PHILADELPHIA (MNI) – In a speech at a Global Interdependence Center
conference Tuesday, Kansas City Federal Reserve President Thomas Hoenig
repeated his call for commercial banks to be restricted to their core
lending activities. He argued that the risks associated with dealing,
market making and proprietary trading are difficult to assess, monitor
or control.

Hoenig also proposed changes to the rules for money market funds
and repo instruments — such as eliminating the automatic stay exemption
for mortgage-related repo collateral — that he said would increase the
stability of the shadow banking system “because term lending would be
less dependent on ‘demandable’ funding and more reliant on term funding,
and the pricing of risk would reflect the actual risk incurred.”

The following is the second and final part of excerpts from his
speech:

Historically, bank investments were restricted to loans and
investments in investment-grade securities. As demonstrated in the
financial crisis, the complexity of many asset-backed securities made it
very difficult to determine their credit quality. As a result,
“complicated” multilayer structured securities should be treated as
other non-investment-grade assets are, and commercial banks should be
limited or prohibited from holding them.

Critics of restricting activities have raised concerns that it
would cause problems for U.S. banks because they would face a
competitive disadvantage relative to universal banks that are allowed to
conduct the full range of activities. They say it would drive U.S. banks
and jobs to other countries. If this were accurate, it would be an
unfortunate outcome, certainly. However, this conclusion should be
considered carefully before it is accepted. First, we have 200 years of
banking success in this country that tends to refute that assertion.
Second, it seems improbable that any other country should be willing or
able to expand its safety net to new large and complex banking
organizations. Third, and finally, the U.S. authorities should consider
carefully whether it is wise to insure and therefore protect creditors
of foreign organizations that operate in this country outside of the
U.S.’s prudential standards.

Reforming the shadow banking system

Critics of restricting the activities of banking organizations also
argue that it could worsen the risk of financial instability by pushing
even more activities to the unregulated shadow banking system. I agree
that focusing solely on the regulated banking industry would not solve
the problem and might in fact expand the shadow banking sector that was
an integral part of the financial crisis.

However, much of the instability in the shadow banking system
stemmed from its use of short-term funding for longer-term investment.
This source of systemic risk can be significantly reduced by making two
changes to the money market.

The first change addresses potential disruptions coming from money
market funding of shadow banks money market mutual funds and other
investments that are allowed to maintain a fixed net asset value of $1
should be required to have floating net asset values. Shadow banks’
reliance on this source of short-term funding and the associated threat
of disruptive runs would be greatly reduced by eliminating the fixed $1
net asset value and requiring share values to float with their market
values.

The second recommendation addresses potential disruptions stemming
from the short-term repurchase agreement, or repo, financing of shadow
banks. Under bankruptcy law, repo lenders receive special treatment as
compared to other secured lenders because they are allowed to take
possession of the underlying collateral if the borrower defaults. In
other words, repo lenders are not subject to the automatic stay that all
other creditors are subject to when default occurs. The bankruptcy law
also specifies the eligible assets for the automatic stay exemption.

One of the changes in the 2005 bankruptcy reform law was to make
mortgage-related assets used in repo transactions exempt from the
automatic stay. Prior to 2005, only very safe securities were exempt
from this stay. The change meant that all of the complicated and often
risky mortgage securities could be used as repo collateral just when the
securities were growing rapidly and just prior to the bursting of the
housing price bubble. One of the sources of instability during the
crisis was repo runs, particularly on repo borrowers using subprime
mortgage-related assets as collateral. Essentially, these borrowers
funded long-term assets of relatively low quality with very short-term
liabilities.

Therefore, to improve the stability of the shadow banking market,
the bankruptcy law for repo collateral should be rolled back to the
pre-2005 rules and eliminate the automatic stay exemption for
mortgage-related repo collateral. This would discourage such activity
and tend to reduce the potential instability that is associated with
repo runs. Term wholesale funding would continue to be provided by
institutional investors such as mutual funds, pension funds and life
insurance companies.

Overall, these changes to the rules for money market funds and repo
instruments would increase the stability of the shadow banking system
because term lending would be less dependent on “demandable” funding and
more reliant on term funding, and the pricing of risk would reflect the
actual risk incurred.

Conclusion

The proposal I am placing before you today will not take all risks
out of the financial system. Reasonable risk is, in fact, part of the
financial system and essential to our economic success. However, the
proposal will improve the stability of the financial system by
clarifying where risks reside; improving the pricing of risk; and, thus,
enhancing the allocation of resources within our economic system. It
also will promote a more competitive financial system, as it levels the
playing field for all financial institutions. And finally, it will raise
the bar of accountability for actions taken and, to an important degree,
reduce the likelihood of future bailouts funded by the American
taxpayers.

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** Market News International **

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