We need simple new names for financial market institutions (Premium Content)

We argue for better language to describe various functions in financial markets. There are banks and bank holding companies that offer a wide variety of credit intermediation and agency services. There are nonbanks including hedge funds and asset managers that provide liquidity and offer credit intermediation. Calling something Shadow Banking doesn’t work when we are talking about financial market activities since banks can perform supposedly Shadow Banking activities, and nonbanks like insurance companies and corporates issue funding obligations, like a bank, on a regular basis. The language doesn’t work. We propose here some straight-forward alternatives based on function, not form.

We see two broad classes of financial institutions today: Financial Intermediators and Fee-based Agency Businesses.

Financial intermediators. If it takes maturity or credit risk, then this is one category of institution. It makes no sense for us to call a hedge fund providing credit a different beast than a bank or broker-dealer. If the financial industry and its regulators are going to get serious about systematic risk, then they should capture all institutions that are engaged in risky business. These institutions should then be evaluated based on Basel III, EMIR, Dodd-Frank, etc, to ensure their stability and capital adequacy in times of crisis. Banks, CCPs, SOME hedge funds, SOME asset managers, SOME corporates and others meet this definition. But not all. It is important to separate out what entity does what and why it matters.

Fee-based Agency Businesses. This includes trading on an agency basis for a fee (ie, equity trading); asset managers including UCITS and mutual funds paid to invest in hard assets for a fee; custody; and other strictly fee-based businesses. These businesses are driven by a principal investor outsourcing investing knowledge, technology or operations. Deal-making like investment banking that includes no principal positions should be included here as well. These businesses are not first and foremost seeking to be paid to intermediate credit or to be principal in a maturity transformation trade.

What of organizations that contain both financial intermediators and fee-based agency businesses? We propose splitting them out. Make the financial intermediation businesses sit together and have one set of regulatory and capital requirements. Let the fee-based businesses sit together elsewhere and have their own rules. Bank Holding Companies, diversified asset managers and hedge funds with their own broker-dealers and other hybrids will always exist.

How about clearing, which is a credit intermediation business? It is fee-based but clearing firms are relying in part on their own guaranty funds deposited with CCPs in order to facilitate client business. The definition says enough: this is a financial intermediation business.

As one argument for why our nomenclature makes sense, we point to a FT op-ed from Tuesday December 30, 2014 – “Stress testing should not just be for the banks“. We agree, but we’ve gotten trapped in this naming convention that lets some big financial institutions (“nonbanks”) not be stress tested even when they perform the exact same functions as banks. There are also different stress tests for form that have nothing to do with function. That just doesn’t make sense.

It’s time to make new names for the institutions that define our financial markets. A bank used to be something with a clear definition, now it can be most anything with a particular regulatory wrapper. The same goes for asset managers, hedge funds and insurance companies. We’d much prefer two sets of institutions: one that intermediates and takes a certain level of risk, and another that is paid a fee for facilitating an 100% agency transaction. If regulators apply one set of regulations based on function, not form, that may sort out many of today’s arguments about who should be regulated and how.

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