The financial market turmoil resulting from the onset of the COVID crisis in early 2020 highlighted continuing risks to financial stability posed by non-bank financial intermediaries (NBFIs). Many financial oversight agencies have roles in crafting a regulatory response, but the Securities and Exchange Commission (SEC) will be most important in determining its effectiveness. While there are grounds for optimism that the SEC will finally take the macroprudential regulatory role it has been reluctant to play in the past, significant obstacles remain.
The integration of capital markets with traditional lending activities has been steadily increasing for decades. The 2007-2009 Global Financial Crisis (GFC) revealed not only the serious undercapitalization of traditional banks, but also the extent to which free-standing investment banks, money market funds, and other non-bank financial institutions provided a credit intermediation function. Post-crisis reforms increased the resiliency of banking organizations and eliminated their links to the Structured Investment Vehicles (SIVs) that lay at the heart of the precarious shadow banking system for mortgage finance.
The more stringent regulation made banking organizations—which are overseen by the Fed and now include all the formerly free-standing investment banks—a source of stability during the COVID crisis. But money market funds again experienced runs. And this time around hedge funds, mortgage real estate investment trusts, and bond mutual funds were also sources of stress. They suffered liquidity squeezes and began to resort to fire sales of assets into declining markets. Without the unprecedented liquidity provided by the Federal Reserve to so many capital markets, the consequences for many of those NBFIs, and for the financial system, would have been dire.
The NBFIs were obviously not the precipitating cause of the COVID financial turmoil. But their fragile funding practices and, in some cases, excessive leverage, amplified the stress. Indeed, the growth of many of these NBFIs has been fueled in part by regulatory arbitrage: They can avoid the capital and liquidity requirements now applicable to banks and their affiliates. The problem is that capital markets tend to be pro-cyclical and can thus increase systemic risk. In normal times margins on funding are low, reflecting a perceived low risk to the value of collateral and the ability of the borrower to repay. As stress increases, funding may be rolled over, but with progressively shorter funding maturities, by which lenders try to protect themselves. At some point, margins jump precipitously, or lenders withdraw entirely. Thus funding is cut off essentially overnight, which can result in fire sales and market panic.
Markets now have good reason to believe that, in extremis, the NBFIs will effectively be supported by the Fed. Thus we have the same conjunction of moral hazard and risk to the financial system that motivated the post-2009 changes to banking regulation. Many policy observers have argued ever since the GFC for a more proactive approach to regulating NBFI contributions to systemic risk. The 2020 experience produced something close to a consensus for a regulatory response. While it would have been better if the international Financial Stability Board and the agencies composing the U.S. Financial Stability Oversight Committee had acted earlier, their belated recognition of the vulnerabilities could still pave the way for action. This is especially the case in the United States as financial regulatory agency principals are replaced over time by Biden appointees.
This brings us to the SEC. In our balkanized financial regulatory system, there is no systemic risk regulator. The Fed has the expertise and at least a general inclination toward regulating with an eye to the stability of the entire financial system. But it has at best indirect, and often no, regulatory authority over many forms of NBFI activity. The SEC, on the other hand, has authority over investment companies and any financial intermediary whose buying and selling of securities meet the fairly capacious statutory definition of “brokers” or “dealers.” Exemptions from the securities laws for entities with small numbers of well-heeled investors do limit the SEC’s authority over hedge funds. Overall, though, the SEC has enough authority to act as a credible prudential regulator of market-based credit intermediation.
An agenda for this SEC role could begin with the following initiatives:
- Requiring margining practices that do not increase procyclicality and systemic risk for securities financing transactions.
- As mentioned earlier, the frequent practice in repo and other short-term lending markets is to reduce maturity, but not amount, as questions about a counterparty’s soundness arise. Then, after maturities have shortened, margins are increased dramatically if the counterparty’s circumstances continue to deteriorate. This leaves the already stressed borrower with little choice other than to sell its leveraged assets into what may well be a declining market. If many borrowers are also under stress (or become so because their holdings, similar to the dumped assets, lose value), the classic conditions for a self-perpetuating fire sale are in place.
- The SEC can, either on its own or in cooperation with the Fed and the Treasury, require minimum initial margins that would vary inversely with the maturity of the loan. This framework would inhibit financial firms from assuming unsustainable amounts of leverage. It would also force more gradual reductions in exposure and thus avoid some of the cliff effect we have seen in the last two financial crises. In the near term, action on short-term lending backed with Treasury securities is perhaps the most important step the SEC can take, playing its part in what will necessarily be a multi-agency effort to improve the functioning of Treasury markets.
- Neutralize first-mover advantage in fixed income funds.
- The vulnerabilities of money market mutual funds were again on display during the COVID crisis. The SEC has now apparently recognized that the limited reforms it implemented after the GFC were inadequate, and may even have exacerbated runs on those funds. Another lesson of the turmoil in the spring of 2020 was that the enormous growth in other open-end fixed income mutual funds—including bond and bank loan funds—created run risks that resembled those created by money market funds.
- These funds offer relatively quick (usually one-day) redemption of shares of a security founded on debt instruments of longer—sometimes considerably longer—duration. Instruments such as high-yield corporate bonds that are less than highly liquid even in non-stress periods may be especially hard to sell in periods of stress. Knowing this, investors have an incentive to move quickly to redeem their shares in the fund, since the SEC’s forward pricing rule requires that those shares be redeemed at a price based on the NAV next computed after receipt of an order. This requirement applies even when the fund may later need to sell assets into a declining market—quite possibly at distress prices—in order to meet redemption obligations.
- It is unclear whether the rapid growth of fixed-income mutual funds has altered relevant markets to the extent that there are systemic risks beyond those contributed by first-mover incentives. At a minimum, though, the SEC can return to the unfinished business of money market funds regulation. It can also revise its complicated, but still excessively flexible, 2016 rule on liquidity risk in fixed income funds so as effectively to neutralize first-mover advantage.
- Improve data reporting requirements.
- Although the SEC does not have authority to require hedge funds to, for example, limit their leverage, it can require most hedge funds to report on their activities and positions. The current Form PF could be revised to improve and expand the information collected by the SEC. Similarly, the SEC could make use of its unexercised authority under the 2010 Dodd-Frank Act to require the reporting of the total swap return arrangements involved in the collapse of Archegos, as well as other swaps that may create common and potentially risky exposures across the financial system. To the extent possible, these improved data flows should be shared with Treasury, the Fed, and other regulators responsible for assessing and addressing systemic risk.
- Proactively assess and, as warranted, respond to developments in securities markets that contribute to systemic risk.
- As important as any near-term agenda items would be a shift in the SEC’s approach to systemic risk. In recent years the SEC has acted only after considerable pressure from other regulators and then often only with half measures. The reluctant, delayed, and ultimately inadequate response to money market funds in 2014 is the most obvious example. By adopting rules of more general application and/or orienting itself to monitoring and responding expeditiously as systemically risky activities evolve, the SEC could better complement the regulation of banking organizations by the Fed, OCC, and FDIC.
Although the COVID crisis underscored the risks to financial stability from non-bank intermediaries engaged in securities transactions, all those risks had been identified beforehand. Yet, with a couple of exceptions, the SEC has been reluctant in the years since the GFC to take on a systemic risk regulatory role.
One factor has been the agency’s limited bandwidth. The traditional SEC missions of protecting investors and assuring the operational integrity of securities markets are daunting in their reach. The volume of securities issuance is enormous, the evolution of issuer practices and products unending, and, unfortunately, the opportunities for fraud extensive. Securities fraud is often much publicized, with accompanying loud calls for action to punish the malefactors and provide redress to victims. The latest scandals predictably capture the attention of the Commission. Response to these immediate concerns can squeeze out consideration of important, longer-run financial stability concerns. It was telling that Gary Gensler’s first Congressional testimony as the newly installed Chair was dominated by recent investor protection issues such as “gamifying” securities trading and payment for order flow. There was only brief mention of systemic risks. Because, unlike the federal banking agencies, the SEC is dependent on Congressional appropriations, it is more likely both to focus on current Congressional concerns and to shy away from lower profile but important issues that might provoke a lobbying effort by affected firms to limit its appropriation.
Quite apart from the bandwidth issue is the institutional culture of the SEC. The dedication of the career staff to the investor protection mission has been a decided strength of the agency. But it seems to have engendered a resistance to assuming a financial stability function, which was evident in the joint rule-making exercises required by Dodd-Frank. Some staff, and even a couple of Commissioners, argued explicitly that the SEC had no financial stability responsibilities.
Whether motivated by fear of distraction from the SEC’s traditional mission or by discomfort with the analysis and judgment required for financial stability regulation, this attitude sits uneasily with the Dodd-Frank Act. The SEC is one of the agencies on the Financial Stability Oversight Council (FSOC) and, as such, is required to respond with either action or explanation for inaction to recommendations made by FSOC for the mitigation of financial risks. It was included in the joint rulemakings for some of the new regulations required by Dodd-Frank—the Volcker Rule, risk retention, and incentive compensation, among others.
The resistance to incorporating financial stability considerations into the SEC’s regulatory activities is also hard to square with the investor protection mission itself. After all, runs on money market funds or freezes in repo markets hurt investors in the first instance, even as they harm the financial system and economy as a whole.
In the last several years there have been some signs that the resistance is diminishing. While rules on mutual fund liquidity and margining fall short of what is needed, the SEC has taken steps that seem at least partially motivated by financial stability considerations. Moreover, the dynamic among the members of the Commission itself seems considerably healthier than it was during the period during which effective money market fund reform could not be accomplished. In the person of Gary Gensler, the Commission now has a Chair with a demonstrated commitment to addressing financial stability issues. Still, he and the rest of the Commissioners have their work cut out for them if they are to push the SEC’s institutional culture forward and to address financial stability risks alongside more conventional investor protection and market functioning concerns. If they succeed, the foundation may be laid for effective, appropriate regulation of NBFI activities that contribute to systemic risk. If not, opportunities for regulatory arbitrage and the spread of moral hazard will grow, and with them the risks of a non-bank sourced financial crisis.
 Metrick, Andrew and Tarullo, Daniel K., Congruent Financial Regulation (April 1, 2021), written for the Brookings Papers on Economic Activity Spring 2021 Conference. Available at SSRN: https://ssrn.com/abstract=3817621 or http://dx.doi.org/10.2139/ssrn.3817621.
 Testimony of Chair Gary Gensler before the House Financial Services Committee, May 6, 2021, https://www.sec.gov/news/testimony/gensler-testimony-20210505.