SEC Commissioner Gallagher Delivers Speech on the Philosophies of Capital Requirements (with Lofchie Comment)
SEC Commissioner Daniel M. Gallagher delivered a speech on the theories behind capital requirements for both banks and non-bank financial institutions.
According to Commissioner Gallagher, policymakers often advance the mistaken view that there is a one-size-fits-all approach to capital. Rather, he explained, there are several models of capital requirements.
Commissioner Gallagher stated that, in the banking sector, capital requirements are designed with the goal of enhancing safety and soundness, serving as a cushion against unexpected losses. By placing bank owners' equity at risk in the event of a failure, capital requirements reduce risk and the possibility that taxpayers would be required to backstop banks in times of stress.
Gallagher also stated that capital requirements for broker-dealers are predicated on risk and focus on managing failure rather than avoiding it. Therefore, Gallagher said, applying bank-based capital requirements to non-bank financial entities is "like trying to manage an orange grove using apple orchard techniques."
To highlight the danger of imposing a bank capital regime on broker-dealers, Gallagher pointed to 2008, when the Fed "became the investor of last resort" and went beyond offering access to the discount window to depository institutions in its capacity as the lender of last resort. According to Gallagher, the extension of the Fed's regulatory paradigm to non-bank institutions had an adverse effect on these institutions, such as broker-dealers who had their own regulatory capital regime that was "designed to manage, rather than prevent, failure in order to ensure the return of customer assets."
Citing the Financial Stability Oversight Council's ("FSOC") proposal of capital requirements for money market funds which, contrary to the intention behind the proposal, would not mitigate the risk of investor panic leading to a run on a fund, Gallagher concluded that the situation is "terribly muddled." He questioned whether the goal is to expand the Fed's role by making it the lender of last resort to non-bank entities, or to use the Fed's Bank Holding Company Act authority and its role in FSOC to dictate capital requirements to non-bank entities in order to prevent them from gaining access to the discount window. Gallagher stated that it is his hope in the coming year to work with the SEC and FINRA to review whether it is appropriate to establish separate capital rules for bank-affiliated broker-dealers.
Lofchie Comment: It is always gratifying to see senior level financial regulators addressing the important big-picture regulatory issues in a serious manner. SEC Commissioner Gallagher's thoughtful commentary shows his willingness to take on the complexities of the situation publicly, and, more specifically, to provide support for the role of the Fed as the lender of last resort in a liquidity crisis.One should carefully consider a scenario, however, where liquidity really dries up. If that were to happen, it is likely that the Fed might be forced to (and should) provide liquidity support to broker-dealers as well as to banks, since, like banks, broker-dealers are vulnerable to runs. Where there is a general market confidence crisis, the markets stop settling trades, which has the potential to cause every firm to fail.