FRB Vice Chair Fischer Discusses the Non-bank Financial Sector (with Lofchie Comment)

Board of Governors of the Federal Reserve System ("FRB") Vice Chair Stanley Fischer delivered remarks on the significant challenges presented by the non-bank financial sector. He spoke at the Debt and Financial Stability – Regulatory Challenges conference, hosted by the Bundesbank and the German Ministry of Finance in Frankfurt, Germany.

Mr. Fischer described how non-bank intermediation in the United States has changed. He discussed the non-bank financial institutions' role in the financial crisis and how the growth of the non-bank sector increased the complexity of the financial system and lengthened intermediation chains. Non-banks "increase the amount of maturity transformation conducted in the financial system without the stability-enhancing backstops offered to banks," he stated.

Mr. Fischer also explained that a variety of reforms helped address risks in the non-bank financial sector, such as the creation of the Financial Stability Oversight Council ("FSOC"), the SEC's adoption of new rules for money market mutual funds, and a new rule regarding securitization. He stated that while "there are signs of reduced non-bank financial sector vulnerabilities," there are areas that require continued work, including:

• short-term wholesale funding markets – there are many non-bank financial firms that continue to rely on secured short-term funding to finance their activities, many of which involve longer-term and illiquid assets;
• areas of the non-bank sector that are not subject to prudential supervision, such as the asset management industry; and
• gaining better data coverage on certain areas of the non-bank financial system, such as the hedge fund industry.

Lofchie Comment: Governor Fischer's underlying suggestion that the Board of Governors or the FSOC should exert greater control over the investment and funding decisions made by private investors; i.e., the "asset management industry," is arguably, quite radical. Mr. Fischer is not the only member of the Federal Reserve to indicate that governmental control over private investment decisions should be increased: see, e.g., Governor Tarullo's speech on Macroprudential Regulation.

It is obvious that Dodd-Frank magnified by many times the power of the government with respect to the financial sector; while one can debate whether that is all to the good, there is certainly no doubt that an increase in governmental power was intended. It is not at all clear that Congress intended the type of increase in governmental power suggested by Governors Fischer and Tarullo. What they suggest goes beyond regulating financial intermediaries.

The suggestion by the FSOC, to which Governor Fischer refers, that asset managers could be "systemically significant" – is deeply problematic. Under this thinking, the FSOC could determine that asset managers as a group make decisions that are not optimal for the economy as a whole, perhaps because they invest in too similar a manner. (By way of example, here is a key take-away from the report of the Office of Financial Research ("OFR") on the asset management industry (at page 10): "[Existing] regulation [of asset managers] focuses on helping ensure that managers adhere to their clients' desired risk-return profiles, but does not always address collective action problems and other broader behavioral issues that can contribute to asset price bubbles or other market cycles.") One can readily concede to the truth of this OFR/FSOC observation: it is the nature of a free, capitalist economy that individual investors make investment decisions that are not dictated by the government, even if some government agency might determine that some other set of investment decisions, taken as a whole, would be preferable.

Of course, the government has many ways to influence private investment decisions; e.g., by altering tax rates, tax deductions, governmental subsidies, the money supply, borrowings through the Federal Reserve Bank of New York, and so on. There is certainly room for debate as to which measures are appropriate and effective, but moving beyond those "traditional" exercises of government power to the actual dictation of investment decisions and financing decisions made by private parties should not be viewed as ordinary course.

See: Mr. Fischer's Speech.
Related news: FSOC Requests Information on the Asset Management Industry (with Lofchie Comment) (January 30, 2015); SEC, FRB and HUD Join OCC, FDIC and FHFA in Adopting Credit Risk Retention Rules (with Lofchie Comment) (October 22, 2014); FDIC and OCC Approve Final Credit Risk Retention Rule (October 21, 2014).