A Law and Finance Approach
Chapter 7: Concluding observations
This book promised a contemporary approach to understanding the funding dynamics of its protagonist – the bank – and trends in its regulation. Rather than suggest how bank failure may be reduced (a worthy goal but not mine here), this book has laid out a framework for analyzing the internal funding structure of a bank and appreciating its points of contact with external financing markets. In concluding, let me briefly recapitulate the main points.
First, bank funding should be seen as an organic notion that captures the financial consequences to the bank of acting as an intermediary. Historically, these activities revolved around the bank’s conversion of demand deposits into longer-term assets such as fixed-rate mortgages. Today, the bank’s intermediation is more complex, in part because of the bank’s involvement in a credit market organized around the originate-to-distribute model. The notion is a funding relevancy argument that links the bank’s internal financial structure to its role as an intermediary and its place in the liquidity value chain. In doing so, it also points to a concrete set of institutions and practices – how firms finance and refinance their short-term position, contingent liabilities, collateral markets – that help to unpack systemic risk and financial stability, two important post-crisis mantras that remain fuzzy. Both ideas will require regulators, academics, and lawmakers to better map the evolving patterns of funds flow in the credit market.
The funding mechanism integrates the bank’s funding liquidity and its capacity for loss absorption. Funding liquidity refers to the bank’s ongoing ability to successfully meet its payment and outflow obligations. To this end, the bank’s liability structure plays a key role in fixing the timing and amount of these obligations. The bank’s assets also impact its funding liquidity because they can provide liquid resources with which to meet payment obligations. While funding liquidity addresses the bank’s routine operations over a relatively short-term horizon, the bank’s loss-absorption comes into play only in exceptional circumstances when financial losses mount. In this situation, the bank’s equity cushion determines how much loss it can absorb during a market downturn.
Second, within funding the money position occupies a special place deserving sustained and focused attention. An interval that spans the bank’s intra-day, overnight and short-term financial structure, the money position is the bank’s threshold for survival as a financial intermediary. In important ways, the money position is the true locus of the bank’s intermediation because it is there that the bank transforms funds and credit inputs (from the right side of the balance sheet) into new asset outputs. These transformations occur as an intended byproduct of settlement, funds transfer, collateral exchanges and a variety of operational tasks not visible to bank consumers. When the federal government provides back-up funding to a borrowing bank, it is to help keep the money position performing liquidity intermediation.
Though the 2007–2008 crisis impacted different kinds of financial intermediaries, disruption of the money position was a common factor. Whether the disruption occurred due to interruption of securities financing markets (Bear Stearns), the burden of unprovisioned-for liabilities that suddenly mature (AIG), inadequate resources to meet daily redemption requests (money market mutual funds), or asset congestion on pipelines to moribund secondary markets (banks and many others), these problems became emergencies justifying public intervention only when they threatened the operational integrity of the money position. The turning point came with the Federal Reserve’s financial rescues because they reanimated the ability of depository banks, dealer banks and other non-bank intermediaries to successfully manage their money position. Reflecting the regulatory learning from these episodes, the liquidity coverage ratio directly targets the bank’s money position. If the ratio works as intended, banks should sustain higher levels of liquid assets, which should reduce the likelihood that they will turn to the central bank for emergency liquidity.
Third, bank funding regulation – including prudential regulation – should be seen as a unified discipline that targets bank funding (for both public and private interests) rather than as a series of unrelated requirements. Not surprisingly, some have suggested that capital and liquidity should be seen as somewhat substitutable.1 The current prudential regime emphasizes the bank’s short-term liquidity – as exemplified by the liquidity coverage ratio – and its loss-bearing capacity. Soon, the net stable funding ratio will impose important constraints on the bank’s funding liquidity over a one-year horizon. Working in tandem, the liquidity coverage ratio and the net stable funding ratio may rebalance the traditional financial mismatch intrinsic to the borrow-short/lend-long model, raising questions about whether banks remain special as liquidity intermediaries. To a certain extent, this rebalancing will mean that banks earn less on some assets (the most liquid ones) and pay more for longer-term funding, something that will impact the bank’s net interest margin. In time, regulation may also address the swathe of liabilities beyond the one-year horizon and before permanent capital begins. As funding regulation continues to evolve, this book’s approach will provide a useful framework for understanding new regulations.
Fourth, regulators have become more pragmatic about matching funding regulation with business models rather than regulatory silos. Before the 2007–2008 crisis, regulators tended to adhere to the system of regulatory silos, which matched financial activities to particular legal forms, each of which had a distinct regulatory profile. The financial rescues implemented by central banks and governments both validated and rejected the dealer approach to credit markets.2 For example, the Federal Reserve formed its own shadow banks in order to rehabilitate the structured finance products that had contributed to the crisis. At the same time, major dealer banks including JPMorgan and Goldman Sachs were absorbed into the banking supervision universe when they reorganized themselves into bank holding companies, subject to the jurisdiction of the Federal Reserve. This re-intermediation of formerly shadow banking suggests changes to the business of banking as the traditional divisions between depository and other forms of financial intermediation become hazier.
After the crisis regulators are more willing to look through legal forms in order to more effectively reach regulatory targets. Doing this often turns on the funding models of financial firms. Insofar as legally different entities show a family resemblance to depository banks, these non-banks run the risk of becoming subject to prudential regulation, as suggested by the fate of financial conglomerates designated as systemically important by the Financial Stability Oversight Council (FSOC). By helping to draw parallels between depository banks, dealer banks, insurers, pensions and passive income conduits, this book provides a useful tool for comparing financial firms in terms of their funding models.
Finally, these developments elevate the importance of the bank’s treasury operations, a back office function that has become a hive of compliance initiatives and profit-seeking strategies. Though structured in different ways, every bank or non-bank financial intermediary relies on treasury operations to manage the cash position, collateral flows, maturing obligations and the short-term funding needs caused by draw-downs on contingent credit facilities. Treasury is the steward of the money position and, in general, of the bank’s short-term funding operations. Increasingly, these treasury operations are imbued with regulatory consequences, hence they deserve attention. As banks struggle to maintain a net interest margin while complying with regulatory liquidity requirements, treasury operations will become a more important part of the bank’s business model overall.
1 See, e.g., Jochen Schanz, A Joint Calibration of Bank Capital and Liquidity Ratios (2011) (on file with author).
2 An unfortunate consequence of these processes is that Congress has significantly increased its legislative oversight of the Federal Reserve. In 2015, Congress raided the Federal Reserve’s capital account to fund a highway appropriation. In 2016, Congress began to consider proposals to interfere with the central bank’s ability to set the rate paid on the excess reserves that banks keep.
The book concludes with five major conclusions about bank funding. First, bank funding should be seen as an organic notion that internalizes the funding liquidity and loss-absorption consequences of the bank’s role as an intermediary. Second, within this notion short-term funding liquidity – its money position – deserves special, focused attention because it is the bank’s financial threshold for survival. Third, funding regulation – be it of banks or nonbank intermediaries – should be seen as a unified field with inter-related elements that address funding liquidity and loss-absorption in complementary and, to a certain extent, substitutable ways. Fourth, since the crisis lawmakers are more likely to look beyond an enterprise’s regulatory shell to determine whether the enterprise presents financial risks that justify funding regulation. Finally, these developments elevate the status of the bank’s treasury operations, a back office function that has become a hive of compliance initiatives and profit-seeking strategies. As banks contend with growing funding requirements, treasury operations will be at the heart of the business model.
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