REG-REWRITE TARGETS SHOW UP ON FED’S RADAR SCREEN
May 18, 2020
The May 15 Federal Reserve financial-stability report makes clear that the Fed will renew efforts to impose systemic rules on prime MMFs, leveraged hedge funds, and higher-risk securitization vehicles. Life-insurance capitalization in the BHC context will get tougher and nonbank mortgage servicers will either get new rules or find it hard to access the U.S. banking system. Credit origination via off-balance sheet obligations at big banks also has a bull’s-eye on it for next-round rules no matter all the COVID-inspired relaxation.
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The Federal Reserve’s latest assessment of U.S. financial stability made headlines due to the systemic-risk now blinking red on the Fed’s radar. Unremarked upon but also blinking closer to the horizon are conclusions about why some financial-sectors hit so much risk so fast and hard when COVID struck. Structural change for key nonbank sectors was already on the to-do list for the Fed and global regulators, but the new report provides considerably greater insight into where the Fed will turn first when the emergency subsides to the point at which prospective actions are possible. Politics will of course play a major role in not just what the Fed prioritizes, but also in what it and FSOC can do. However, the magnitude of a financial- crisis staunched to some degree only by trillions in Treasury and support makes action certain – the only question in our view is not if there will be a regulatory rewrite, but how fast it comes for whom.
After 2008, nonbank financial regulation largely hit a brick wall, leading to reform only through indirect results from all the tough Dodd-Frank standards imposed on big banks. This empowered nonbank financial intermediation and “shadow” structures of which Treasury and the Fed are now painfully aware. As a result, the post-COVID regulatory push will be far more sector symmetric:
- Prime MMFs, especially those with large positions in bank loans, are hot targets. We expect another run at MMF capital requirements for credit-risk heavy positions. Expanded U.S. or even global restraints on short-term wholesale funding are also possible. As we noted earlier, firewalls and other barriers will be built in bank-sponsored funds with a hard push by the FRB and large banks to impose like-kind standards via FSOC pressure on the SEC.
Leveraged hedge funds are another top concern, with the FRB likely to impose new restrictions on dealer-bank exposures and concentration to cool it off. FSOC is also likely to weigh in to broaden activity-and-practice rules across this sector via the SEC.
MREITs and CLOs will also come under systemic scrutiny, with activity-and-practice rules – capital ones definitely included – back on FSOC’s agenda. The Fed fears the worse for life-insurance capitalization, but neither it nor FSOC can do much about it. The Fed’s primary weapon is via insurance-focused holding companies with bank subs, and the Fed will wield this more forcefully going forward. If strain turns into realized stress, the Fed and FSOC will also return to insurance-resolution standards.
Big banks will not stand apart from the regulatory rewrite. New capital and liquidity standards are likely to constrain off-balance sheet lending, which the Fed showed reach $3.6 trillion right before the crisis. Unlike 2008’s credit-line draws, huge deposit inflows cushioned this blow. The Fed is not the least bit sure this scenario would work out as well next time around, noting also that it threw trillions into funding markets no matter the ability of the very biggest banks to stand firm.
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