On May 7, the Financial Stability Oversight Council issued its annual report, which noted that some traditional bank activities are moving to nonbank firms that are not subject to capital and liquidity requirements. The FSOC is a group of financial regulators established by the 2010 Dodd-Frank Wall Street Reform Act that watches out for market risks and imposes additional regulation on large "systemically important" firms whose collapse could harm the financial system.
Regulators at the state and federal level are pushing to impose some type of prudential regulation on nonbank financial firms. Much of the concern in the U.S. regarding nonbanks comes from the fact that they are growing rapidly, especially in the area of mortgage lending and servicing. This growth stems largely from such recent regulatory changes as the Basel III capital rules, the multistate mortgage settlement and Dodd Frank itself, each of which is effectively pushing commercial banks out of the mortgage business.
It is important to recall that almost half of all 1-4 family mortgage loans are made by nonbanks and that, as recently as three decades ago, mortgage lending was not a significant activity for commercial banks in the United States. Instead, the mortgage business was dominated by S&Ls and nonbanks which could finance their activities in the deposit and money markets. Today, however, nonbanks are largely dependent upon commercial banks for funding.
Contrary to the popular notion that nonbanks are not regulated, they are closely regulated by state and federal regulators with regard to business activities, consumer protection and other laws related to their operations. American nonbank lenders and loan servicing companies, for example, are regulated by the Consumer Financial Protection Bureau and the various states in terms of lending and loan servicing equally with banks. In fact, the largest nonbank institutions are the housing government-sponsored enterprises such as Fannie Mae, Freddie Mac, and the Federal Home Loan banks.
Only in the area of prudential regulation of safety and soundness, and ownership, can nonbanks in the U.S. escape the oversight applicable to depositories (and broker-dealers) with respect to capital. And this exception may soon change. Consider several key developments:
- In 2014, the FSOC finalized the criteria it will use to determine which nonbank companies are systemically important financial institutions or "SIFIs." The FSOC has the authority to prescribe capital requirements for SIFIs, including insurers, asset managers and nonbank lender/servicers.
- The Federal Housing Administration and the Federal Housing Finance Agency are engaged in a broad review of counterparty risk issues as they apply to nonbank seller/servicers which face the various housing guarantors, including the housing GSEs. Both banks and insurance companies, for example, are permitted to be members of the Federal Home Loan Bank system.
- The Conference of State Bank Supervisors has requested proposals to develop draft language for state legislatures to use in prescribing minimum capital ratios and other prudential norms for nonbank mortgage servicing companies. The concern of the CSBS and other regulators is the rapid growth of nonbank mortgage servicing companies.
All of these developments point to a heightened concern among regulators at the federal and state level regarding the appropriate levels of regulation and capital for nonbank companies. Many contemporary observers view the issue of regulation of nonbanks as being new. Nicholas Borst, writing in The International Economy, notes that the focus on nonbanks by international regulators is a relatively recent development. Yet concern about nonbank financial companies is hardly a new revelation.
In fact, nonbank financial firms have been an important part of the U.S. economy for more than a century. Nonbank financial institutions in the form of mortgage, insurance and securities companies were a key cause of the Great Crash of 1929 as well as the subprime bust of 2007-2009. And nonbanks have been a key part of financial regulation ever since.
Half a century ago, for example, Professor Allan Meltzer talked about the regulation of nonbanks in the broader context of financial regulation as "being based on a peculiar notion of equity." The Nixon Administration subsequently created the Commission on Financial Structure and Regulation to ensure that the uneven erosion of 1930s era regulations did not create an "uneven playing field" between banks and nonbanks.
Balancing the benefits and risks that nonbank financial institutions represent is an important and appropriate goal for public policy, and one that has been ongoing for decades. The discussion regarding the role and financial stability of nonbanks is a healthy development for consumer and investors. But the current debate is filled with a number of misconceptions that detract from the goals of enhancing market stability and economic growth as called for in the Dodd-Frank law.
"The main problem with the [FSOC] report," notes Borst, "is that while claiming to cover both entities and activities outside of the regular banking system, the focus of the report is decidedly on entities and not activities."
Before the FSOC or other agencies start to impose capital requirements on nonbank financial companies, let's make sure we understand the business models and the risks that these firms actually take.
Christopher Whalen is senior managing director at Kroll Bond Rating Agency and is responsible for financial ratings as well as research activities for the group.