Financial regulation made simple..

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Everything the IMF wanted to know about financial regulation and wasn’t afraid to ask

Sheila Bair, 9 June 2013

Does anybody have a clear vision of the desirable financial system of the future? This column has one. It gives simple answers to 12 simple questions panellists at a recent IMF conference failed to answer.

I was honoured when the IMF asked me to moderate the Financial Regulation panel at this year’s Rethinking Macro II conference. And while naturally, I delivered one of the more enlightening and thought-provoking policy discussions of the conference, I did fail in my duties as moderator to make sure my panellists covered all the excellent questions our sponsors submitted to us. Of course, this was to be expected, as panellists at these types of events almost never address the topics requested of them (I certainly never do), but rather, like Presidential candidates, answer the questions they want to answer. However, being the conscientious person I am, who accepts responsibility for my mismanagement (unlike some bank CEOs we know), I will now step up and answer those questions myself.

1) Does anybody have a clear vision of the desirable financial system of the future?

Yes, me. It should be smaller, simpler, less leveraged and more focused on meeting the credit needs of the real economy. And oh yes, we should ban speculative use of credit default swaps from the face of the planet.

2) Is the ATM the only useful financial innovation of the last thirty years?

No. IF bankers approach the business of banking as a way to provide greater value at less cost to their customers, (I know – for a few bankers, that might be big 'if' technology provides a virtual gold mine for product innovations. For instance, I am currently testing out a pre-paid, stored value card which lets me do virtually all my banking on my I-phone. It tracks expenses, tells me when I’ve blown my budget, and lets me temporarily block usage of the card when my daughter, unbeknownst to me, has pulled it out of my wallet to buy the latest jeans from Aeropostale. The card, aptly called Simple, was engineered by two techies in Portland, Oregon. (Note to mega-banks: ditch the pin stripes for dockers and flip flops. The techies are coming for you next.)

3) Does the idea of a safe, regulated, core set of activities, and a less safe, less regulated, non-core make sense?

No.

The idea of a safe, regulated, core set of activities with access to the safety net (deposit insurance, central bank lending) and a less safe, MORE regulated, noncore set of activities which DO NOT UNDER ANY CIRCUMSTANCES have access to the safety net – that makes sense.

4) How do the different proposals (Volcker rule, Liikanen, Vickers) score in that respect?

Put them all together and you are two-thirds of the way there. The Volcker Rule acknowledges the need for tough restrictions on speculative trading throughout the banking organisation, including securities and derivatives trading in the so-called “casino bank”. Liikanen and Vickers acknowledge the need to firewall insured deposits around traditional commercial banking and force market funding of higher risk “casino” banking activities. Combining them would give us a much safer financial system.

But none of these proposals fully address the problem of excessive risk taking by non-bank financial institutions like AIG. Title I of Dodd-Frank empowers the Financial Stability Oversight Council to bring these kinds of “shadow banks” under prudential supervision by the Fed. Of course, that law was enacted three years ago and for nearly two years now, the regulators have promised that they will be designating shadow banks for supervisory oversight “very soon”. This was repeated most recently by Treasury Secretary Jack Lew on 22 May 2013, before the Senate Banking Committee (but this time he REALLY meant it). For some reason, the Fed and Treasury Department were able to figure out that AIG and GE Capital were systemic in a nano-second in 2008 when bailout money was at stake, but when it comes to subjecting them to more regulation now, well, hey we need to be careful here.

5) How much do higher capital ratios actually affect the efficiency and the profitability of banks?

You don’t have to be very efficient to make money by using a lot of leverage to juice profits then dump the losses on the government when things go bad. In my experience, the banks with the stronger capital ratios are the ones that are better managed, do a better job of lending, and have more sustainable profits over the long term, with the added benefit that they don’t put taxpayers at risk and keep lending during economic downturns.

6) Should we go for very high capital ratios?

Yep. I’ve argued for a minimum leverage ratio of 8%, but I like John Vickers 10% even better (and yes, he put out that news-making number during my panel&hellip

7) Is there virtue in simplicity, for example, simple leverage rather than capital ratios, or will simplicity only increase regulatory arbitrage?

The late Pat Moynihan once said that there are some things only a PhD can screw up. The Basel Committee’s rules for risk weighting assets are Exhibit A.

These rules are hopelessly overcomplicated. They were subject to rampant gaming and arbitrage prior to the crisis and still are. (If you don’t believe me, read Senator Levin’s report on the London Whale.) A simple leverage ratio should be the binding constraint, supplemented with a standardised system of risk weightings to force higher capital levels at banks taking undue risks. It is laughable to think that the leverage ratio is more susceptible to arbitrage than the current system of risk weightings given the way risk weights were gamed prior to the crisis, e.g. moving assets to the trading book, securitising loans to get lower capital charges, wrapping high risk CDOs in CDS protection to get near-zero risk charges, blindly investing in triple A securities, loading up on high-risk sovereign debt, repo financing … need I go on?

8) Can we realistically solve the “too big to fail” problem?

We have to solve it. If we can’t, then nationalise these behemoths and pay the people who run them the same wages as everyone else who work for the government.

9) Where do we stand on resolution processes, both at the national level and cross border?

Good progress, but not enough. Resolution authority in the US could be operationalised now, if necessary, but it would be messy and unduly expensive for creditors. We need thicker cushions of equity at the mega-banks, minimum standards for both equity and long-term debt issuances at the holding company level to facilitate the FDIC’s “single point of entry” strategy, and most importantly, we need regulators who make clear that they have the guts to put a mega-bank into receivership. The industry says they want to end “too big to fail” but they aren’t doing everything they can to make sure resolution authority works smoothly. For instance, industry groups like ISDA could greatly facilitate international resolutions by revising global standards for swap documentation to recognise the government’s authority to require continued performance on derivatives contracts in a Dodd-Frank resolution.

10) Can we hope to ever measure 'systemic risk'?

Yes. It’s all about inter-connectedness which mega-banks and regulators should be able to measure. Ironically, inter-connectedness is encouraged by those %$#@& Basel capital rules for risk weighting assets. Lending to IBM is viewed 5 times riskier as lending to Morgan Stanley. Repos among financial institutions are treated as extremely low risk, even though excessive reliance on repo funding almost brought our system down. How dumb is that?

We need to fix the capital rules. Regulators also need to focus more attention on the credit exposure reports that are required under Dodd-Frank. These reports require mega-banks to identify and quantify for regulators how exposed they are to each other. Mega-bank failure scenarios should be factored into stress testing as well.

[Since these questions relate to financial regulation, I will not opine on measuring systemic risks building as a result of loose monetary policy.]

10) Are banks in effect driving the reform process?

Sure seems that way.

11) Can regulators ever be as nimble as the regulatees?

Yes. Read Roger Martin’s Fixing the Game. Financial regulators should look to the NFL for inspiration.

12) Given the cat and mouse game between regulators and regulatees, do we have to live with regulatory uncertainty?

Simple regulations which focus on market discipline and skin-in-the-game requirements are harder to game and more adaptable to changing conditions than rules which try to dictate behaviour. For instance, thick capital cushions will help ensure that whatever dumb mistakes banks may make in the future (and they will), there will be significant capacity to absorb the resulting losses. Unfortunately, the trend has been toward complex, prescriptive rules which smart banking lawyers love to exploit. Industry generally likes the prescriptive rules because they always find a way around them, and the regulators don’t keep up.

You can see that dynamic playing out now, where the securitisation industry is seeking to undermine a Dodd-Frank requirement that securitisers take 5 cents of every dollar of loss on mortgages they securitise. They say risk retention is no longer required because the Consumer Bureau has promulgated mortgage lending standards. But these rules are pretty permissive (no down payment requirement, and a whopping 43% debt-to-income ratio) and I’m sure that the Mortgage Bankers Association is already trying to figure out ways to skirt them.

Rules dictating behaviour can sometime be helpful, but forcing market participants to take the losses from their risk-taking can be much more effective. One approach tells them what kinds of loans they can make. The other says that whatever kind of loans they make, they will take losses if those loans default.

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An excellent article!

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Does Dodd-Frank work? We asked 16 experts to find out

By Mike Konczal, Updated:

July 20, 2013

Sunday is the third anniversary of the Dodd-Frank Act. To get a sense of how implementation has been going, I asked 16 people at the forefront of the debate to answer two questions: What has gone better than you had expected? And what has gone worse? – Mike Konczal

Sheila C. Bair served as the 19th chairman of the Federal Deposit Insurance Corp. for a five-year term, from June 2006 through June 2011.

“Things that went better than expected: just about all of the rules where an agency could act alone, e.g., the FDIC’s rules on resolution authority and deposit insurance premiums; the CFPB’s rules on mortgage lending standards; the CFTC’s rules on moving standardized domestic swaps to centralized clearing.

“Things that were bigger problems than expected: just about all of the rules where inter-agency coordination and agreement were required: e.g. tougher bank capital standards, the Volcker Rule, risk retention for securitizers. Between agency squabbling and industry lobbying, Sisyphus could move faster than the agencies in moving these rules.”

Michael S. Barr is a  professor of Law at the University of Michigan Law School and former assistant secretary of the treasury for financial institutions, where he was a key architect of the Dodd-Frank Act.

“The opponents of financial reform are losing. There’s a strong, new Consumer Financial Protection Bureau, looking out for American households, and Senate Republicans finally relented and confirmed, by a lopsided vote, Rich Cordray as director of the bureau. Capital requirements are going up, derivatives are coming out of the shadows and major financial firms will be subject to strict supervision and wind-down authority regardless of corporate form. But much remains to be done, from LIBOR reform to the Volcker Rule, and the financial industry will continue to try to lobby, litigate and legislate their way out of the tough new rules. Now is not the time to lose hope, stop fighting or give in, but to renew the commitment to making the financial system fairer and safer.”

Louise Bennetts is the associate director of financial regulation studies at the Cato Institute and was formerly a corporate lawyer in private practice advising bank and nonbank clients on Dodd-Frank implementation.

“The FDIC has taken some positive steps towards developing a viable bankruptcy regime for large firms through their ‘single point of entry’ strategy, although they still have some way to go. Otherwise, the implementation of the act has been messy. The act has many design flaws, but chief among them has been the amount of discretion awarded to regulators, which creates significant economic costs and uncertainty in the market as well as undermining the rule of law. Overall, the act has resulted in a contraction of ordinary credit, more expensive loans for consumers, a reduction in global capital flows and less efficiency in capital allocation without addressing most of the fundamental causes of the 2008 crisis.”

Heather Slavkin Corzo is the Senior Legal and Policy Advisor for the AFL-CIO Office of Investment.

“It has been a pleasant surprise to see how efficiently the CFTC, a tiny agency, has moved to implement derivatives regulatory reform. While there are certainly areas where I wish the rules were stronger, I think Chairman Gensler deserves a lot of credit for putting a regulatory framework in place that will make our financial system more safe and sound.

“At the same time, it has been shocking to witness how quickly so many people in Washington have forgotten the lessons of the crisis. Under the guise of technical amendments, some in Congress have moved to repeal key components of Dodd-Frank, such as CEO-to-worker pay ratio disclosures, and create dangerous loopholes in derivatives regulation. Other provisions important to protecting the safety and soundness of the financial system, like the Volcker Rule and the requirement that banks move certain types of derivatives trades into separately capitalized subsidiaries, remain in regulatory limbo.”

Douglas Elliott, fellow in economic studies at the Brookings Institution

“I’ve been pleased and surprised by the great progress on developing a workable method of resolving large troubled banking groups using the Single Point of Entry approach, which has been led by the FDIC and received good cooperation from other regulators.

“I’ve been disappointed by the problems in working through many of the issues that require transatlantic cooperation. There is so much agreement on the goals and overall approaches that we really ought to be able to do a lot better in agreeing on the specifics.”

Alexis Goldstein worked on Wall Street for seven years and is now an Occupy Wall Street activist

“The inaction and administration’s weakness on the Volcker Rule has been inexcusable and disappointing. Myself and others documented in the Occupy the SEC comment letter how the draft of the rule was rife with loopholes. The final rule is over one year late, with no end in sight. President Obama trumpeted this rule for a good PR buzz, and then allowed it to languish in purgatory. A strong final Volcker Rule would ensure that banks that enjoy the benefits of the Fed discount window can’t make risky bets that put the entire economy at risk. The lack of meaningful pressure coming out of the administration on the Volcker Rule shows their complete disinterest in meaningful financial reform.

“Overall, the Financial Stability Oversight Council (FSOC) has been a disappointment. They were given many new responsibilities and powers that they have left unused, including the ability to break up any systemically risky institution. But the FSOC has been quite strong on money market reform. When the SEC wasn’t moving on money market reform, the FSOC threatened to override the Agency if they failed to act. Given how vigorously the Chamber of Commerce lobbied against money market reform, the fact that the FSOC insisted on kick-starting these reforms anyway was a welcome surprise.”

Dennis Kelleher is president of the nonprofit Better Markets, a former senior staff member in U.S. Senate and a former partner at Skadden Arps.

“No question that former Goldman Sachs partner Gary Gensler as chairman of the CFTC has regulated derivatives, correctly referred to by Warren Buffett as ‘financial weapons of mass destruction,’ better than anyone expected. Virtually all other financial reform has been a much bigger problem because no one expected Wall Street’s scorched earth strategy of fighting all financial reform nonstop.”

Aaron Klein directs the Bipartisan Policy Center’s Financial Regulatory Reform Initiative

“The part that has gone better is in failure resolution. Dodd-Frank attempted to solve the ‘too big to fail’ problem in several ways, including creating a new failure resolution regime that applies to all systemically important financial institutions. The FDIC came up with a ‘single point of entry’ approach to carry out the new regime although that approach does not appear in Dodd-Frank. It has been a breakthrough, gaining significant international buy-in from both the United Kingdom and Canada.

“The part that has gone worse is regulatory cooperation. The financial crisis of 2008 showed the importance of domestic and international regulatory cooperation. Dodd-Frank’s efforts to encourage greater cooperation have so far been mixed at best. Domestic regulators can’t agree on a Volcker Rule, the SEC and CFTC can’t agree on a common definition for a U.S. person, and the Federal Reserve has moved aggressively through its foreign bank proposal in a way that has raised threats of retaliation from other central banks.”

Adam Levitin is a law professor at the Georgetown University Law Center

“On the plus side, the CFPB has been a huge success. The newly created agency has impressed even its critics by turning out a battery of balanced rule-makings on schedule and flexing the most effective enforcement muscle yet seen from a financial regulator even as it continues to staff up and in the face of intense political headwinds. On the minus side, the failure of other federal bank regulators to agree on the definition of the ‘qualified residential mortgage’ exemption from the Dodd-Frank Act’s credit risk retention for securitization has contributed to the uncertainty about the future of the housing finance market, which is the Dodd-Frank Act’s unaddressed elephant in the room for financial regulatory reform.”

Brad Miller is a former member of the House Financial Services Committee, where he led efforts to prohibit predatory mortgage lending and create the CFPB. He is now a senior fellow at the Center for American Progress and of counsel to the law firm of Grais & Ellsworth LLP.

“On the policy front, the fight over implementing regulations has been harder than imagined. Reformers have just not had the resources to fight. Rulemaking has been dominated by the biggest banks, with unlimited money for lobbyists, lawyers and economists to meet with regulators, write comments, do slanted cost-benefit analyses, bring lawsuits, and whatever else.

“On the positive side, the public is more convinced than ever that Wall Street needs tougher rules and to be held accountable when they break the rules. Public support for consumer protection is still especially strong. The CFPB has generally picked the right fights and worked well with responsible voices in industry. The CFPB is here to stay. The Washington political establishment is still easily swayed when Wall Street lobbyists puff themselves up and declare patronizingly that Wall Street critics simply don’t understand the complexity of financial issues. Since we are still a democracy of sorts, what the public thinks should eventually matter more.”

Bartlett Naylor, financial policy advocate for Public Citizen’s Congress Watch division

“Seven years after the crash, the debate about solutions has grown better than expected, with more sophisticated arguments and actual progress on leverage requirements, a sophisticated Glass-Steagall reconstitution plan, and talk from Republicans about size limits. Also the OCC and FDIC are now moving in the right direction. However the Federal Reserve remains captured. Friendly insiders say staff holdovers from Alan Greenspan’s administrations are quietly sabotage any actual progressive thinking.”

Robert Nichols, president and CEO of the Financial Services Forum

“What’s good: Due to industry-initiated improvements, laws passed by Congress and regulatory changes, real progress has been made to increase the safety, soundness and stability of U.S. financial sector. For example: capital and liquidity are double pre-crisis levels; balance sheets are much more solid; risk management and governance structures have been dramatically improved; banks have significantly deleveraged; compensation structures have been reformed to closely align the personal incentives of employees with banks’ long-term performance and safety and soundness; banks have passed multiple stress tests imposed by the Federal Reserve; and banks recently submitted ‘living wills’ to regulators, detailing the structure of each bank company and how companies could be dismantled in the event of a failure. Overall, the U.S. banking system is safer, more transparent and more accountable.

“What’s bad: Perhaps as a result of the delay in implementing parts of Dodd-Frank, some policymakers have unfortunately proposed additional and, in our view, unnecessary legislative proposals that would harm our economic recovery by undermining the effectiveness, innovative capacity and competitiveness of the U.S. banking sector. Regulators and the industry need time to fully implement the changes that Congress has already mandated. Additional and potentially punitive regulations before the provisions of Dodd-Frank are fully implemented risks over-kill, to the detriment of credit availability and the broader economy, at a time when economic growth remains very slow and fragile, and tens of millions of Americans remain out of work or underemployed.”

Karen Petrou is co-founder and managing partner of Federal Financial Analytics

“What has gone better than I expected is the dramatic improvement in the condition of the U.S. banking system, although much of this is attributable to regulatory action — especially FRB stress tests — not Dodd-Frank. I also commend the FDIC for its work building out the new orderly-resolution standards designed to end too big to fail. The law is strong but the rules remain weak, leading to widespread skepticism that TBTF has been meaningfully addressed. As long as markets believe TBTF lives, sadly it still does.”

Marcus Stanley is policy director for Americans for Financial Reform

“The progress of the CFPB has been the most impressive thing about Dodd-Frank implementation. In 2009, very few people would have predicted that a few years later there would be a fully operational and independent consumer financial protection bureau.

On the negative side, there are too many other areas where regulators have not acted to use the broad authority they were granted in Dodd-Frank to hold the financial system accountable. They have not yet followed through with rules adequate to the problems revealed in the financial crisis, or in many cases with any completed rules at all. An exception has been Gary Gensler at the Commodity Futures Trading Commission. While there are flaws in the CFTC’s derivatives framework it still represents a substantial improvement over the pre-crisis lack of derivatives regulation, and it’s impressive that the smallest financial regulator has managed to actually complete one of the biggest rulemaking jobs in Dodd-Frank.”

Jennifer S. Taub, an associate professor at Vermont Law School, is the author of a book forthcoming in early 2014 from Yale Press on the financial crisis.

“The conditions that brought the financial system to the brink of failure in 2008 persist. The Dodd-Frank Act while a good starting point is insufficient both as enacted and as currently implemented to accomplish its key goals of promoting financial stability, improving accountability and transparency and ending ‘too big to fail.’ The crown-jewel of the Dodd-Frank Act is the Consumer Financial Protection Bureau, which at last has an appointed director.

“The greatest disappointment has been the delays and dilutions. In particular, though proposals have been made to modestly raise permitted equity capital for giant Bank Holding Companies it is still just 3 percent, that financial firms still rely on trillions of dollars in short-term and overnight funding to finance their longer-term assets and that the Volcker Rule has not been implemented.”

Wallace Turbeville practiced law on Wall Street for eight years and was an investment banker at Goldman Sachs for 12 years. He is now a senior fellow at Demos focusing his research on the financial markets.

“Having never been significantly involved in the process of implementing federal laws through regulations, my expectations in July 2010 were uniformly naïve. The ability of CFTC Chairman Gensler and his staff to maintain an intense effort to develop and finalize derivatives rules that are coherent and comprehensive, despite imperfections, exceeded expectations.

On the other hand, I never expected the widespread memory loss concerning the implications of 2008, especially the breadth and depth of the dysfunction in the financial sector at that time. It never occurred to me that talking points drafted to focus attention on the events most proximate to the crash in September 2008 (Lehman, Bear Stearns, AIG) would successfully distract policy makers and pundits from the perversions of the financial sector that emerged from our experiment in deregulation. It is surprising that so many opinion leaders resist the idea that the repeal of Glass-Steagall was a substantial cause of the crisis and that the financial sector’s use of complex and obscure financial transactions was, and is, at its core a predatory practice.”