Paul Tucker on American financial reform: Swallowed by the shadows
Sometimes it takes a friendly neighbor to point out how badly you’ve maintained your house. That’s what Jack Lew, America’s Treasury Secretary, has been doing by calling on Europe to beef up its bank resolution regime. Today, Paul Tucker, a former deputy governor of the Bank of England, did the same for America.
On most matters America is far ahead of other countries in both legislation and supervisory enactment of new rules and procedures. But will those new rules actually prevent, or mitigate, the next crack-up?
I have my doubts, and they have grown after reading a provocative new essay by Mr Tucker, and hearing him speak at today’s debut event of the Hutchins Center on Fiscal and Monetary Policy, based at the Brookings Institution.Mr Tucker, who now hangs out at Harvard Business School, praised many of America’s steps, in particular the stress tests the Fed now regularly applies to large banks to see how well they’d survive another recession or crisis. They bring to supervisory policy “the kind of accountability familiar in monetary policy.” He believes the problem of “Too Big To Fail” (TBTF) banks is “on the brink of being solved.” It just requires banks to hold plenty of capital at the holding company level that regulators can convert to equity to recapitalize it, no matter which subsidiary is insovlent. Unsexy as it is, bank structure is “orders of magnitude more important” than America’s Volcker rule, Britain’s Vickers Report and Europe’s Liikanen report.
The essence of the problem, though, is not bank rules. “The banking reforms are coherent and well conceived,” says Mr Tucker, “but no one should kid themselves that tomorrow’s problems are going to be located in banks.”
As capital and liquidity standards, the Volcker ban on proprietary trading, and stress tests tighten the regulatory vice on banks, “the substance of banking will inevitably re-emerge elsewhere: shadow banking.” Almost as serious as TBTF, he says, is this “endemic regulatory arbitrage”:
The financial services industry is a shape-shifter. As insurance firms have shown, with disastrous results in the case of AIG, anybody holding low-risk securities can build their own shadow bank by lending-out (“repo-ing”) their securities for cash and investing the proceeds in a riskier credit portfolio… [B]anking-like fragility can be generated through Russian doll– like chains of transactions or structures … which don’t involve a financial firm which could be re-labelled and regulated as a bank…
I worry that the authorities—perhaps particularly in this country—face problems in finding robust solutions, partly for political economy reasons.
Legislators in many countries favour rules-based regulation in order to guard against the exercise of arbitrary power by unelected regulators. But a static rulebook is the meat and drink of regulatory arbitrage. And the more detailed the rules, the more rules-arbitrage is implicitly legitimized, because the rule-makers must have said precisely what they meant and no more. “Reg-arb” is why money funds grew here (Regulation Q), and why asset-backed commercial paper conduits could be core to banks’ treasury management unconstrained by bank regulation. And quirks in regulation led to broker-dealer groups and commercial companies sidestepping bans on banking via so-called industrial banks in Utah with FDIC insurance. I could go on. This shape-shifting dynamic can leave policymakers in a game of catch-up, responding only as each incarnation becomes systemically significant—this year money funds, next year who knows what: real-estate investment trusts, credit funds, leveraged exchange-traded funds? A game that sooner or later the authorities would be doomed to lose. That is not least because by the time the products of reg-arb are evidently systemically significant, they have the lobbying power to delay reform.
The authors of the Dodd-Frank law of course recognized the threat of regulatory arbitrage, which is why it empowered the Financial Stability Oversight Committee to apply bank-like regulation to any shadow bank big enough to threaten the system. Mr Tucker thinks the design of the committee, which comprises the heads of all the federal regulatory agencies, “is, perhaps, imperfect.” (One suspects professional courtesy dissuaded him from using stronger language):
It is a committee of representatives, whose duties to Congress are in respect of the agencies they head rather than the FSOC’s stability objective…. Quite apart from the hazards in the label, the new U.S. regulatory regime does not cater well for circumstances where no individual non-bank of a particular kind is “systemic” but, taken together, a group of medium-sized firms or funds, or an activity, could bring about systemic distress. It is not yet clear how much force the FSOC’s public recommendations to the various regulatory agencies will carry… [And] what happens when a source of risk is not within the current jurisdiction of any micro-regulator?
Advocates of tougher bank regulation like Simon Johnson argue this is a red herring. Any activity that tougher bank regulation drives into the shadows “could be controlled in a straightforward and responsible fashion. Whether we have the political will to implement effective controls is, as always, another question – in large part because the big banks are very powerful and they would like the shadows to remain as shadowy as they are now.”
But an economist is being neither helpful nor realistic when he responds to institutional obstacles with, “assume political will”. It’s not a matter of simply muzzling some lobbyists. America’s shadow banking system is as big as it is because Americans and the politicians they elect like the diversity, innovation and competitive pressure with regular banks that it brings. Subprime mortgages were not some cancer that venal bankers inflicted on hapless low-income victims. They were a way to make credit available to a chunk of the population that had been systematically excluded by a highly regulated banking system. That it grew too much, and was exploited by venal bankers, says less about the intrinsic merit of financial innovation than about the tendency in all societies, but especially America, to turn a blind eye to such things when everyone seems to be benefiting.
Financial stability would be better served by one financial regulator using flexibility and discretion than a dozen using thick books of prescribed rules and armies of attorneys. But America does not have an overarching financial supervisor like Britain for the same reason that it does not invest all political power in its executive, as Britain does. That’s how Americans like it. And while the case for financial stability is compelling, they are not about to rewrite the constitution to achieve it.
The original post is linked here.