Gruenberg calls for tailored FSOC designations, more nonbank reporting

Drew Angerer/Bloomberg

WASHINGTON — Federal Deposit Insurance Corp. Chairman Martin Gruenberg said Wednesday he would like to see the Financial Stability Oversight Council consider applying tailored enhanced prudential standards and enhanced reporting requirements to particular nonbanks' like open-ended mutual funds, hedge funds and nonbank lenders.

In a speech delivered to the Exchequer Club, Gruenberg also noted that such firms — not well understood by regulators — would need to report more information so the agencies could better understand the role they play and the risks they pose. 

"Consideration should be given to the development of a more tailored process that reduces undue financial system risk while applying prudential regulation and resolution planning requirements that are fit for purpose in the context of a particular nonbank financial institution's risks," he said. "The FSOC, the Office of Financial Research and individual FSOC agencies should work together to establish a reporting framework to ensure that the FSOC has appropriate information to assess the financial stability risks of nonbanks and the activities in which they engage, and to ensure that public reporting is sufficient for market participants to appropriately understand the counterparty risks associated with individual nonbank financial institutions."

The Financial Stability Board — made up of national financial authorities and international standard-setting bodies — defines nonbank financial institutions as any financial firms that are not central banks, licensed nominal banks, or public financial institutions like the World Bank. Under the Dodd-Frank act, the FSOC — a council chaired by the heads of the federal financial regulators created after the 2008 financial crisis — is authorized to deem nonbank firms systemically risky and subject them to Federal reserve supervision and enhanced prudential standards.

Gruenberg said he believed nonbanks' insufficient regulation, opacity and lack of limits to their reliance on leverage contributed to worsening both the Global Financial Crisis and the COVID-19 economic emergency. In both cases the Federal Reserve ultimately utilized its power to provide emergency lending facilities to such firms to stave off systemic contagion.

"The experience with nonbank financial institutions through these two crises underscores the financial stability risks they can pose, the resulting claim they have on public support, and the urgent need to give careful consideration to how to address those risks," he said.

Gruenberg said one group of firms that particularly concerns him, open-ended mutual funds, including mutual funds and money-market funds which play important roles in the provision of credit to the U.S. economy, contributed to market stress in March 2020 because they often have a mismatch in liquidity. Open-end funds typically invest in longer term, higher yielding instruments, while investors can redeem shares in short order, incentivizing investors to secure "first mover advantage" and pull funds quickly in times of stress.

The FDIC Chairman also expressed concerns about hedge funds — highly leveraged investment vehicles that often rely on short–term funding. He said this business model makes them vulnerable to market shocks and, because they are highly interconnected with traditional banks, especially risky in times of stress.

Gruenberg also highlighted his concerns that nonbanks are increasingly offering bank-like services, such as mortgage finance, business lending, and consumer finance. He noted that the lack of transparency in these markets can make it challenging to assess risks even as nonbank companies have seen their market share in these markets grow. Nonbank companies have witnessed their market share of U.S. mortgage financing increase nearly five-fold over a decade, with nonbanks currently managing over 55 percent of U.S. mortgages — a significant rise from just 11 percent in 2011.

"If a nonbank financial institution conducting these activities is sufficiently large or otherwise serves critical functions, systemic risk issues could be implicated," he said. "It is important that the FSOC has renewed its efforts to review the risks in these sectors and to consider whether our current regulatory authority is sufficient to address them."

Gruenberg also fired back against bank industry criticisms of the federal banking agencies recently issued proposal applying Basel III endgame standards requiring large banks to retain more capital to protect against losses. Many in the banking industry have criticized the proposal, arguing it would reduce lending and cause those activities to migrate out of the highly regulated banking system. Gruenberg noted that adequate banking regulation and attention to the risks of nonbank are not mutually exclusive.

"The obvious response to that is there should be appropriately strong capital requirements for those activities in the banks, complemented by greater transparency, stronger oversight and appropriate prudential requirements for nonbanks," he said. "That would be the most effective and balanced way to enhance the stability of the entire financial system."