Regional President Speech

Statement Oversight and Investigations Subcommittee of the Committee on Financial Services March 30, 2011 Jeffrey M. Lacker President Federal Reserve Bank of Richmond The Committee on Financial Services Rayburn House Office Building Washington, D.C. Good afternoon. I’m honored to speak to this Subcommittee about the federal government’s financial safety net and how the Dodd Frank Wall Street Reform and Consumer Protection Act seeks to address it. At the outset, I should point out that within the Federal Reserve System the Board of Governors has sole authority to write rules implementing the requirements of the Dodd-Frank Act. Federal Reserve Banks supervise financial institutions under authority delegated to them by the Board of Governors. In keeping with Board of Governors guidance, I will not discuss any current or potential Federal Reserve rulemaking. I also should say that my comments today are my own views and do not necessarily reflect those of the Board of Governors of the Federal Reserve or my colleagues at other Federal Reserve Banks. My views have been informed by both my leadership of the Fifth Federal Reserve District over the last seven years and my experience as a research economist, studying banking policy for the prior 25 years. The Dodd-Frank Act was a response to the most dramatic financial turmoil our country experienced in generations. In my view, the crisis resulted largely from a mismatch between a regulatory structure designed for the explicit safety net (consisting mainly of deposit insurance) and the extent of moral hazard induced by a much broader implicit safety net. Given precedents dating back to Continental Illinois in the 1980’s and beyond, market participants made inferences about what government protection might be forthcoming in future instances of financial distress—that is, which institutions were likely to be viewed by authorities as “too big to fail.” This lack of clarity about the safety net grew in the decades leading up to the crisis—and came about because policymakers hoped that “constructive ambiguity” would dampen the markets’ expectations of bailouts, but preserve their option to intervene if necessary. Other factors contributed to the crisis, but I believe the ambiguity of safety net policy was a major driver. Researchers at the Federal Reserve Bank of Richmond have estimated, based on conservative assumptions, that the implicit safety net covered as much as 40 percent of all financial sector liabilities by the end of 2009. When combined with the explicit protection in place for depository institutions and other firms, the broader federal financial safety net now covers 62 percent of the financial sector, compared to about 45 percent a decade earlier. (See Table.) 1 Dodd-Frank contains provisions that will help close the gap between the scope of prudential regulation and the scope of the implicit safety net. It allows the Financial Stability Oversight Council to designate large non-bank financial firms as “systemically important” and subject them to more rigorous constraints on risk-taking. The Act also seeks to limit the implicit safety net by empowering the FDIC to liquidate troubled nonbank firms and placing new constraints on the Fed’s lending powers. But the FDIC retains considerable discretion in the use of funds to limit losses to some creditors, and the Treasury can invoke orderly resolution for firms that have not been subject to enhanced regulation. The Fed also retains some discretionary power to lend to non-bank entities. This creates continued uncertainty about possible rescues, as well as gaps in our ability to provide clear, credible constraints on the safety net. In the near term, I believe regulators have a firm grasp on the industry, and are taking strong steps to tighten risk management at regulated firms, but there are risks in the long-term because firms seen as enjoying broad safety net protection will have strong incentives to take on excessive risks. And firms will have an incentive to by-pass regulation, if they can still enjoy some degree of implicit protection. This desire to operate just outside the perimeter of regulation, but within the implicit safety net, will present ongoing supervisory and regulatory challenges—and may make it difficult to prevent or limit the magnitude of future crises. Continued ambiguity thus would pose risks to financial stability and the economy, including the risk of new costs to taxpayers. But I believe the risks to the effectiveness of our financial system are even more significant. Over time, the devotion of resources to by-passing regulations can create new sources of financial instability and divert resources from the pursuit of financial innovations that are genuinely beneficial to consumers. In the long run, economic growth and job creation would likely suffer. Creating clear and credible safety net constraints is likely to be difficult. One approach is to tightly limit discretion—including discretionary use of public funds to shield creditors. The Act takes important steps in that direction, yet substantial discretion remains around preferential treatment for certain creditors. A far more challenging approach is for regulators to retain discretion, but establish a credible commitment to following clear, pre-announced rules in times of crisis. For example, limiting FDIC resolution authority to firms that are regulated as “systemically important” would help block regulatory by-pass. The credibility of such a commitment would require policymakers to allow significant creditor losses in cases in which they otherwise might have provided support. Some believe that without intervention the economy is too vulnerable to spillover damage from the financial system. I’ve argued that such spillovers are in large part the consequence of ambiguous government rescue policy. If we can establish clear expectations about the federal financial safety net and live up to our commitment to limit rescues, then we can have more confidence that our financial system will contribute positively to economic growth. Thank you. I would be pleased to take your questions. 2 Estimated Federal Financial Safety Net 1999 2009 Explicitly Implicitly Explicitly & Total Explicitly Implicitly Explicitly & Total Guaranteed Guaranteed Implicitly Liabilities Guaranteed Guaranteed Implicitly Liabilities Liabilities Liabilities Guaranteed Liabilities Liabilities Guaranteed Liabilities Liabilities Financial Firms Banking and Savings Firms 2,840 820 3,660 5,963 6,536 7,276 13,812 16,249 (includes BHCs) 47.6% 13.8% 61.4% 40.2% 44.8% 85.0% Credit Unions 336 336 375 725 725 817 89.6% 89.6% 88.7% 88.7% Government‐Sponsored Enterprises Fannie Mae 1,199 1,199 1,199 3,345 3,345 3,345 Freddie Mac 870 870 870 2,333 2,333 2,333 Farm Credit System 74 74 74 188 188 188 Federal Home Loan Banks 477 477 477 973 973 973 Total 2,620 2,620 2,620 6,838 6,838 6,838 100.0% 100.0% 100.0% 100.0% Private Employer Pension Funds 1,805 1,805 2,090 2,799 2,799 3,273 86.3% 86.3% 85.5% 85.5% Other Financial Firms (includes MMF for 2009) 7,723 4,048 4,048 18,458 21.9% 21.9% Total for Financial Firms 4,981 3,440 8,421 18,771 10,059 18,162 28,221 45,635 26.5% 18.3% 44.8% 22.0% 39.8% 61.8% 41.1% 1999 and 2009 data from December, in billions of dollars. Figures may not sum exactly due to rounding. For details, see: John R. Walter and John A. Weinberg. 2002. “How Large is the Financial Safety Net?” Cato Journal 21 (Winter): 360-93; Nadezhda Malysheva and John R. Walter. 2010. “How Large Has the Federal Financial Safety Net Become?” Federal Reserve Bank of Richmond Economic Quarterly 96 (Third Quarter): 273-90. The following definitions correspond to the 2009 data (for 1999 definitions see Walter and Weinberg, 2002): - Explicitly Guaranteed Liabilities of Banking and Savings Firms: FDIC-insured deposits of all commercial banks and savings institutions including transaction accounts covered by the FDIC’s TAGP, plus debt guaranteed by the FDIC’s DGP - Implicitly Guaranteed Liabilities of Banking and Savings Firms: Total liabilities of the 19 stress-tested institutions, less FDIC insured deposits and accounts covered by TAGP and debt covered by DGP for the 19 stress-tested institutions - Credit Unions: National Credit Union Administration-insured shares and deposits - Government-Sponsored Enterprises: Total liabilities, enterprise’s mortgage-backed securities held by third parties, and other guarantees - Private Employer Pension Funds: Pension liabilities backed by the PBGC - Other Financial Firms: Total liabilities of AIG, less FDIC-insured deposits of AIG Federal Savings Bank, and total MMF balances EconomicQuarterly—Volume96,Number3—ThirdQuarter2010—Pages273–290 How Large Has the Federal Financial Safety Net Become? NadezhdaMalyshevaandJohnR.Walter In 2002, Walter and Weinberg examined the federal financial safety net as it stood at the end of 1999 (Walter andWeinberg 2002). At the time, theauthorsestimatedthatapproximately45percentofallfinancialfirm liabilitieswereprotectedbythesafetynet. Asonewouldexpectinthisarticle, thecurrentestimateindicatesthatthesizeofthenethasgrown,asthefinancial marketturmoilthatbeganin2007ledfederalgovernmentagenciestoexpand therangeofinstitutionsandthetypesofliabilitiesprotectedbythesafetynet. 1. THESAFETYNET:ITSDEFINITION,COSTS, ANDBENEFITS Walter andWeinberg defined the federal financial safety net as consisting of all explicit or implicit government guarantees of private financial liabilities. Privatefinancialliabilitiesarethoseowedbyoneprivatemarketparticipantto another. AsusedbyWalterandWeinberg, thephrasegovernmentguarantee meansafederalgovernmentcommitmenttoprotectlendersfromlossesdueto aborrower’sdefault(WalterandWeinberg2002).1 Followingthisdefinition, weincludeinourestimateofthesafetynet,insuredbankandthriftdeposits, certainotherbankingcompanyliabilities,somegovernment-sponsoredenter- prise(GSE)liabilities,selectedprivateemployerpensionliabilities,aswellas The authors would like to thank Jason Annis, Marc Chumney, Tim Pudner, and Deanna West for providing data and valuable advice, as well as Huberto Ennis, Robert Hetzel, Sabrina Pellerin, and John Weinberg for their insightful comments on an earlier draft. The views expressed in this article are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Richmond or the Federal Reserve System. E-mail: john.walter@rich.frb.org. 1In addition to estimating the proportion of financial firm liabilities backed by the federal government, Walter and Weinberg also estimated the proportion of nonfinancial firm and household liabilities with such backing. 274 FederalReserveBankofRichmondEconomicQuarterly asubsetoftheliabilitiesofotherfinancialfirms. Thedetailsofwhywechose toincludetheseliabilitiesareprovidedbelow. EffectofaSafetyNetonEconomicEfficiency Government actions in the form of subsidies, taxes, or regulations change marketoutcomes,andincompetitivemarketssuchchangesdistortallocations andcanreduceeconomicefficiency. Doesthefinancialsafetynetcausedis- tortions? AsdiscussedinWalterandWeinberg,inprinciple,thegovernment could design guarantees that mimic market outcomes. Typically, however, government intervention arises from a desire to alter market outcomes. In thecaseofguarantees,thismeanseitherexpandingcoverageorunderpricing relative to private market guarantees. Underpricing means that the guaran- tor collects fees that are less than the expected value of its obligations. This underpricingsubsidizesrisktaking. Underpriced guarantees tend to shift resources away from activities that are not covered toward those that are. In that way, a government guarantee issimilartoadirectsubsidypaidtothoseengagedinaparticularactivity. A guaranteeisdifferent,however,inthewayitaffectsattitudestowardrisk. By assigningtothegovernmentpartoftheriskintheactivitiesbeingfinanced,the safety net reduces market participants’willingness to control risk. Overpro- visionofguarantees,whilenotnecessarilydrawingresourcesintoanactivity, doesshiftriskpreferencesinawaysimilartounderpricing. Inshort,guaran- teesleadtoexpandedrisktaking. Ourcalculationofthesizeofthesafetynetdoesnotrepresentameasure of the size of the distortions to the allocation of resources and risk taking. Such a measure would require knowledge of the extent of underpricing or overprovisionofgovernmentguarantees. Thosewouldbedifficulttomeasure, especiallythelatter,sincegovernmentprovisionoftenpreemptsprivatemarket activity. Weneverthelessbelievethattheextentofdistortionsisdirectlyrelated tothesizeofthesafetynet. Otherthingsbeingequal,thegreatertheshareof privateliabilitiesprotectedbythegovernmentsafetynet,themorelikelyitis thatgovernmentguaranteesareextendingbeyondthelevelofprotectionthat wouldbeprovidedinaprivatemarket. WhyHaveaSafetyNet? If the safety net is distortionary, why have one? Proponents of the financial safety net, especially as it applies to banks, often argue that private risk- sharing arrangements tend to disregard the systemic consequences of large lossesbornebyanindividualorasmallgroupofinstitutions. Theideahereis thatsuchlossesmightspilloverandgeneratefurtherlossescaused,forexam- ple,byacontagiouslossofinvestorconfidence. Undersuchaview,govern- N.MalyshevaandJ.R.Walter:TheFederalFinancialSafetyNet 275 mentprotectionforcertaininvestorscouldpreventwidespreadfinancialpanic or distress. While the potential systemic consequences of a large financial failure are difficult to assess, when faced with the possibility of widespread failuresoffinancialfirms,policymakersarelikelytoconcludethatpreventing such failures by protecting creditors of financial firms (providing safety net protection)isprudent. Similarly, some observers maintain that the safety net protections can lowerthecostsof,andthereforeencourage,certainhighlybeneficialfinancial arrangements. For example, Diamond and Dybvig (1983) argue that banks’ performanceofthematuritytransformationfunctionishighlybeneficialtothe economybutismorecostlywithoutgovernment-provideddepositinsurance. Banks perform maturity transformation by gathering money from numerous short-termdepositors(thosebankcustomerswhosedepositsmaturesoonafter deposited—especially checking deposits, which are available, meaning that they mature, immediately after being deposited) to fund long-term loans to businesses and individuals. Without deposit insurance, which only the gov- ernment has sufficient resources to provide, bank runs are likely to occur. A bank run happens when many depositors attempt to withdraw their funds simultaneously. Sincebanksmakelong-termloans,theycannotrecoversuf- ficient money from borrowers to meet a run and, therefore, fail. To protect themselvesfromruns,bankscanundertakecostlyprivatemeasures,butDia- mondandDybvigarguethatgovernmentdepositinsuranceislikelytobeless expensiveandthereforepreferabletosuchmeasures. 2. LEGISLATIVEANDREGULATORYCHANGESTHAT EXPANDEDTHESAFETYNET AsshowninTable1,weestimatedtheproportionoffinancialfirmliabilities protected as of the end of 2009. By the end of 2009, a number of govern- ment programs had been established to address turmoil in financial markets. EmployingmethodssimilartothoseusedbyWalterandWeinbergwhenthey measuredthesizeofthesafetynetfortheendof1999,wefindthatasofthe endof2009about59percentoffinancialfirmliabilitieswereprotectedbythe federalsafetynet. One of the most important reasons for the increase from 1999 to 2009 istheenlargedportionofbankingfirmliabilitiesthatmarketparticipantsare likelytoconsiderprotected: bankingandsavingsfirmliabilitieswithanim- plicitbacking. In1999,implicitlyguaranteedliabilitiesofbanksandsavings institutionsamountedtoabout13percentofallofthesefirms’liabilities(15.9 percentforcommercialbanksand4.2percentforsavingsinstitutions),or$820 276 FederalReserveBankofRichmondEconomicQuarterly teNytefaSlaicnaniFlaredeFdetamitsE 1elbaT seitilibaiL latoT ylticilpmI dna ylticilpxE deetnarauG ylticilpmI deetnarauG ylticilpxE smriF laicnaniF seitilibaiL deetnarauG seitilibaiL seitilibaiL smriF sgnivaS dna gniknaB 942,61 218,31 672,7 635,6 )sCHB sedulcnI( %0.58 %8.44 %2.04 718 527 527 snoinU tiderC %7.88 %7.88 sesirpretnE derosnopS-tnemnrevoG 543,3 543,3 543,3 eaM einnaF 333,2 333,2 333,2 caM eidderF 881 881 881 metsyS tiderC mraF 379 379 379 sknaB naoL emoH laredeF 838,6 838,6 838,6 latoT %001 %001 372,3 997,2 997,2 sdnuF noisneP reyolpmE etavirP %5.58 %5.58 851,51 847 847 smriF laicnaniF rehtO %9.4 %9.4 533,24 129,42 268,41 950,01 smriF laicnaniF rof latoT %9.85 %1.53 %8.32 eht ni serugfi ehT .gnidnuor ot eud yltcaxe mus ton yam serugiF .srallod fo snoillib ni ,9002 rebmeceD morf ataD :setoN ylticilpxE“ ,snmuloc owt tsrfi eht ni srebmun eht fo mus eht era ”seitilibaiL deetnarauG ylticilpmI dna ylticilpxE“ nmuloc .dnegel elbat rof xidneppA eeS ”.seitilibaiL deetnarauG ylticilpmI“ dna ”seitilibaiL deetnarauG N. Malysheva and J. R. Walter: The Federal Financial Safety Net 277 billion;in2009,about45percentofbankingandsavingsfirmliabilitieswere implicitlyguaranteed,byourestimate,amountingto$7.3billion.2 HowdidWalterandWeinbergdeterminewhichinstitutionstoincludeas havinganimplicitguaranteeandwhichliabilitiesissuedbytheseinstitutions might be covered? As the authors noted, the critical question is whether market participants believe that a given institution will be protected, even though official policy may not state explicitly that all of these liabilities are protected. As of 1999,Walter andWeinberg argued that market participants werelikelytoassumethatcertainholdersofliabilitiesinthelargest21banking companiesandthetwolargestthriftcompanieswouldbeprotectedintheevent thatthesefirmsbecametroubled. These21bankingcompaniesandtwothrifts all had assets (in 1999 dollars) of more than $50 billion, which was greater than the smallest of the 11 institutions identified by the Comptroller of the Currency in 1984 as potentially too big to fail (Walter and Weinberg 2002, p. 381). TheliabilitiesthatWalterandWeinbergassumedthemarketwould be highly likely to view as protected were deposits of more than $100,000 (deposits of less than $100,000 are included in the “Explicitly Guaranteed Liabilities” column in the tables), federal funds loans made to the 21 banks and two thrifts, and repo transactions with these banks and thrifts. Though we intend to use a similar methodology for estimating the size of implicit guaranteesforbankingcompaniesin2009,eventsduringtherecentfinancial crisisrequiredsomeadjustments. SupportforStress-TestedFinancialCompanies Giventhatthegovernmenthadrespondedaggressivelytoproblemsinfinancial firms during the financial turmoil of 2008–2009, our challenge is to decide which institutions have implicit guarantees. Here we maintain that market participantswereverylikelytoassumethattheliabilitiesofthefinancialfirms that were stress tested early in 2009 (participants in the Supervisory Capital Assessment Program—SCAP) had a strong likelihood of receiving federal backing if they suffered financial distress. Indeed, the announcement of the stress tests in February 2009 came with a promise of government-provided capitalforstress-testedinstitutionsthatwereshowntobeinneedofadditional capital: Under [the Treasury’s CapitalAssistance Program] CAP, federal banking supervisors will conduct forward-looking assessments [SCAP stress tests] to evaluate the capital needs of the major U.S. banking institutions un- der a more challenging economic environment. Should that assessment indicate that an additional capital buffer is warranted, banks will have 2An explanation of the factors underlying the large increase is provided below. 278 FederalReserveBankofRichmondEconomicQuarterly an opportunity to turn first to private sources of capital. In light of the current challenging market environment, the Treasury is making govern- ment capital available immediately through the CAP to eligible banking institutions to provide this buffer. (FinancialStability.gov 2009) Additionally,anumberofthesefirmsdid,infact,receivegovernmentaid intheformofcapitalinjectionsin2008andearly2009throughtheTreasury’s Capital Purchase Program or in response to the stress tests (FinancialStabil- ity.gov 2010, pp. 21, 27, 67–80). This aid, both the aid promised under the CAPandaidreceivedthroughtheCapitalPurchaseProgram,reducedthelike- lihood that all liabilityholders of the protected firms would suffer losses, so here we include all liabilities of the stress-tested banking institutions in our safetynetcalculation. While some observers in 2009 may have viewed the likely passage of financial reform legislation as diminishing federal backing, we nevertheless count the liabilities of the stress-tested firms. Legislation that was intended to limit the chance that financial institutions would receive federal aid was being considered in the U.S. Congress during 2009. If market participants were convinced that such legislation would forestall any opportunity for the creditors of the largest financial institutions to be protected by the federal government, then our calculation might appropriately exclude the liabilities ofstress-testedbankinginstitutions. Infact,mostofthelegislativeproposals includedlanguagethatcalledfortheclosureoftroubledfinancialfirmswith lossestoequityholdersandatleastsomecreditors(thoughatleastoneleading proposalcontainedprotectionsforcreditorsoffinancialfirmsifthefailureof suchafirmmightcreateasystemicrisk).3 Nevertheless,legislativeproposals containedprovisionsmeanttoestablishamechanismthatcouldclearlyiden- tify “systemically important” financial firms. Such mechanisms seem likely toencouragemarketparticipantexpectationsoffederalaidtothecreditorsof thelargest(i.e.,systemicallyimportant)firms. Giventheambiguouseffectof the reform proposals on the probability of federal aid to the largest banking firms,andtheclearprotectionsprovidedfortroubledfirmsandfortheircred- itorsduringthefinancialturmoil,weretaintheirliabilitiesinourestimateof liabilities protected by the safety net, in keeping with Walter and Weinberg (2002). (Inalatersectionweremovetheliabilitiesofstress-testedinstitutions andre-estimatethesizeofthesafetynet—seeTable2.) Asindicatedearlier,thetotalliabilitiesofthe19stress-testedbankholding companies,lesstheirliabilitiesthatwereexplicitlycoveredbydepositinsur- ance,summedto$7.3trillion(“ImplicitlyGuaranteedLiabilities”columnin 3See H.R. 4173 as of December 2, 2009, p. 370, available at: http://www.house.gov/apps/ list/press/financialsvcsdem/presscfpa121109.shtml. N.MalyshevaandJ.R.Walter:TheFederalFinancialSafetyNet 279 thetables). Thissumequalsabout45percentofallbankingandsavingsfirm liabilities. IncreasedCeilingonInsuredDeposits Several Federal Deposit Insurance Corporation (FDIC) programs expanded the explicit portion of the safety net for banks and thrifts (“Explicitly Guar- anteed Liabilities” column in the tables) beyond the long-standing $100,000 coveragefordeposits(whicharealsoincludedinthe“ExplicitlyGuaranteed Liabilities”columninthetables).4 Forexample, inOctober2008theEmer- gencyEconomicStabilizationActof2008temporarilyincreasedFDICdeposit insurancecoveragefrom$100,000to$250,000,untilDecember31,2009. In May 2009, the $250,000 cap was extended to December 31, 2010, by the HelpingFamiliesSaveTheirHomesAct. InJuly2010,legislationmadeper- manentthe$250,000coveragelimit(FederalDepositInsuranceCorporation 2010a). TransactionAccountGuaranteeProgram Further, in October 2008 the FDIC implemented a program to insure unin- sureddeposits(thosedepositsinaccountscontainingmorethan$250,000)in noninterest-bearing transactions accounts for those insured banks and thrifts wishing to participate. The program is temporary. At first it covered such transactions accounts until December 31, 2009. Later the FDIC extended the program’s coverage until June 30, 2010, and then extended it again until December 31, 2010, with a pre-announced option to extend it an additional 12 months (Federal Deposit Insurance Corporation 2010a).5 This program, the TransactionAccount Guarantee Program (TAGP), added $834 billion to our“ExplicitlyGuaranteedLiabilities”columninthetablesforbankingand savingsfirms(FederalDepositInsuranceCorporation2009c). DebtGuaranteeProgram Last, in October 2008 the FDIC offered, to banking and savings institutions wishingtoparticipate,theoptiontoreceiveFDICinsurancecoverageforsenior unsecured debt issued by such institutions. This Debt Guarantee Program 4Since April 2006, deposits in certain retirement accounts at banks and thrifts have been protected by the FDIC up to $250,000 (Federal Deposit Insurance Corporation 2006). Deposits in such accounts, up to the $250,000 ceiling, are included in the “Explicitly Guaranteed Liabilities” column of our tables. 5The Dodd-Frank Wall Street Reform and Consumer Protection Act extended coverage for noninterest-bearing transaction accounts through December 31, 2012 (Federal Deposit Insurance Corporation 2010c). 280 FederalReserveBankofRichmondEconomicQuarterly (DGP)atfirstcovereddebtissuedbyJune30,2009,andmaturingbyJune30, 2010. TheDGPwaslaterextendedtocoverdebtissuedbyOctober31,2009, andmaturingbyDecember31,2012. AsofDecember31,2009,theprogram was insuring $309 billion in debt (Federal Deposit Insurance Corporation 2009b). 3. OTHERCOMPONENTSOFTHESAFETYNET As in 1999, we include for 2009 the liabilities of government-sponsored en- terprises (direct GSE liabilities plus the dollar amount of mortgage-backed securityguarantees)inthe“ImplicitlyGuaranteedLiabilities”columninthe tables. Earlierwenotedthatgovernmentguaranteescanoftenmodifymarket prices. Though our article has made no attempt to measure the size of guar- antees’effect on market prices, in the case of the GSEs’implicit guarantee, thesizeoftheeffectonmarketpriceshasbeenestimatedbyPassmore(2005) and others.6 Passmore (2005) estimates that the average homeowner saved between3and11basispointsonhisorhermortgagebecauseoftheimplicit guarantee. The subsidy lowers the GSEs’borrowing costs, and some of this savedborrowingcostispassedontohomeownersbytheGSEintheformof lowered mortgage interest rates. Passmore calculates that about half of the guarantee’sbenefitflowstotheshareholdersoftheGSEs. WhiletheTreasury made clear its support for Fannie Mae and Freddie Mac once these two fi- nancialfirmswereplacedinconservatorshipinSeptember2008,thesupport wasnotasstronglystatedasthatgiventoinsureddeposits,soweleavethese liabilitiesintheimplicitcolumninthetables.7 Weestimatetheamountofprivatepensionsexplicitlyguaranteedin2009 by the Pension Benefit Guarantee Corporation (PBGC) based on the latest privatepensiondataavailable,whicharedatafor2007(PensionBenefitGuar- antee Corporation 2010, pp. 83, 105). Our admittedly rough 2009 figure is derivedbysimplyadjustingthe2007figurebytwicetheaverageannualgrowth rateofprivatepensionliabilitiesfortheprevious10years(1997–2007). WealsocountalloftheliabilitiesofAmericanInternationalGroup(AIG) as implicitly guaranteed in the “Other Financial Firms” row in the tables.8 6Beyond Passmore, the Congressional Budget Office (2001) also developed estimates of the GSEs’ guarantee on mortgage interest rates. 7We treat Fannie Mae and Freddie Mac as private entities and therefore include their liabil- ities in our table, consistent with the way Walter and Weinberg treated these entities, even though the status of Fannie Mae and Freddie Mac as privately owned firms is more ambiguous now than in 1999. 8The insured deposit liabilities ofAIG’s savings bank are not included in the “Other Financial Firms” row since these liabilities were included in the “Banking and Savings Firms” row. While AIG owns a savings bank, it is not classified as a bank holding company (and does not file a bank holding company report [Y9C] with federal regulators), so we do not include it in the Banking and Savings Firms row. N.MalyshevaandJ.R.Walter:TheFederalFinancialSafetyNet 281 We count their liabilities as such because of the aid provided them by the FederalReserveandtheU.S.TreasuryfollowingAIG’sfinancialproblemsin September2008. Becausetherewerenoclearsignalsaboutwhetheraidmight beforthcomingforotherlarge,nonbankfinancialfirms(beyondthestresstest firms), we did not include the liabilities of any firms other thanAIG in the “OtherFinancialFirms”rowintables. 4. ALTERNATIVEESTIMATESOFTHESIZEOFTHE SAFETYNET As has been noted, Table 1 is based on several assumptions similar to those made by Walter and Weinberg in 2002. For example, we assumed that all liabilities of stress-tested bank holding companies would be protected, not just the liabilities representing FDIC-insured bank deposits. What would be thesizeofthesafetynetiftheseassumptionswerechanged? Contrarytoourassumptionaboutthelikelyprotectionofliabilityholders ofstress-testedcompanies,onecanimaginecircumstancesunderwhichsuch liabilityholdersmightbeleftunprotected. Ifoneofthesecompanieswereto failatatimewhenfinancialmarketswerebroadlyhealthy,policymakerscould moreeasilyallowthecompanytobehandledasabankruptcysothatnogov- ernmentfundsareemployedtoprotectliabilityholders(ofcourse,theholders ofFDIC-insureddepositswouldstillbecoveredgiventhatsuchdepositsare protected regardless of the circumstances surrounding the failure). In times of general financial market strength, the failure of a large holding company couldperhapsbeabsorbedwithoutworriesofacascadeofadditionalfailures. Andatsuchtimes,ifthefirmwerehandledthroughtheDodd-FrankAct’sor- derlyliquidationprocess,itispossiblethatneitherthegovernmentnorother financialfirmswouldprovidefundstoprotectliabilityholders.9 Whileinvestorsmightexpectlargefinancialfirmfailurestotypicallyoc- cur in times of widespread financial weakness, and therefore anticipate that theirinvestmentswouldbeprotected,somelargefirmshavefailedintimesof financialmarkethealth. OnesuchexamplewasLondon-basedBaringsBank, whichfailedwhenfinancialmarketswerebroadlystrongin1995. Itsfailure was because of the huge trading losses generated by one unchecked Barings traderwhotooklarge,unauthorizedfuturespositions. Giventhattherearecir- cumstancesunderwhichtheholdersofstress-testedcompanyliabilitiesmight beleftunprotected,droppingtheassumptionoftheircoverageandrecalculat- ingourestimateofimplicitlyguaranteedliabilitiesseemsworthwhile. 9The Orderly Liquidation Authority section of the Dodd-Frank Wall Street Reform and Con- sumer Protection Act of 2010 contains provisions that allow funds gathered from assessments on the largest financial firms to be used to protect liabilityholders. 282 FederalReserveBankofRichmondEconomicQuarterly denfieDylworraN,teNytefaSlaicnaniFlaredeFdetamitsE 2elbaT seitilibaiL latoT ylticilpmI dna ylticilpxE deetnarauG ylticilpmI deetnarauG ylticilpxE smriF laicnaniF seitilibaiL deetnarauG seitilibaiL seitilibaiL smriF sgnivaS dna gniknaB 942,61 293,5 293,5 )sCHB sedulcnI( %2.33 %2.33 718 527 527 snoinU tiderC %7.88 %7.88 sesirpretnE derosnopS-tnemnrevoG 543,3 543,3 543,3 eaM einnaF 333,2 333,2 333,2 caM eidderF 881 881 881 metsyS tiderC mraF 379 379 379 sknaB naoL emoH laredeF 838,6 838,6 838,6 latoT %001 %001 372,3 997,2 997,2 sdnuF noisneP reyolpmE etavirP %5.58 %5.58 851,51 smriF laicnaniF rehtO 533,24 357,51 838,6 519,8 smriF laicnaniF rof latoT %2.73 %2.61 %1.12 eht ni serugfi ehT .gnidnuor ot eud yltcaxe mus ton yam serugiF .srallod fo snoillib ni ,9002 rebmeceD morf ataD :setoN ylticilpxE“ ,snmuloc owt tsrfi eht ni srebmun eht fo mus eht era ”seitilibaiL deetnarauG ylticilpmI dna ylticilpxE“ nmuloc .dnegel elbat rof xidneppA eeS ”.seitilibaiL deetnarauG ylticilpmI“ dna ”seitilibaiL deetnarauG N.MalyshevaandJ.R.Walter:TheFederalFinancialSafetyNet 283 Large financial firms that are not bank holding companies might receive no protection in such instances, so we also drop liabilities of AIG from those liabilitieswithimplicitbacking. Also,weincludedinourexplicitlyinsureddepositscategorythosedeposits coveredbytheFDIC’stemporaryguaranteeprograms, sincetheseprograms were in place in 2009. But under the debt guarantee program no new debt issues were covered after October 31, 2009 (Federal Deposit Insurance Cor- poration 2010b). TheTAGP was set to expire as of the end of 2010, though theDodd-FrankActextendedittoDecember31,2012. Inthecaseoffuture financial firm failures, such programs may not be in place, and might not be reinstated. Therefore, re-estimatingourmeasureofthesizeofthesafetynet withoutconsideringthesedepositsasprotectedalsoseemsworthwhile. Table2containsourestimateofthesizeofthesafetynetwithoutincluding theliabilitiesofthestress-testedbankholdingcompanies,AIG,andtheFDIC temporaryinsuranceprogramdeposits. Thesechangesmeanthat,comparedto Table1,theproportionofliabilitiesreceivingexplicitandimplicitguarantees fallsto37.2percent. Additionally,whileweassumethattheliabilityholdersofthehousingand farmcreditGSEswillbeprotectedfromloss,asweresuchholdersofFannie MaeandFreddieMacdebtduringthe2007–2009financialcrisis,undersome circumstances such holders might be left unprotected. As in the case of the stress-testedcompanies,ifaGSEweretofailduringaperiodinwhichfinan- cialmarketswerehealthy,policymakersmightleavedebtholdersunprotected. Therefore, it is possible that one might want to exclude the liabilities of the GSEsfromthecalculationofthesafetynet. Ifthe$6.8trillioninliabilitiesof the GSEs were removed (which are the only implicitly guaranteed liabilities inTable2),thenourmeasureofthesafetynetwouldshrinkto21percentof totalliabilitiesinTable2,theamountofexplicitliabilitiesshowninTable2. Somereadersmightcontendthatonecategoryofliabilities,whichwehave excluded from our safety net estimate, could legitimately be added: money market mutual fund liabilities. In the creation of our tables, and in Walter andWeinberg (2002), mutual fund liabilities are excluded because the prin- cipalvalueofmutualfundinvestments,includingmoneymarketmutualfund investments, can decline, without the mutual fund defaulting, if the entity in whichthefundsareinvesteddefaults. Asaresult,theseinvestmentsareakin to equity and unlike private liabilities—the focus of our estimates—which typicallymustpaybackfullprincipal(orelsebeindefault). Forexample,an investor in a money market mutual fund, which in turn invested in financial firmcommercialpaper,couldloseprincipalifthecommercialpaperwasnot repaid,butthemutualfundcancontinuetooperate(i.e.,notdefault).10 This 10Money market mutual funds are loath to pay back less than full principal (“break the buck” in mutual fund parlance), and few have done so over time. Instead, the money market 284 FederalReserveBankofRichmondEconomicQuarterly viewofmoneymarketmutualfundinvestmentsasequitymustbetempered, however, by events in 2008. Specifically, the Treasury stepped in and pro- tected investors in mutual funds from losses, thereby treating investments in the funds like other guaranteed liabilities, in which losses are prevented by government assistance or guarantees. As a result, one might argue that our estimatesofthefractionoftotalliabilitiescarryingagovernmentguarantee— both the numerator and denominator—should include money market mutual funds. Ifoneaddstheamountofsuchfundbalancesoutstandingattheendof 2009($3.3trillion[InvestmentCompanyInstitute2010])toourestimatesin thecolumn“ExplicitlyandImplicitlyGuaranteedLiabilities”inTable1,the proportion would increase to 67 percent. TheTable 2 figure would increase to45percent. 5. CONCLUSION Recent government actions by legislators and financial regulators expanded thefederalfinancialsafetynet. Suchactionsincludeaugmentationofdeposit insurance, debtguaranteesforbankingcompanies, aidtostress-testedfinan- cial firms, and, perhaps, various regulatory reform legislative proposals. As discussed in Walter and Weinberg (2002), this expansion has likely encour- agedaviewthatliabilityholderswillbeprotectedbythefederalgovernment intimesoffinancialdifficultyinthefuture. Asaresultofthisexpectationof governmentprotection,liabilityholderswillexerciselessoversightoverfinan- cialfirmrisktakingthentheywouldwithoutthisexpectation,financialfirms willundertakemorerisk,andfinancialmarketdecisionswillbedistortedand inefficient. mutual fund’s parent typically injects funds to allow the fund to pay back full principal. This behavior by mutual fund parent companies indicates that parent companies and investors may well view money market mutual fund investments more as liabilities than equity, regardless of the fact that money market mutual funds can break the buck without defaulting. N.MalyshevaandJ.R.Walter:TheFederalFinancialSafetyNet 285 APPENDIXA: LEGENDTOTABLE1 • BankingandSavingsFirms11 – ExplicitlyGuaranteedLiabilities ∗ FDIC-insureddepositsofallcommercialbanksandsavingsin- stitutionsincludingtransactionaccountscoveredbytheFDIC’s TAGP,plusdebtguaranteedbytheFDIC’sDGP – ImplicitlyGuaranteedLiabilities ∗ Totalliabilitiesofthe19stress-testedinstitutions, lessFDIC- insureddepositsandaccountscoveredbyTAGPanddebtcov- eredbyDGPforthe19stress-testedinstitutions • CreditUnions – ExplicitlyGuaranteedLiabilities ∗ National Credit Union Administration-insured shares and deposits • GovernmentSponsoredEnterprises – ImplicitlyGuaranteedLiabilitiesof: ∗ FannieMae · Totalliabilities · Fannie Mae mortgage-backed securities held by third parties · Otherguarantees ∗ FreddieMac · Totalliabilities · Freddie Mac participation certificates and structured securitiesheldbythirdparties ∗ FarmCreditSystem · Totalliabilities · FarmerMacguarantees ∗ FederalHomeLoanBanks · Totalliabilities 11See Section 4 for a description of the differences between Table 1 and Table 2 estimates. 286 FederalReserveBankofRichmondEconomicQuarterly • PrivateEmployerPensionFunds – ExplicitlyGuaranteedLiabilities ∗ PensionliabilitiesbackedbythePBGC • OtherFinancialFirms – ExplicitlyGuaranteedLiabilities ∗ Total liabilities of AIG, less FDIC-insured deposits of AIG FederalSavingsBank APPENDIXB: DATAAPPENDIXTOTABLE1 BankingandSavingsFirms—ExplicitlyGuaranteedLiabilities: “Estimated FDIC-insured deposits” of commercial banks, savings institutions, and U.S. branches of foreign banks (Federal Deposit Insurance Corporation 2009a), plus “Amount Guaranteed” in the TransactionAccount Guarantee Program (Federal Deposit Insur- ance Corporation 2009c), plus “Debt Outstanding” in the Debt GuaranteeProgram(FederalDepositInsuranceCorporation2009b). BankingandSavingsFirms—ImplicitlyGuaranteedLiabilities: Totalliabilitiesofthe19stress-testedinstitutionsfoundintheY9C(quar- terlybankholdingcompanyfinancialreports),less1)theexplicitly guaranteed deposits of the banks and savings institutions owned bythese19firms,and2)theFDIC-insureddebt(insuredunderthe DGP) of each of these institutions. The estimated FDIC-insured deposits and the guaranteed amount in noninterest-bearing trans- actionaccountsforeachbankcanbefoundontheFDIC’swebsite inthe“InstitutionDirectory”(www2.fdic.gov/idasp). Theamount ofDGPdebtofeachfirmcanbefoundonthefirms’10Ks. BankingandSavingsFirms—TotalLiabilities: Total liabilities from the following sources: For large (consolidated as- setsofover$500million)bankholdingcompanies, Consolidated FinancialStatementsforBankHoldingCompanies(FRY9C);for small (consolidated assets less than $500 million) bank holding N.MalyshevaandJ.R.Walter:TheFederalFinancialSafetyNet 287 companies,ParentCompanyOnlyFinancialStatementsforSmall Bank Holding Companies (FRY9SP)—from which consolidated totalliabilitiescanbederived;forbanksnotownedbyabankhold- ing company, Consolidated Reports of Condition and Income for a Bank (FFIEC 031 and FFIEC 041); and for all thrift liabilities, ThriftFinancialReports. CreditUnions—ExplicitlyGuaranteedLiabilities: Total insured shares at the $250,000 limit (National Credit Union Administration2009). CreditUnions—TotalLiabilities: Board of Governors (2010), Table L.115—Credit Unions, “Total liabilities.” Government-SponsoredEnterprises: FannieMae: Total liabilities, plus Fannie Mae MBS held by third parties, plus other guarantees found in the Fannie Mae 10K, “Item 6. SelectedFinancialData”(p. 70). FreddieMac: 10K report of Freddie Mac, “Total liabilities” (“Consolidated Bal- ance Sheets,” p. 209), plus “Total PCs and Structured Se- curities issued” (“Item 6. Selected Financial Data,” p. 57), less “Total Freddie Mac PCs and Structured Securities held” inFreddieMacportfolio(Table28,p. 104). FarmCreditSystem: FarmCreditSystem(2010),“Totalliabilities”(“CombinedStatement of Condition Data,” p. 3), plus “Farmer Mac guarantees” (p. 12). FederalHomeLoanBanks: Federal Home Loan Banks (2010), “Total liabilities” (“Combined StatementofCondition,”p. 194). PrivateEmployerPensionFunds—ExplicitlyGuaranteedLiabilities: LiabilitiesofallpensionfundsinsuredbythePBGC(whichinsuresonly definedbenefitplans)were$2,559billionin2007,thelatestdatefor which data are reported (Pension Benefit Guarantee Corporation 288 FederalReserveBankofRichmondEconomicQuarterly 2010,pp. 83,105). Thisfigureisinflatedbytwice(because2007– 2009involvestwoyearsofgrowth)theaverageannualgrowthrate ofPBGC-insuredpensionliabilitiesfrom1997–2007toobtainour estimateofallliabilitiesinpensionfundsinsuredbythePBGCas ofDecember31, 2009($2,946billion). SincePBGCcoverspen- sionsonlyuptoaspecifiedmaximumpaymentperyear,aportion of beneficiaries’ pensions in guaranteed plans—those with pen- sions paying above this maximum—are not insured. According tothePBGC,thisportionisestimatedtobe4–5percent(Pension BenefitGuaranteeCorporation2007,p. 24;PensionBenefitGuar- antee Corporation 1997, footnote to Table B-5). To arrive at the guaranteed portion of PBGC guaranteed pension fund liabilities, wemultipliedtotal2009fundliabilities($2,946billion)by0.95to yield$2,799billion. PrivateEmployerPensionFunds—TotalLiabilities: Thereappearstobenodataonthetotalliabilitiesofallprivateemployer- defined benefit pension funds. Therefore, we estimate our total liabilityfigurebasedonPBGCdata. Toderiveourfigure,webegin withourpreviouslydeterminedestimateofallprivatepensionfund liabilitiesthatareincludedinPBGC($2,946)andthendivideitby 0.9toarriveatourtotalliabilityfigureof$3,273billion. ThePBGC insures only about two-thirds of private sector single-employer- definedbenefitplans,butalmostallmulti-employerplans(Pension Benefit Guarantee Corporation 2009, p. 5). Among the types of defined benefit plans PBGC does not insure are small (fewer than25employees)plansmaintainedbysmallprofessionalservice employerslikedoctors,lawyers,andaccountants. SincethePBGC excludesonlythesmallersingle-employerplans,andincludesmost multi-employerplans,weassumethatitcoverswellmorethan66 percent(i.e.,two-thirds)ofallliabilities,settingourestimateat90 percent. OtherFinancialFirms—ImplicitlyGuaranteedLiabilities: “TotalliabilitiesofAIG”foundinits10Kreport,less“estimatedinsured deposits”ofAIGFederalSavingsBankfoundontheFDIC’sweb- siteinthe“InstitutionDirectory”(http://www2.fdic.gov/idasp). OtherFinancialFirms—TotalLiabilities: BoardofGovernors(2010),TablesL.116—Property-CasualtyInsurance Companies; L.117—Life Insurance Companies; L.126—Issuers N.MalyshevaandJ.R.Walter:TheFederalFinancialSafetyNet 289 ofAsset-BackedSecurities;L.127—FinanceCompanies;L.128— RealEstateInvestmentTrusts;L.129—SecurityBrokersandDeal- ers;L.131—FundingCorporations,lesstaxespayablewhenevera figurefortaxeswasreportedonthesetables. 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Jeffrey M. Lacker (2011, March 29). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20110330_jeffrey_m_lacker

@misc{wtfs_regional_speeche_20110330_jeffrey_m_lacker,
  author = {Jeffrey M. Lacker},
  title = {Regional President Speech},
  year = {2011},
  month = {Mar},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20110330_jeffrey_m_lacker},
  note = {Retrieved via When the Fed Speaks corpus}
}