicles. If they are financed materially by short-term debt, Mr. Tucker believes that they should be subject to bank-type regulation and supervision of the resilience of their balance sheets. In the EU, many dealers are investment firms and thus already subject to the same Directives as banks on capital adequacy. But this is not true of finance companies in many jurisdictions. The central bank official suggested that there should be a size threshold for applying bank-style capital and liquidity regulation to such non-bank banks.

For non-banks, he continued, any client moneys and unencumbered assets should be segregated and should not be used to finance the business to a material extent. It should, however, remain permissible for non-banks to lend to such clients on a collateralized basis to finance their holdings of securities, such as margin lending. This is an area where regimes vary enormously around the world or are non-existent. For example, the US domestic regime is stricter on this than Europe. Mr. Tucker called for a global discussion in this area.