By Karen Petrou
Starting in 2010, U.S. regulators erected a pyramid of complex, costly, and stringent safety-and-soundness, resolution-planning, and conduct regulations for the largest U.S. banking organizations that have come to be called SIFIs (i.e., systemically-important financial institutions). Starting in 2018, the agencies began to demolish the still-incomplete SIFI pyramid, issuing on October 31 two sweeping proposals (here and here) not only to implement new U.S. law, but also to go farther. Bankers say this is nice, but not enough; critics lambast the proposals as forerunners of the next financial crisis. Either could be right – the proposals repeat the most fundamental mistake of post-crisis financial regulation: rules piled upon rules or, now, rules subtracted from rules without even an effort to anticipate how all of the revised rules work taken altogether in the financial marketplace as it exists in the real world, not in a set of academic papers or political edicts. The most fundamental safeguard for economic equality is a sound financial system offering sustainable products to low-and-moderate income households. By this criterion, the new rules fail as badly as the current ones.
What the Proposals Proffer
As seems always the case, these notices of proposed rulemaking (NPRs) are intimidating documents running to hundreds of pages backed by at least half a dozen footnotes per page along with statistics that seemingly support every assertion. Many questions are asked, but only a few seem intended for genuine discourse on concrete alternatives – once three agencies have combined forces to construct something with which each can live that they all think might satisfy Congress, it’s pretty much a done deal despite the request for comment.
Using authority provided in EGRRCPA, the proposals “tailor” current big-bank capital, liquidity, stress-testing, and a few other rules for banks and some parent holding companies with assets above $50 billion. Although the proposals extend now not just to bank holding companies (BHCs) but also to at least one savings-and-loan holding company (S&LHC), they do not reach to other depository institution holding companies even though some of these are big and some new ones could be far bigger and even less traditional. So, a first-order question is: why are the agencies perpetuating asymmetries within their own regulatory framework even though all their public statements suggest that doing so is dangerous? Leaving the politics aside – which the agencies clearly didn’t – if these rules make sense for regulated companies owning insured depositories, why impose them only selectively?
The NPRs then create four categories of covered banking organizations under regulatory frameworks ranging from the far more relaxed one for companies scored as non-complex between $100 billion and $250 billion to no change at all for U.S. global systemically-important banks (GSIBs). GSIBs hold about 66% of U.S. banking assets, so institutions with about only 30% or so of the nation’s banking assets would see any change.
The aggregate statistics in the NPRs state that the rules make little difference. If this is so, then why bother? They reach this undoubtedly incorrect conclusion by failing to refine their analysis to only the banks for which the rules make a difference. Yet again, the agencies are offering a complex proposal backed by aggregate data providing no clue as to its real-world impact. Our own analysis suggests it will be very significant for all but the very biggest U.S. banking companies. Second-order question: how could the agencies blithely promulgate these complex proposals with such scant, back-of-the envelop analytics?
And, even if all the data made sense, these proposals must fit seamlessly into the remaining framework – not considered in the NPRs – and are only part of a package of rules announced along with them but weeks or months away from public release. For example, the new categories and capital rules are supposed to fit somehow into the stress capital buffer the regulators released in April, a framework for foreign banks at some future date, a set of unannounced changes to the capital-planning rules on which the new stress-test regulations rely, and a complete rewrite of the way big banks plan for their own demise. At best, regulators have a clue about what these rules might do at one point in time; more likely, they don’t know now and will be still more confused after the current proposals hit the hard reality of the redefined post-crisis framework in a financial market under increasing stress dominated by more and more non-banks.
The Sound-Banking Criterion
As I said, there are two criteria for equality-enhancing banking, the first being that rules combine with market incentives to reduce the risk of crises and ensure that, when the inevitable crisis befalls us, the only ones who suffer are financial-institution shareholders, senior management, and other large financial companies that should have known better than to do business with the troubled bank.
Since 2008, U.S. and global regulators have built a bulwark of capital and liquidity rules in which they take great pride as for-sure crisis prophylactics. Now, key aspects are being dismantled, on grounds that the only banks that could cause a crisis are the biggest ones kept under all the current rules. Does this make sense? The NPRs give this only brief consideration and content themselves with expectations that a lot of small banks won’t fail at once and, if they did, there’s always the FDIC to come to the rescue.
It’s indeed unlikely that a lot of smaller banks would fail all at the same time and, if they did, do as much damage as correlated failures among the GSIBs. However, as a Federal Reserve Bank of New York official opined just last week, bank business models are increasingly correlated down well below the GSIB thresholds. As a result, dismantling the resolution-planning rules in concert with providing all this regulatory relief is dangerous. The principle that banks should fail at cost only to themselves and those who should have known better applies regardless of size unless the U.S. wants a partly nationalized banking system.
It makes a lot of sense to eliminate rules such as the advanced approach to risk based capital, which has demonstrable inequality effects and to temper the liquidity rules to give banks more balance-sheet capacity. These rules have demonstrable inequality impact, especially in the context of current, unconventional monetary policy and the wholly asymmetric nature of U.S. bank regulation. Changing these rules enhances the availability of sustainable financial services from regulated financial institutions, thus helping to achieve the second economic-equality criterion. That said, stress testing may still be needed – do we really know if eliminating these once-critical rules can occur safely without regular stress testing and crisis-ready resolution protocols? The NPRs again shed no light on this critical question nor is anyone else asked to opine on it.
What Banks Are For
The new proposals combine with all the old rules to prove yet again that bank regulators are designing rules with their own institutional and political priorities firmly in mind and the resulting structure of U.S. financial intermediation at best an after-thought founded on dubious quantitative estimates. If it is true that equality-enhancing finance must be founded on resilient, regulated, and well-distributed financial intermediation – and I think this is hard to dispute – then the post-crisis framework, even as amended, falls far short.
Some inequality-increasing rules are being removed for some banks some of the time, but the framework still applies to more than two-thirds of the banking system. It is thus inevitable that, as long as inequality-enhancing rules apply in this lopsided way, low-and-moderate income households will go to nonbanks or go begging for basic banking. At the same time, banks of all sizes are under sweeping rules that still may not ensure resilience under stress and ready resolution in the event of failure. The most important lesson of 2008 was that financial-services firms must be readily resolvable at the expense only of the FDIC insurance fund and their shareholders, senior management, and knowledgeable market partners. Ten years later, we’re about to have a different regulatory framework , but one just as inequitable, big, just as unworkable, and just as ill-prepared for the next financial crisis.