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From Securities Regulation Daily, January 16, 2014

Gallagher says capital requirements are not one-size-fits-all

By Jacquelyn Lumb

Commissioner Daniel Gallagher this week spoke to the Exchequer Club in Washington, D.C., about the regulatory capital requirements for banks and for non-bank financial institutions. Gallagher said that a lot of attention has focused on the amount of capital a financial institution should be required to hold, but not on the theories behind the capital requirements. The application of a one-size-fits-all approach to capital is a mistake that may affect the U.S. economy, he warned.

Capital requirements for banks. Gallagher explained that capital requirements in the banking sector are correctly designed with the goal of enhancing safety and soundness for the individual banks and the banking system as a whole. The bank capital requirements provide a cushion against unexpected losses and reduce the likelihood that taxpayers will have to provide a backstop in a time of stress.

Capital requirements for broker-dealers. The capital requirements for broker-dealers serve a different purpose, he said. Informed risks are important to the capital markets. So, while bank capital requirements are based on the need to avoid failure, the broker-dealer capital requirements are designed to manage failure by providing a sufficient cushion to enable a failed broker-dealer to liquidate in an orderly manner. The two models differ in fundamental ways.

Gallagher also talked about the distinction between insolvency and illiquidity for financial institutions. He made clear he is against bailouts, but offering access to the discount window to illiquid, but solvent banks, against good collateral, comports with the traditional role of a central bank as the lender of last resort.

Expansion of the Fed’s reach. However, in 2008, the Federal Reserve Board went well beyond offering access to the discount window to depository institutions in its capacity as the lender of last resort and became the investor of last resort, Gallagher said. In his view, the Fed’s investment in AIG and Bear Stearns marked a fundamental departure from the Fed’s traditional role.

Gallagher believes the Fed has taken steps to extend its regulatory reach to non-bank institutions, including broker-dealers. He said its efforts to extend the failure prevention paradigm of bank capital regulation to financial entities that are subject to failure management regulatory schemes implies an institutionalization of the concept of too-big-to-fail.

Money market funds. Gallagher also reviewed the Financial Stability Oversight Council’s (FSOC) intervention in the money-market mutual-fund reform debate. After the lack of a consensus among the SEC commissioners about the way to proceed with money market reforms, FSOC took up the cause and intervened in the regulatory purview of an independent regulator. FSOC issued a report in which it recommended a net asset value buffer that would function as a capital requirement for money market funds.

The intention of the capital buffer for money market funds was to mitigate the risk of investor panic, which could lead to a run on a fund, he explained, but the buffer would have amounted to chicken feed for the largest funds. To his relief, the SEC subsequently proposed reforms that did not include a capital buffer.

Gallagher supports a healthy debate about how much capital is enough in the banking and capital markets, but believes that capital market regulators must abide by the theory of capital as a tool to facilitate the unwinding of a failed firm with the goal of returning customer assets.

Gallagher would like to see the SEC and FINRA begin an in-depth review of whether it would be appropriate to establish separate capital rules for bank-affiliated broker-dealers. If a bifurcated approach is appropriate, he said, it must be based on the current broker-dealer net capital program that stands on its own, without any reference to the discount window. Gallagher also called on the SEC to play an active role in the policy debate to maintain the vibrancy of the capital markets.

Companies: AIG; Bear Stearns

MainStory: TopStory BrokerDealers RiskManagement DistrictofColumbiaNews

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