Market-based Finance
Mark J. Flannery
Prepared for The Second Annual Conference on
Financial Market Regulation
May 1, 2015
The Securities and Exchange Commission, as a matter
of policy, disclaims responsibility for any private
publication or statement by any of its employees. The
views expressed herein are those of the author and do
not necessarily reflect the views of the Commission or
of the author’s colleagues upon the staff of the
Commission.
Squeeze a Balloon
• Regulated banks find it more expensive to
– Hold credit risk on their balance sheets
– Provide liquidity services to the nonbank sector.
• Even as the banks get safer, credit and liquidity risk will
migrate elsewhere.
• Institutional forms mean less than in the past.
• 70-30 vs. 30-70
• FSB and FSOC are (now) concerned about systemic risk in
the non-bank sector.
Some Market Finance Channels
Intermediation
Activities
Credit
Maturity
Nonbank lending institutions (e.g. GE
Capital)
X
X
“Pass through” securitization vehicles
--
--
Recent securitization vehicles
X
X
Mutual funds and ETFs
--
X
‘40 Act Mutual Funds
• Mutual funds promise next-day repayment, at
today’s NAV.
• Can they do that reliably with any sort of
assets?
• Under terms of the ‘40 Act, funds must pay
out for redemptions within seven days.
– Investor expectations?
– How can disclosure affect investor reactions to
losses or to possible “run” incentives?
What’s the worry?
“The concern is that if investors seek to withdraw massively
from mutual funds and ETFs focused on relatively illiquid
high-yield bonds or leveraged loans, the pressure could lead
to fire sales in credit markets.” (IMF Global Financial
Stability Report April, 2014 )
• Mutual fund liquidity has two dimensions
– time between sale of an asset and settlement
– need to sell less liquid assets quickly, perhaps in a stressed
market.
• No known, liquidity-related problems from (non-MMF)
mutual funds in the past.
• Will this time be different?
Doug and Phil Run a Mutual Fund
• How the assets are held may determine the systemic effect
of belief re-alignments.
• Assume a fund suffers a large redemption. The fear is
– The fund sells all its liquid assets, leaving those with higher
spreads.
– Late-redeemers are left to claim only the least liquid assets – most
costly to liquidate.
– Thus, a large redemption can start a run – because the NAV may
over-state the portfolio’s future value.
• Chen, Goldstein and Jiang (2010)
Asset Price
P0
P1
Ptemp
Time
t0
What’s a Fund to Do?
• Hold liquid assets (despite cash drag)
• Redemptions  sell a vertical or horizontal slice?
• Fair valuation of NAV
– E.g. a U.S. fund investing in foreign stocks
– “Fair value” cannot look ahead
• “Swing pricing” in Luxembourg, Ireland,
Australia
SEC Regulatory Tools
• If fire sales are possible, privately optimal
liquidity policies will be insufficient for social
purposes.
• In December 2014, Chair White reported that SEC
staff are working on rules for
– Liquidity management
– Stress testing
– Transition planning
– Enhanced data reporting (fund holdings, adviser
activities - e.g. indemnification in sec lending)
Large Funds?
• Analogy with large banks, insurance
companies.
• A fund’s systemic risk potential depends on its
activities, not size.
– IMF Global Financial Stability Report
– SEC staff research
Disclosure and Contagion
• FSB/FSOC expressions of concern often rely
upon investor panic.
• What could cause panic?
– Large losses
• Can ex ante risk disclosures avoid this outcome?
– 25% of bank equity lost every 30 days.
• Value of disclosure?
– Feared mis-valuation of mutual fund’s NAV
• Need strong advantage to first mover
• In a sector that is large enough to cause systemic
problems.
Stress Tests
• Dodd-Frank Section 165(i) requires stress tests
for asset managers with assets above $10
billion.
• Legislation compares to Fed stress tests
• Not a good analogy
– Sale prices?
– Redemptions?
An Alternative Approach to Liquidity
Management?
• Mutual funds investing in illiquid assets
– Broaden the set of interested investors
– Presumably increase the aggregate supply of such
assets.
• Forbid certain types of mutual funds?
– E.g. SEC has not approved a synthetic ETF since
2010
– At least two major advisers chose to avoid a bank
loan fund
– “Lots of investors don’t know what they own.”
Summary
• Tighter bank controls shift risks elsewhere.
• The system of market-based finance is large and
robust.
• Current supervisory concerns ≡ “bank run”.
• With disclosure and floating NAVs, how big a
worry is this? How big might it become?
• Stress testing sounds good to some, but the
details are yet to be specified.