1. Regulation of Financial Institutions Eric S. Rosengren President & CEO Federal Reserve Bank of Boston Open Classroom Northeastern University Boston, MA November 30, 2011 www.bostonfed.org

2. Why Do We Regulate Financial Institutions?  If everyone wants funds at the same time cannot liquidate loans  Depositors want immediate access to funds  Borrowers want longer-term financing  Financial intermediaries borrow short and lend long – assume diversification reduces risk from maturity mismatch  Depression – bank runs – widespread bank closures 2

3. Depression Era Solution  Deposit Insurance – FDIC  Banks have special role – depositors get limited government guarantee  Taxpayers at risk during failure  Banks limited in what risk they take  Banks have capital requirements – CAMELS  Regular bank exams 3

4. Problems Emerge  Interest on deposits does not rise at weaker banks  Weak banks have incentive to take more risk  Gains go to shareholders, losses go to taxpayers  Use financial institutions for other goals  Savings and Loans  GSEs  Banks become larger and more complicated 4

5. Too Big to Fail  International loans – assumption that governments would not default  Real estate loans – assumption real estate values would not fall  Real estate securities – assumption securities with national pools of mortgages would be protected since national housing prices had not fallen 5

6. 2007-2008  Runs are not unique to banks  Investment banks – Bear Stearns, Lehman  Insurance – AIG  Money market funds – Reserve Primary Fund  Exotic structures – SIV  International transmission of shocks – global banks are global problems 6

7. Money Market Mutual Funds ( MMMFs )  Regulated by the SEC  Must maintain significant liquidity ratios  Limited in the duration and credit ratings of instruments they can hold  Not required to alter net value (NAV) to reflect small movements in underlying asset values  Like other mutual funds, not required to hold any capital as protection  This structure can generate shareholder “runs” during times of financial stress 7

8. Importance of Money Market Mutual Funds  Critical players in short-term credit markets  Significant buyers of CP, ABCP and CDs  Important source of financing for organizations dependent on wholesale financing  Largest investor focused on high-quality, very short-term paper 8

9. 9 Figure 1 Total Money Market Mutual Fund Assets Under Management Source: iMoneyNet September 12, 2006 - September 6, 2011

10. 10 Figure 2 Total Money Market Mutual Fund Assets Under Management by Type of Fund Source: iMoneyNet September 12, 2006 - September 6, 2011

11. 11 Figure 3 Daily Changes in Assets Under Management in Prime Money Market Mutual Funds August 1, 2008 - October 7, 2008 Source: iMoneyNet

12. Response to the Rapid Withdrawals  Treasury temporary insurance program  Federal Reserve Bank of Boston administered Fed lending facility  Addressed short-term liquidity needs of MMMFs  Helped stabilize short-term credit markets disrupted by rapid liquidations  Efforts proved successful at restoring stability, avoiding further harm  Balances have gradually declined (low rate environment and corresponding returns) 12

13. 13 Figure 4 Highest-Yielding Prime Funds Average Gross and Net Yields Source: iMoneyNet August 30, 2011

14. 14 Figure 5 Foreign Exposure of Five Largest Prime Money Market Mutual Funds Source: Crane Data, Mutual Fund Company Websites As of February 28, 2011 and August 31, 2011

15. Financial Stability and MMMFs  Actions have been taken recently – improved liquidity and monthly reporting of holdings  Credit risk and MMMFs holdings  Is the current structure appropriate given the critical role of MMMFs to short-term credit markets? 15

16. No One Proposal has been Settled on – My Preferred Approach  A meaningful capital-like buffer – perhaps 3%  If violated, automatically leads to conversion to a floating NAV  If plan for a buffer isn’t produced and accepted, require MMMFs to float NAV 16

17. Additional Actions  A more proactive regulatory approach  Reporting should be more frequent  Reducing a fund’s maximum permissible exposure to any one firm  Many (but not all) MMMFs have been significantly reducing exposure to troubled institutions – but are assets of riskier firms appropriate investments for MMMFs? 17

18. MMMFs are Intertwined with Another Systemic Risk Issue  Dependence of foreign branches and agencies in the U.S. on short-term wholesale funding  Not able to get deposit insurance or FHLB membership  Issuing jumbo CDs, CP, and repurchase agreements  During times of stress, less stable than retail deposits 18

19. Challenges from Europe  Banks are large relative to their economies  Global banks have significant operations in the United States  Many global banks have large exposures to European sovereign debt  Wholesale credit markets showing significant stress 19

20. 20 Figure 6 Bank Size Relative to Country Size: Assets of Largest Bank as a Share of GDP Source: Global Finance, IMF as of Year End 2010 Note: Includes the U.S. and all European countries with a bank ranked in the top 50 worldwide as of year end 2010.

21. 21 Figure 7 Stock Prices of Largest Banks in Europe and the United States Source: Global Finance, Bloomberg

22. Final Thoughts  Financial markets remain stressed  Many global banks are experiencing wholesale funding issues  We are not insulated from European stress  Political will in many countries is lagging for directly addressing problems 22