A Law and Finance Approach
Chapter 3: Other funding models
In addition to the depository bank, three other financial intermediaries are active in the credit market: dealer banks; insurers; and passive investment vehicles. Each is a regulatory silo with a distinctive legal regime. Some – such as the dealer bank and the private defined-benefit plan – are based on federal law. Others – such as insurers, public defined-benefit plans, and most special-purpose vehicles – revolve primarily around state law, although any contact with capital markets means complying with federal securities laws. This chapter examines their respective funding practices.
In effect, each of these silos revolves around a funding model particular to its defining business lines. Dealer banks serve as brokers and dealers in securities markets. Reflecting their large asset portfolios, dealer banks borrow heavily for the short-term – often overnight – pledging securities as collateral and maintaining a rough match between their assets and liabilities. Income assurance entities such as insurers and pensions make long-term promises in exchange for premium inflows. While these inflows reduce the insurer’s need to borrow, this profile produces a mismatch between long-term liabilities and liquid assets, that is, the converse of the depository bank’s borrow-short/lend-long approach. Passive vehicles, like asset managers and special-purpose entities, pool funds for investment while shifting liquidity risk to their investors or to contractual counterparties.1
A. THE DEALER BANK – EXPLOITING ADVANTAGES IN COLLATERAL
Writing after the 2007 crisis, Darrell Duffie analyzed the failure dynamics of a certain kind of non-bank intermediary that had played an important role in the financial crisis – the dealer bank.2 After registering as broker-dealers with the U.S. Securities and Exchange Commission, dealer banks become subject to a panoply of federal regulation concerning customer protection, record keeping, licensure, disclosure, and financing with additional licensure requirements imposed at the state level. Rather than focusing on maturity intermediation like the depository bank, the dealer bank’s business lines focus on derivatives, securities markets, and collateral management. As analyzed below, much of the dealer bank’s lending and borrowing revolves around these business lines.
1. Equity, Fixed Income, Currency, and Commodity Business Lines
The dealer bank emerged in tandem with the development of capital markets. During the 18th and 19th centuries, the rise of joint stock companies and share companies created new asset classes – private equity and debt securities. Governments also began financing operations by issuing public debt. Primary markets developed to accommodate the flotation of these equity and debt issues, which investors traded in secondary markets.
Corporations and their investors needed agents to effect transactions in the exchanges and over-the-counter markets. Agency services included executing particular orders, helping a corporation raise money through its issuance of shares or debt, and helping clients manage their investment portfolio. These were fee businesses in which the agent charged a commission based on the transactions involving the capital of clients. Firms that served as agents could also make proprietary investments for their own account or hold themselves out as market makers in a company’s shares or debt. This involved promising to use the firm’s own proprietary capital to buy in bear markets and sell in bull markets. Doing so meant that the firm was gambling with its own capital rather than using a customer’s capital.
Today’s dealer bank reflects this dual history of serving as broker and dealer. Part of the dealer bank business model grew out of fee-based services provided as agent. Today, as brokers, dealer banks execute and settle trades on behalf of clients, maintain accounting and regulatory records and hold the customers’ cash and securities, which become liabilities of the dealer bank. Additionally, dealer banks became active as outright investors in a variety of securities and other financial products. Large dealer banks describe the purview of their business activities as four sectors: equity; fixed income; currency; and commodities with ‘FICC’ referring to all of these business lines except for equity. Dealer banks may serve as broker or principal to transactions involving any of these sectors. To participate in these markets, dealer banks have a presence both in the physical markets such as the New York Stock Exchange and the London Stock Exchange, as well as over-the-counter markets like the NASDAQ and trading mechanisms such as electronic communication networks. Many dealer banks form part of financial conglomerates, though some operate as stand-alone firms.
More so than depository banks, dealer banks are protean, able to create and implement new financial practices or products with relative ease. Their worldview lends itself to creating, marketing, and bearing new kinds of risks with both regulated and open market entities. Swaps are one example. Others include depository receipts, exchange-traded funds, index products and funds, and private label asset-backed securities. This risk-friendly attitude also makes dealer banks an interface between banks and historically unregulated entities like hedge funds.
2. Lending and Borrowing
As part of its services, the dealer bank lends to its clients. Retail investors are familiar with margin loans extended by a broker-dealer to finance the investor’s purchase of a security. The dealer bank does the same on a larger scale for institutional clients. For example, as prime brokers to hedge funds, dealer banks helped these hedge funds to maintain positions in a variety of markets. As prime brokers, the dealer bank lends its hedge fund client the money to buy a financial asset. To protect its position, the dealer bank lends only a fraction of the asset’s value, the excess serving as margin to collateralize the hedge fund’s exposure to the dealer bank. The dealer bank will hold the asset, either in a segregated custody account on behalf of the hedge fund or in a form that lets the dealer bank rehypothecate the asset as collateral for a loan by the dealer bank. The hedge fund consents to this in exchange for the dealer bank charging the hedge fund less for its loan.
Brokerage and proprietary investment leaves the dealer bank with substantial inventories of financial assets, which the dealer bank uses as collateral for short-term loans. Dealer banks come to hold assets for several reasons. As investors for their own account, dealer banks hold a wide variety of financial assets, purchased on the open market and from clients. As brokers, dealer banks hold assets in custody on behalf of their customers. Dealer banks also receive assets from clients to hold as collateral for loans extended to these clients. Dealer banks receive collateral by lending to clients on margin, borrowing a security (or structuring the securities loan as a reverse repurchase agreement), and from derivatives trades in which a counterparty must collateralize its exposure to the dealer. As a result of these activities, dealer banks amass large portfolios of financial assets.
Unlike depository banks, dealer banks lack access to insured deposits and – historically at least – did not qualify for last resort lending from the central bank.3 One source of financing is subordinated debt, which can help the dealer bank meet its regulatory financing requirements. Since their business model results in holding large inventories of financial assets, dealer banks have developed several ways to finance inventory, typically without having to resort to a depository bank. Dealer banks use the wide range of assets they hold (both as fiduciaries of clients and as outright owners in their proprietary accounts) as collateral for short-term loans. One common format is the repurchase agreement. Although arranged as two separate purchase and sale transactions, these are collateralized loans for a short term. The margin is often small, but large volume transactions allow the dealer bank to reduce the costs of carrying them. Dealer banks have learned how to extract the collateral premium from these assets through standardized, high-volume, low-margin trades.4
Given their comparative advantage at executing these high-volume, low-margin trades, dealer banks often negotiate for the right to rehypothecate assets received by customers and counterparties by re-pledging these assets as collateral for a loan by a dealer bank. Assume the dealer lends cash to a hedge fund, which collateralizes the loan with Treasuries. These transactions leave the dealer with two legal obligations: it must repay the insurance company; and it must return the collateral to the hedge fund after the loan is paid. The dealer also has two rights: it is owed cash by the hedge fund and collateral by the insurance company. The dealer then pledges those securities as collateral for a loan from an insurance company. The collateral provided by a derivatives counterparty provides a similar opportunity. In a derivative, one party (the short) owes the counterparty (the long) money. The long may demand that the short collateralize the credit exposure. The long remains liable to return the collateral to the short, but typically the long can reuse that collateral for its own purposes, including as collateral for its own loan.5
The dealer bank may also negotiate for broader rights of use that essentially replicate contractually the incidents of ownership. This way the dealer can use the borrower’s collateral not only for re-pledging but also in outright transfers, as in settling a short position. Doing this exposes the dealer bank to risk because it remains contractually bound to return the borrower’s collateral at loan repayment. As these examples suggest, grants of rehypothecation rights may create a daisy-chain of trades in which counterparties serially retransfer the same collateral. Because the dealer bank can re-pledge the collateral, one can think in terms of the velocity of collateral through serial transfers, just as the same dollar bill may change hands several times.6
Customers also provide funding by leaving deposits with the dealer bank, sometimes as an investment but also as collateral for a transaction. The hedge fund may also keep more on deposit with the dealer bank than is required. Under the Securities and Exchange Commission’s net capital rule, cash that a dealer bank’s client can demand is considered a free credit balance, which the dealer bank must keep in an account separate from its own assets.7 The amount over the required margin is an excess credit balance that the hedge fund may withdraw. This makes the dealer bank’s financing with excess credit balances risky, because – like any fickle institutional investor – the hedge fund can withdraw the balance, forcing the dealer bank to come up with substitute financing.
Even though they lend and borrow, dealer banks do not set out to intermediate term by following a borrow-short/lend-long strategy like the depository bank. In effect, a dealer bank has a split balance sheet – matched and unmatched. The matched part includes short-term arrangements to finance securities inventory through repurchase agreements and securities loan. Many of these financing instruments mature daily, but the dealer can easily refinance the maturing debt, either through the lender or in the collateral market. The unmatched part of the dealer bank’s balance sheet includes unhedged exposures to derivatives trades and any intentional mismatch based on an outlook about future price movements.
B. INSURERS AND DEFINED-BENEFIT PENSIONS – LONG-TERM LIABILITIES AND LIQUID ASSETS
Insurers represent another major regulatory silo, one whose legal content has until recently been determined by state insurance authorities. Insurers share important funding similarities with two other regulatory silos – the private defined-benefit plan and the public defined-benefit plan, both of which seek to provide their employees with income security. Private employers must comply with extensive federal regulation about how these plans are established, funded, invested and operated. They must also comply with the regulations of the Pension Benefit Guaranty Corporation, which guarantees vested pension obligations up to a threshold. In general, the defined-benefit plans of public authorities maintained for their staff need not comply with federal law: instead, each state’s constitution and governing law establishes the legal contours of these plans.
Federal law imposes standards to determine the actuarial sufficiency of covered defined-benefit plans offered by private employers.8 The federal government also maintains pensions, which must comply with federal regulation.9 Pensions offered by state authorities, however, face virtually no federal regulation. Instead, these public plans must comply with state law requirements, including standards about the adequacy of their financial resources to meet their obligations to retired employees. Private defined-contribution plans expose beneficiaries to market risk, and also to political risk in the form of reduction of benefits by state legislatures.
Though these pension types take different forms, they share a defining characteristic that impacts their funding structure, one that is predicated on a long-term relationship with clients. During the first phase, the client transfers resources to the intermediary, which invests them in assets. During the second phase, the intermediary pays the client a contractually-determined amount, either in a lump sum or through a stream of payments. Though insurance and defined-benefit pensions involve two separate regulatory silos, they share a funding model. Made up of liquid assets and long-term liabilities, this mismatch is the converse of the depository bank model.
In exchange for premiums, insurers promise to indemnify their clients from a variety of risks. Examples include policies that insure a person’s life or property or those that insure against the risk of loss arising from an accident or a particular liability. In business and investment, monoline insurers also underwrite policies to protect against discrete losses, such as borrower defaults on a bond owned by an investor. In a monoline policy, the investor would pay the monoline insurer a premium in exchange for its promise to indemnify the investor if the borrower does not make scheduled payments. These policies provide the client with security in the face of discrete events.
Insurers also offer products that pay a stream of income over time, such as annuities, guaranteed investment contracts, disability policies, and stable value contracts. These policies provide income security over a longer period. Many life insurance and annuity products let the insured surrender the policy to the insurer in exchange for getting its cash value, so these long-term promises can be cashed out in a lump sum payment just as property insurance is.
Insurers use these premium proceeds to acquire considerable asset portfolios from which future obligations to policyholders will be funded. In general, statutory and contractual provisions require that the insurer buy only investment-grade assets. Their needs for current investment make insurers and pension plans buy-side firms that provide capital for other intermediaries. The return on these reflects the success of investment strategy more than insurance underwriting, although it is by issuing policies that the insurance company gets the money to invest in its assets. Operating profit is measured by comparing claims paid and expenses incurred against premiums received, sometimes called a combined ratio. Dividends are paid from this net income with the rest being added to the insurer’s capital accounts.
As noted, the insurer incurs liability because it takes on obligations that are either a lump-sum payout or an annuity. As reflected in Figure 3.1, this liability drives the insurer’s funding profile. In financial terms, the promises made by the insurer in its policies are a liability because the beneficiaries become the creditors of the insurer. Just as depository and dealer banks borrow from their clients, insurers borrow from their insureds by declaring that in the future the insurer will perform a promise. The liabilities that an insurer takes on – in the form of promises to honor claims – may stretch out over a long period.
An estimate of these costs is reflected on the balance sheet as a liability called the policyholders’ fund, which reflects the aggregate value of the company’s duty to pay claims.10 An insurer’s liabilities remain somewhat unstable because it does not control the occurrence and timing of the outcomes embedded into policies. Because many of its liabilities are long-term, though, insurers have time to prepare for bad news.
Figure 3.1 Balance sheet structure of insurer
Life and annuity policies relate to outcomes that are certain (the insured will die or retire) but whose timing is not known. Most other kinds of insurance are more uncertain in that it is not even known whether the event will occur. For example, if customers are nervous about an insurer’s long-term financial health, they may surrender their annuities, putting pressure on the insurer as it attempts to fund its redemption obligation.
The insurer sets aside reserves for these policyholder liabilities. Nevertheless, all insurers face the risk that the ultimate cost of paying claims will exceed the amounts set aside to fund those claims.11 Moreover, the insurance profile can be very susceptible to changes in spot interest rates. Since insurers face mostly long-term liabilities, they can profit by investing in long-term assets. This is profitable so long as interest rates do not rise, at which point a portfolio of long-term fixed-rate assets would lose value. The simplest way to understand the impact of interest rates is to see the plan as a single fixed-rate bond. The plan pays a sum certain just as a bond promises to return principal and a liquidated amount of interest. If interest rates decline, it gets harder for the plan to meet its obligations. Conversely, if interest rates increase, it gets cheaper to service the plan’s promise.
Interest rates also play an important role in determining how well funded an insurer is. When forward rates are projected to be high (resulting in a proportionally high discount rate), the present value of the insurer’s liabilities is reduced and the anticipated financial return from its assets increases. The opposite happens when forward rates drop. In this case, a low discount amplifies the present value of these obligations while projecting a smaller revenue stream from investments.
Since insurers receive premium flows, they do not need to borrow much, apart from the effective borrowing they do from their clients. As a result, insurance companies often remain relatively liquid because they have time to adjust to unexpected losses or liquidity events. Nor do they have to issue many long-term bonds. Insurers do, however, transfer some of their underwriting risk by issuing catastrophe bonds. Catastrophe bonds are on-balance sheet liabilities with some similarities to securitized receivables or covered bonds because the payout on the former depends on a designated pool of policies. Insurers also reduce their risk by diversifying through pooling many such contracts and by transferring risk to a reinsurer. These reinsurance companies have a more conventional liability pattern in that – instead of a policyholder’s account – they issue more standardized debt.
Like banks, insurers have a mismatch between their sources and uses of funds. The insurer makes a long-term promise that is the opposite of credit: the obligation is a liability of the insurance company and an asset of the consumer. The bank’s mismatch revolves around liquidity risk but the mismatch of these assurance entities involves more long-term market risk. In effect, what these plans are trying to do is to better align the revenue streams from their investments with the obligations to make payments to their clients (and retirees in the case of pension funds). The moment of truth comes when the time comes for the insurer or pension fund to perform.12 Because these are long-term promises these funds have a buffer of time in which to adjust. Some insurers have also experimented with securitization to issue catastrophe bonds.
To help insure against loss, states have guarantee funds – financed by assessments on insurers – that can protect customers from loss when insurers experience financial difficulty. Until the 1990s, state regulators imposed fixed capital standards on insurance companies that did not reflect the particular risk profile of a company. After a series of insolvencies of large insurance companies, the National Association of Insurance Commissioners (NAIC) developed a risk-based capital rule that estimated an insurer’s particular risks from underwriting commitments, asset, and other market events. To a certain extent, this rule mimics the risk-based regulatory capital system for banks because it also uses a risk-based framework, one that lets regulators take both preventive and corrective measures based on an insurer’s financial condition. NAIC also maintains a database of financial information about insurers compiled by state authorities.
Pensions promote income security for retired workers by providing them with a stream of regular payments after they have stopped working and receiving wages. Today traditional pensions are organized as defined-benefit plans, which promise the employee a definite annuity value based on a formula, typically combining years worked, highest salary, age, and cost of living adjustments. In contrast, the other retirement vehicle is the defined-contribution account, to which both the employer and the employee contribute during her working life. Unlike a sum certain, the payout of a defined-contribution plan depends on the amount contributed and its investment return. In the defined-benefit plan, the plan bears market risk: in the defined-contribution plan, the worker bears the risk.13 This section focuses on the financing only of defined-benefit plans, that is, pensions.14
Both private and public defined-benefit plans have similar financial dynamics. These plans receive contributions during the working life of employees. At one point, these contributions tended to come just from the employer, although the trend is to require the beneficiaries to contribute as well, typically through a payroll deduction.
Pension plans can be funded in various ways.15 The plan may own an insurance policy that undertakes to honor the plan’s obligations. Especially for public pensions, the plan may remain on the balance sheet of the employer as a general obligation. Like the United States Social Security system, benefits may be funded on a pay-as-you-go basis. Finally, a plan may pool these contributions into large asset portfolios. Given their scale, pensions have become an important source of capital (both debt and equity) for businesses seeking financing.16 Because many of their liabilities are long-term, pensions can afford to invest in products of higher risk and return, like equities.17 Insofar as they invest in short-term assets, these funds reverse intermediate (compared with banks) because these short assets are financed with long-term liability.
Determining how well funded a pension is involves comparing the fund’s assets with some measure of its obligations. Similar to the policyholder’s account on an insurer’s balance sheet, pensions end up with sui generis liabilities reflecting the payout mandates of their beneficiary pool. Like insurers, pensions face a similar risk that their investments will not generate enough income to honor their obligations to retirees.
Pensions face funding challenges because the ultimate amount that the plan will owe to the retiree will not be determined with accuracy until immediately before the pension enters the income stage. Typically, the annual benefit to which a retiree is entitled is based on a formula using some number of the employee’s highest earning years. During the accumulation stage, the worker may be earning increasing wages that will gross up the amount of his periodic payments. In that sense, the dollar amount of the pension’s liability is real and inflation-adjusted, because it will always be based on the worker’s last wages. However, this leaves the pension with some risk that it will miscalculate its liabilities. Pensions also face some of the same interest-rate risks discussed above for insurers.
The notion of liability-driven investment has developed in the context of defined-benefit plans. The term is misleading because all investment is liability-driven, just as all securities are asset-backed. Moreover, defined-benefit plans do not have liabilities produced by borrowing from creditors. As with the insurer, the liability is a way of representing the fund’s legal (and moral) duty to its members.
What the emergence of the term means now, however, is that these income security funds are taking a closer look at how adequately they are funded. Due to demographic changes, many of these funds face larger payouts as more of their liabilities become current. One potentially troubling response is for these funds to invest in riskier assets. This is reminiscent of the savings and loan crisis, in which saving and loans dealt with creeping borrowing costs – which rose after deregulation of interest rates – by investing in speculative real estate.
C. PASSIVE INCOME CONDUITS – SHIFTING FUNDING LIQUIDITY RISK BY CONTRACT
The final regulatory silo is in effect an umbrella category non-bank intermediation mechanisms that give its clients access to passive income by segregating assets and allocating their income between investors. Some of these entities – for example mutual funds and investment companies – are regulated by federal law. Others may be governed primarily by state law – for example, as with special-purpose vehicles registered in Delaware – but may have to comply with federal disclosure requirements insofar as their securities are issued or traded in capital markets.
Regardless of their particular regulatory profile, these mechanisms represent variations on a theme: segregating income-producing assets (securities, securitized receivables, or other kinds of assets) and allocating their income based on a priority scheme. The simplest version of this approach is the special-purpose vehicle used for securitization. More complex versions are asset investment pools such as mutual funds and asset management companies.
1. Special-purpose Vehicles
The special-purpose vehicle (SPV) was the atom of much of the new credit market, which expanded into new practices built on secondary markets for credit products. The SPV can take different forms, including a corporation, a limited partnership, or a trust. Unlike the other intermediaries studied here, however, the SPV is only an accounting and legal entity used to implement a transaction: it has no staff, office or expression other than its legal rights and duties. Its raison d’être is another firm – often a depository bank – which has or can originate long-term receivables, including residential mortgages or commercial loans. Rather than waiting for the receivables to amortize, the originator wants to cash them out.
The originator sells the receivables to the SPV, which finances their purchase with the proceeds of its own issuance of asset-backed obligations, certificated interests that represent claims to the receivables. The purchasers of these certificates tend to be institutional investors. To protect the priority of these investors, the SPV is bankruptcy remote, which means that the originator’s creditors cannot reach the SPV’s assets, that is, the receivables formerly owned by the originator. As the receivables mature, they generate a cash waterfall into the SPV, which allocates the cash to the certificate holders based on their respective seniority.
Note: * Senior investment-grade; most senior position; least risky; lowest coupon rate.
Figure 3.2 Tranche structure of securitization vehicle
As reflected in Figure 3.2, the right side of an SPV balance sheet typically does not resemble that of an operating entity, although the certificates are arranged in a hierarchy from liquidated to residual risk akin to the more familiar debt-equity array. The certificates are designed to appeal to different kinds of investment preferences about seniority, risk and credit quality. At the top of the heap are certificates with an investment grade rating, designed with an eye to institutional investors who can hold only high-quality instruments. To secure an investment-grade credit rating on its senior securities, the SPV may have to get a letter of credit or other form of credit enhancement from a bank. Lower down the hierarchy are riskier interests, including sub-investment grade interest designed for investors looking for a higher, more leveraged return.
As the rights of certificated investors mature, they become payables that put funding pressure on the SPV’s money position. When the cash flow waterfall does not yield enough cash to honor all maturing payables, the SPV must turn to external sources of liquidity. To this end, the SPV may obtain a liquidity line from a bank to cover any shortfalls in the cash flow waterfall.
Many of these vehicles are financial outgrowths of banks and other financial firms. Securitization lets companies disaggregate their balance sheet by spinning off portfolios of assets and liabilities into separately-capitalized entities. When financial conglomerates such as JPMorgan or Goldman report that they consist of several thousand distinct legal entities, most of these are SPVs established to provide some degree of asset and liability segregation and legal separation from the parent. Once spun off, these entities have different ties to the original parent.
This can make it difficult to determine the legal perimeter of the parent bank. Enron’s practice of using special-purpose vehicles provides a notorious example. Enron established dozens of these SPVs, each of which issued liabilities. When the company entered into crisis, it was forced to reconsolidate those SPVs on its own balance sheet, which fell apart from the cumulative weight of the reconsolidated liabilities. Even when these SPVs are legally separate, banks sometimes engage in their own version of too-big-to-fail by voluntarily providing financial support when the entities get into trouble, that is, moral recourse. The SPV’s liabilities migrated back onto the originating entity, whose leverage increased.
2. Investment Funds
While special-purpose vehicles arise in the context of a particular transaction with designated receivables, investment funds also use conduit structures, but they tend to be structured as longer-term entities, such as mutual funds, asset management companies and investment trusts. Rather than taking on proprietary risk, the sponsors of these funds earn money through fees for advising and administering the funds.
Often these funds are not heavily leveraged. For example, money market funds do not use leverage to increase their returns to investors. Money market funds are based on the idea that high-quality commercial paper’s price will not fluctuate, an assumption that the 2007 crisis did not bear out. As a result, it is the fund’s investors who bear the residual risk – both up and down – in the fund. To a certain extent, this arrangement reduces the pressure on the fund’s money position, because the risk stays with the investor.
Another example of an investment fund – in reality, a complex of funds – is Blackrock, an asset manager with nearly five trillion dollars in assets under management. As emphasized by Blackrock as a defense to federal attempts to impose prudential requirements, assets under management belong to clients not the company, which holds these investment accounts for the benefit of its clients. Hence these assets are held as separate accounts with separate associated liabilities. Changes in the value of assets under management do not impact Blackrock’s residual position. Instead, the respective owners of the funds are the residual claimants. Blackrock earns management and advisory fees from these assets which do pass through its income statement to the company’s equity accounts. In addition to these separate liabilities, Blackrock also has its own liabilities attributable to it. In its financial statements, Blackrock presents an adjusted balance sheet that breaks out these separate assets and liabilities so that a reader can appreciate Blackrock’s net financial position, which is much smaller than the one reported on its GAAP balance sheet. This is a form of on-balance sheet secured finance because Blackrock’s general creditors cannot reach the assets under management.
* * *
So far, the funding portraits of these four business models – the depository bank, the dealer bank, the insurer, and the conduit – have presented them in equipose. The next Part analyzes how these intermediaries fared during the financial crisis that began in 2007.
1 To some extent, depository banks also engage in these activities. Depository banks can run bank dealer units that trade and underwrite certain securities, much like a dealer bank. Banks also issue annuities and the contingent credit products that banks offer involve the receipt of fees in exchange for issuing credit in the future, much like an insurance business. Banks have also long operated trust departments that were, in effect, internal asset management funds. So a bank can amalgamate all of these funding profiles. Also, financial conglomerates consist of all four business lines – depository banking, dealer banking, income assurance, and asset management. So understanding the funding dynamics of these discrete business lines helps – albeit in an impressionistic way – to build an understanding of how funding works at the conglomerate level.
2 Darrell Duffie develops the very useful notion of dealer bank to explain the activities of large financial institutions that are more active in securities markets and collateral businesses than commercial banks. This corresponds roughly to the largest broker-dealers in the United States and to the analogous business units in the universal banks of other jurisdictions. See Darrell Duffie, How Big Banks Fail and What To Do About It (Princeton University Press, 2011). In the United States, dealer banks came to be known as investment banks after a separation in New Deal legislation between depository and investment banking.
3 As a result, they have had to contend with the liquidity risks from wholesale funding without a federal safety net. The Securities Investor Protection Corporation provides customers some protection for their assets held by a broker-dealer. Unlike the funding subsidy that federal deposit insurance provides to depository banks, however, this customer insurance scheme probably does not convey a substantial funding benefit to the broker-dealer, in part because the broker-dealer must meet rigorous liquidity and customer protection requirements imposed by the United States Securities and Exchange Commission. Its net capital rule forces broker-dealers to maintain liquid assets to ensure their ability to meet their duties to clients. See 17 C.F.R. § 240.15c3-1 (2014). In effect, net capital rules limit what the broker-dealer can do with these customer funds and the assets into which they are invested. Also, separate reserve and customer protection requirements limit the broker-dealer’s ability to rehypothecate customer securities. See 17 C.F.R. § 240.15c3-1 (2014). These constraints offset any funding advantage that might accrue to a broker-dealer from free-riding on investor insurance.
4 In general, the dealer’s balance sheet only reflects the cash items, i.e., the cash it owes and the cash it is owed. To a large extent, these offsetting cash items result in a wash. So the balance sheet grows. Insofar as it is only cash financing this asset growth, this should make the firm appear more leveraged. Missing, however, are the offsetting collateral transactions – the dealer bank’s offsetting duties to get and give collateral. These collateral legs can involve risk, especially if market disruption makes it harder for the dealer to obtain the securities needed to settle its collateral delivery obligations.
5 A different transaction occurs when the dealer bank borrows securities and posts cash collateral. In terms of flows, this can look the same as a collateralized loan, but unlike a real cash loan what induces the trade is the dealer bank’s desire to hold the securities rather than the cash.
6 Manmohan Singh, Velocity of Pledged Collateral: Analysis and Implications 9 (Int’l Monetary Fund, Working Paper WP/11/256, 2011), accessed 1 June 2016 at http://nowandfutures.com/large/VelocityOfPledgedCollateral-wp11256(repo_hypothecation)(imf).pdf, at 9.
7 The liquidity coverage ratio examined later encourages banks to maintain an asset liquidity profile more like that of a broker-dealer. See Basel Comm. on Banking Supervision, Bank for Int’l Settlements, Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools (2013) [hereinafter LCR], accessed 2 June 2016 at http://www.bis.org/publ/bcbs238.pdf.
8 See Employee Retirement Income Security Act of 1974, 29 U.S.C. Ch. 18 §§ 1001–1461 (2015).
9 The federal retirement system is complex because it maintains several parallel retirement security schemes eligibility for which depends on where the employee works and when she started.
10 Richard Herring and Til Schuermann, ‘Capital Regulation for Position Risk in Banks, Securities Firms, and Insurance Companies’, in Hal Scott (ed.) Capital Adequacy Beyond Basel: Banking, Securities, and Insurance (Oxford University Press, 2005), 15.
11 Scott Harrington, ‘Capital Adequacy in Insurance and Reinsurance’, in Scott, Capital Adequacy Beyond Basel: Banking, Securities, and Insurance, 87, 88.
12 AIG took on this kind of risk by issuing credit default swaps.
13 Historically pensions were common in both the private and public sector, although the trend has been to substitute pensions with individualized private investment accounts for employees. The general trend is for employers to replace defined-benefit plans with defined-contribution plans, although many public employers still operate defined-benefit plans for their staff.
14 The funding profile of defined-contribution retirement accounts is more like the conduit structure discussed next. Some plans combine features of both defined-benefit and defined-contribution plans.
15 Jean Frijns and Carel Petersen, ‘Financing, Administration, and Portfolio Management: How Secure is the Pension Promise?’, in Zvi Bodie and E. Phillip Davis (eds), Foundations of Pension Finance (Edward Elgar, 2000), 332, 336.
16 As a result of their equity investments, they have become a new type of shareholder activist. For example, the California Public Employees Retirement System (CalPERS) represents the retirement contributions of California employees and has become a visible force in corporate governance.
17 E. Philip Davis, Pension Funds, Financial Intermediation and the New Financial Landscape 3 (Pensions Inst., Discussion Paper PI-0010, 2000), accessed 2 June 2016 at http://www.pensions-institute.org/workingpapers/wp0010.pdf.
This chapter examines the funding of three non-bank intermediaries active in the credit market: dealer banks, insurers and passive investment vehicles. Each of these regulatory silos has a distinctive funding model. Dealer banks active in securities markets as brokers and dealers acquire a large inventory of assets, typically used as collateral for short-term loans that are rolled-over at maturity. This form of funding inventory also creates a financial mismatch in term, although dealer banks tend to otherwise maintain a rough match between their assets and liabilities. The funding practices of insurers and pensions leave them with a converse mismatch: current inflows of premiums and contributions create liquid assets, while the entity’s promises to provide benefits create long-term liabilities. Passive vehicles like asset managers and special-purpose entities pool funds for investment while shifting liquidity risk to their investors or to contractual counterparties.
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