By Steven K. Beckner
(MNI) – Kansas City Federal Reserve Bank President Thomas Hoenig
said Monday that ending affiliations between primary dealers and
commercial banks and limiting access to the federal safety net need not
hurt the conduct of monetary policy — provided that the Fed revived the
expired Term Auction Facility.
“By broadening the Federal Reserve’s monetary tools to include the
TAF to provide term funds through the banking system in parallel with
the primary dealers, we could greatly expand the number of
counterparties used in the conduct of monetary policy,” he said.
Hoenig also urged reforms to the so-called “shadow banking system,”
including changes in the bankruptcy law to discourage the use of
mortgage-related collateral for repo financing.
As he often has before, Hoenig warned of the dangers of
“systemically important financial institutions” or SIFIs, which he said
“are larger than ever” since the government bail-outs during the
financial crisis.
During the crisis, the Fed hurriedly allowed investment banks to
become bank holding companies with full access to the safety net, which
includes deposit insurance, access to the Fed’s discount window and
access to the Fed-operated payment system,
Unless they are “simplified” and restricted, he said SIFIs pose a
danger not only to financial stability but also to free market
capitalism itself.
Hoenig is scheduled to retire on Oct. 1, 2011.
Hoenig said it is crucial to limit access to the safety net in
remarks prepared for delivery at a forum on the Dodd-Frank Act a year
after it was enacted.
Taking a dim view of that legislation, he said, “it is not an
anniversary that we can celebrate” because it did not reestablish the
Glass-Steagall separation between commercial and investment banking.
If further instability is to be avoided, Hoenig emphasized,
“institutions that have access to the safety net should be restricted to
certain core activities that the safety net was intended to protect —
making loans and taking deposits — and related activities consistent
with the presence of the safety net.”
“Banking organizations with access to the safety net should be
generally confined to the following activities: commercial banking,
underwriting securities and advisory services, and asset and wealth
management services,” he said. “Banking organizations should be
expressly prohibited from activities that include dealing and
market-making, brokerage, and proprietary trading, which expose the
safety net but have little in common with core banking services.”
“Thus, banking organizations would not be allowed to do trading,
either proprietary or for customers, or make markets because such
activity requires the ability to do trading,” he added.
Hoenig rejected arguments that SIFIs are needed to realize the
benefits of “economies of scale” and to provide adequate credit to
Americans.
He also rebutted concerns that his proposals would hurt the Fed’s
ability to conduct monetary policy.
“As a member of the Federal Open Market Committee, I realize that
we must consider the potential effects of these proposals on the conduct
of monetary policy,” he conceded. “The impact could be significant
because, as currently practiced, monetary policy operations are
channeled through a limited number of counterparties called primary
dealers. These dealers are required to participate in all auctions of
U.S. government debt and represent a key element in the implementation
of policy.”
Hoenig noted that “there are only 20 primary dealers” and that
“most are affiliated with commercial banks.” And he acknowledged that
“it is with this relationship that the changes I propose could affect
the conduct of monetary policy.”
“Specifically, given that primary dealers could no longer be
affiliated with commercial banks, would this inhibit market-making in
securities, including Treasuries, and therefore interfere with the
conduct of monetary policy?” he asked, then answered his own question.
“The answer is ‘no,'” he said.
Hoenig said “it is not necessary that primary dealers be affiliated
with banks. It is only necessary that they be institutions that deal in
U.S. Treasuries and participate in auctions of U.S. government debt.”
Noting that formerly at least half of primary dealers were not
affiliated with commercial banks, he said “the fact that primary dealers
are not commercial banks would have little effect on the Federal
Reserve’s ability to conduct monetary policy.”
Even though his proposals would not allow commercial banks to be
primary dealers, “they could remain a key part of the monetary policy
mechanism” if the Fed were to revive the TAF, which was set up to
provide 28-day or more term credit at auction against certain collateral
to avoid the perceived stigma of going to the regular discount window.
The Fed conducted its final TAF auction on March 8, 2010. Hoenig
suggested it be reinstated.
“Recently, the Federal Reserve gained experience in using the Term
Auction Facility (TAF),” he said. “The TAF might very successfully be
used in conjunction with primary dealer operations to conduct policy
well into the future … . By broadening the Federal Reserve’s monetary
tools to include the TAF to provide term funds through the banking
system in parallel with the primary dealers, we could greatly expand the
number of counterparties used in the conduct of monetary policy.”
“Thus, the TAF and primary dealers would provide deep markets for
the term portion of policy; primary dealers and traditional open-market
operations would continue as the means for managing day-to-day
operations and for maintaining the federal funds rate close to the
target,” he went on. “With more counterparties, we enhance competition
and enable nearly all banks to play a role in the conduct of monetary
policy.”
Hoenig also proposed two reforms to the shadow banking system:
“First, investors in money market mutual and other investment funds
that are allowed to maintain a fixed net asset value of $1 have an
incentive to run if they think their fund will ‘break the buck.’ Thus,
if the fixed $1 net asset value is eliminated and the share values of
such funds are required to float with their market values, shadow bank
reliance on this source of short-term funding and the associated threat
of disruptive runs would be greatly reduced.”
“Second, the potential disruptions to funding stemming from the
repo financing of shadow banks should be ended. 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.”
“These practices would be greatly reduced by rolling back the
bankruptcy law for repo collateral to the pre-2005 rules,” he said.
“Prior to then, if a repo borrower defaulted, mortgage-related
collateral could not be immediately taken and sold by the creditors.”
“Returning to these rules would discourage the use of
mortgage-related assets as repo collateral and reduce the potential for
repo runs,” he continued. “Term lending through securitization would
continue, probably at a smaller scale, with more closely matched term
wholesale funding provided by institutional investors such as mutual
funds, pension funds and life insurance companies.”
Hoenig issued dire warnings if these kinds of changes are not made.
“The problem with SIFIs is they are fundamentally inconsistent with
capitalism. They are inherently destabilizing to global markets and
detrimental to world growth.”
“So long as the concept of a SIFI exists, and there are
institutions so powerful and considered so important that they require
special support and different rules, the future of capitalism is at risk
and our market economy is in peril,” he added.
** Market News International **
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