Two recent speeches by financial regulators are the latest entries in an ongoing discussion about regulating nonbank financial institutions and financial stability. Decisions made in this area will have significant consequences for the health of our financial system.
Federal Reserve Governor Jeremy Stein's speech came in the form of comments on an academic paper that looked at how monetary policy affects financial stability through the actions of non-leveraged investors. Governor Stein, addressing the risks posed by asset managers to financial stability, argued that open-ended mutual funds could experience bank-like runs. Although explicitly refraining from making a regulatory recommendation, he discussed the role mandated exit fees could play in diminishing mutual-fund investors' incentive to run. He noted that "the rapid growth of fixed-income funds--as well as other, similar vehicles--bears careful watching" and recommended weighing monetary policy and regulatory interventions to address any market failures.
Governor Stein's remarks, although not a direct call for Federal Reserve regulation of asset managers, picked up on the bank-centric thread running through the Office of Financial Research's recent asset management report. The OFR report, which mischaracterized asset management firms and the risks they pose to the financial system, provides fodder for the Financial Stability Oversight Council as it considers whether to designate asset managers systemically important. The Council likely will also take note of Governor Stein's musings about the potential "run dynamics" in the open-end mutual fund context.
Before the regulators rush to designate asset managers or other securities firms, they should read a speech that SEC Commissioner Daniel Gallagher gave last week. He distinguishes the capital markets, in which "there is no opportunity without risk" of loss from the bank world in which principal preservation is key. A regulatory approach rooted in keeping existing financial institutions alive is out of place in the capital markets. Firms that do a bad job fail, and others step in to take their place. Commissioner Gallagher is concerned that the Federal Reserve's extension of bank-like requirements to nonbanks will undercut the capital markets' effectiveness and their mechanisms for pruning poorly performing firms.
The Federal Reserve, the OFR, and the FSOC are understandably trying to identify risks to the financial system. Their favored regulatory responses, however, appear designed to turn nonbanks into bank-like entities subject to bank-like regulations and operating in bank-like perpetuity without regard for the needs of their nonbank customers.