Financial regulation

Qualifying for the Fed

Monetary economists of nearly all persuasions are overwhelming in their condemnation of President Trump’s desire to appoint Stephen Moore and Herman Cain to vacant seats on the Board of Governors of the Federal Reserve. The full-throated case for a high-quality Board offered by Greg Mankiw—former Chief of the Council of Economic Advisers under President George W. Bush—is just one compelling example.

Rather than review President Trump’s picks, in this post we enumerate the key qualities that we believe make a person well suited to serve on the Board. Before getting to any details, we should emphasize our strongly held view that there is no simple prescription—in law or practice―for what makes a successful Federal Reserve Governor. Furthermore, no single person combines all the characteristics needed to make for a successful Board. For that, diversity in thought, preferences, frameworks, decision-making, and experience is essential.

With the benefits of diversity in mind, we highlight three common characteristics that we consider vital for anyone to be an effective Governor (or Reserve Bank President). These are: a deep respect for the Fed’s legal mandate; a clear understanding of an analytic framework that makes policy choices reasonably predictable and effective; and an open-mindedness combined with humility that tempers the application of that framework….

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Treasury Round II: The Capital Markets Report

Earlier this month, the U.S. Treasury published the second of four planned reports designed to implement the core principles for regulating the U.S. financial system announced in President Trump’s February 2017 Executive Order. This report focuses on capital markets. We wrote about the first report—regarding depository institutions—in June (see here). Future reports are slated to address “the asset management and insurance industries, and retail and institutional investment products and vehicles” and “nonbank financial institutions, financial technology, and financial innovation.”

A central motivation for all this work is to review the extensive regulatory reforms enacted in the aftermath of the 2007-09 financial crisis. President Trump’s stated principles provide an attractive basis for evaluating the effectiveness of Dodd-Frank in making the financial system both more cost-effective and safer. Where have the reforms gone too far? Where have they not gone far enough?

Much of the capital markets report focuses on ways to reduce the regulatory burden, and many of the proposals—which address issues ranging from initial public offerings (IPOs) to securitizations to financial market utilities (FMUs)—could improve market function. However, while they would involve a large number of changes—most of which can be implemented without new legislation (see table)—none of the 100-plus recommendations seem terribly dramatic, nor are they likely to have much impact on the goal of promoting economic growth.

Our overall reaction is that Treasury’s predispositions—which were more clearly evident in the earlier report—encourage doubts. To us, the numerous proposals look lopsided in favor of providing “regulatory relief” even where systemic concerns may persist....

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The Other Trilemma: Governing Global Finance

Courses in international economics usually introduce students to the impossible trinity, also known as the trilemma of open-economy macroeconomics: namely, that a fixed exchange rate, free cross-border capital flows, and discretionary monetary policy are incompatible. Why? Because, in the presence of free capital flows under a fixed exchange rate, private currency preferences (rather than policymakers) determine the size of the central bank balance sheet and hence the domestic interest rate. We’ve highlighted this problem several times in analyzing China’s evolving exchange rate regime (see here and here).

While many students learn that a country can only have two of the three elements of the open-economy trilemma, few learn that there also exists a financial trilemma. That is, financial stability, cross-border financial integration, and national financial policies are incompatible as well. The logic behind this second trilemma is that increases in financial integration reduce the incentives for national policymakers to act in ways that preserve financial stability globally. Put differently, as the benefits from financial stability policies spread beyond borders, the willingness to bear the costs of stabilizing the system at the national level decline. This has the important implication that, if we are to sustain increasing financial integration, then we will need greater international coordination among national financial regulators (see here, or for a much broader case for international economic governance, see Rodrik)....

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An Open Letter to the Honorable Randal K. Quarles

Dear Mr. Quarles,

Congratulations on your nomination as the first Vice Chairman for Supervision on the Board of Governors of the Federal Reserve System. We are pleased that President Trump has chosen someone so qualified, and we are equally pleased that you are willing to serve.

Assuming everything goes according to plan, you will be assuming your position just as we mark the 10th anniversary of the start of the global financial crisis. As a direct consequence of numerous reforms, the U.S. financial system—both institutions and markets—is meaningfully stronger than it was in 2007. Among many other things, today banks finance a larger portion of their lending with equity, devote more of their portfolios to high-quality, liquid assets, and clear a large fraction of derivatives through central counterparties.

That said, in our view, the system is not yet strong enough. In your new role, it will be your job to continue to fortify the financial system to make it sufficiently resilient.

With that task in mind, we humbly propose some key agenda items for the first few years of your term in office. We divide our suggestions into five broad categories (admittedly with significant overlap): capital and communications, stress testing, too big to fail, resolution, and regulation by economic function....

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China: Deleveraging is Hard to Do

For the first time in nearly three decades, Moody’s recently downgraded the long-term sovereign debt of China, lowering its rating from Aa3 to A1. As is frequently true in such cases, the adjustment was overdue. Since China’s massive fiscal stimulus in 2008, the government has experienced a surge in contingent liabilities, as its (implicit and explicit) guarantees fueled an extraordinary credit boom that continues today.

While the need to foster financial discipline is obvious, the process will be precarious. Ning Zhu, the author of China’s Guaranteed Bubble, has compared the scaling back of state guarantees to defusing a bomb. China’s guarantees have distorted incentives and risk taking for so many years that stepping back and allowing market forces to operate will inevitably impose large, unanticipated losses on many people and businesses. Financial history is replete with failed policy efforts to address credit-fueled asset price booms, such as the current one in China’s real estate. There is no safe mechanism for economy-wide deleveraging.

China’s policymakers are clearly aware of the dangers they face and are making serious efforts to address them. This year, authorities have initiated a new crackdown aimed at reducing the systemic risks that have been stoked by the credit boom. This post focuses on that policy effort, including the background causes and what will be needed (aside from good fortune) to make it work....

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The Treasury's Missed Opportunity

Last week, the U.S. Treasury published the first of four reports designed to implement the seven core principles for regulating the U.S. financial system announced in President Trump’s Executive Order 13772 (February 3, 2017).

Seven years after the passage of Dodd-Frank, it’s entirely appropriate to take stock of the changes it wrought, whether they have been effective, and whether in certain cases they went too far or in others not far enough. President Trump’s stated principles provide an attractive basis for making the financial system both more cost-effective and safer. And much of the Treasury report focuses on welcome proposals to reduce the unwarranted compliance burden imposed by a range of regulations and supervisory actions on small and medium-sized depositories that—if adequately capitalized—pose no threat to the financial system. We hope these will be viewed universally as “motherhood and apple pie.”

Unfortunately, at least when considering the largest banks, our conclusion is that adopting the Treasury’s recommendations would sacrifice resilience to achieve cost reductions, yet with little prospect for boosting economic growth. Put simply, implementation of the Treasury plan would reduce regulation of the most systemic intermediaries, and in so doing, unacceptably reduce the resilience of the U.S. financial system....

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An Open Letter to Congressman Patrick McHenry

Dear Vice Chair McHenry,

We find your January 31 letter to Federal Reserve Board Chair Janet Yellen both misleading and misguided.

It is in the best interest of U.S. citizens and our financial system that the Federal Reserve (and all the other U.S. regulators) continue to participate actively in international financial-standard-setting bodies. The Congress has many opportunities to hold the Fed accountable for its regulatory actions, which are very transparent. We hope that the new U.S. Administration will support the Fed’s efforts to promote a safe and efficient global financial system.

Your letter is filled with false assumptions and assertions....

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Clinton versus Trump on Financial Regulation

Will the U.S. Presidential election have an impact on financial regulation? The answer depends on who becomes President, the priorities of the winner, and the inclinations of the Congress. That said, we thought it would be useful to examine what the candidates say they will do. To summarize, we find Republican nominee Trump’s call to “dismantle Dodd-Frank” deeply troubling. By comparison, our differences with Democratic nominee Clinton are relatively minor.

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Brexit Stress Test

The U.K. Brexit referendum is providing us with the first significant test of our sparkling new regulatory system. Everyone knew about the referendum months in advance, giving them plenty of time to prepare. Yet, we are left with some fundamental questions related to global financial stability. Do banks have sufficient capital and liquidity to withstand the “shock?” Will financial markets continue to serve their key functions?  Or, is the financial system only as strong as its weakest link? Will turmoil once again prompt liability holders to run, triggering asset fire sales, and compelling central banks once again to do whatever it takes to keep avert a meltdown?

As the rating agencies might say, we are on “stress watch” with a negative outlook. Or, to mix metaphors, numerous lights are flashing yellow, so we are worried...

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Making Markets Safe: The Role of Central Clearing

The financial crisis of 2007-09 prompted two distinct types of regulatory reforms. The first uses capital and liquidity requirements to make financial institutions resilient in the face of severe macroeconomic events. The second concerns market infrastructure and the ability to trade securities and derivatives or to use them as collateral. Here, the emphasis is on both information collection through trade reporting—who is buying or selling what to whom--and on shifting transactions from over-the-counter (OTC) markets to central clearing.

This post examines central clearing of OTC derivatives and highlights its importance for financial stability...

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The Regulatory Counterintelligence Agency

Some days the tone of the financial news matches that of the sports page. Adversaries appear to be locked in an epic battle, with the official sector setting regulations in an attempt to keep the system safe on one side,  and financiers pushing for rules that ensure profitability on the other. The skirmish over the level of large bank capital requirements and the clash over whether municipal bonds can be used to meet liquidity requirements are just two recent examples. (See our earlier posts here and here.)

Following the day-to-day struggle can make it hard to see who is winning. But if history is any guide, the financiers will prevail—to the benefit of their owners and managers—at the expense of systemic fragility.

Can we change this? Can we create a system with greater balance between the authorities and the institutions?

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Global Finance Requires More Global Cooperation

“We have listened to the wisdom of an old Russian maxim, doveryai, no proveryai—trust, but verify.” President Ronald Reagan at the signing of the INF Treaty, December 8, 1987.

In July 2010, central bank governors and supervisors from the 28 jurisdictions that make up the Basel Committee membership were hammering out the agreement on new capital and liquidity requirements now known as Basel III. There was a large sticking point. Some members were standing firm on their desire to have higher capital requirements. Others felt that this would make credit more expensive and less plentiful.

Had agreement not been reached, those insisting on more capital might have said: “Go ahead, be permissive. But if you let your banks operate with low levels of capital, we’ll restrict our banks from doing business with them.” Fortunately, it didn’t come to that....

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Can Margin Requirements Improve Financial Resilience?

Eight years after the financial crisis began, the regulatory reforms it spawned continue apace. Over the past year, regulators introduced total loss absorbing capacity (TLAC) and the liquidity coverage ratio (LCR) to make banks more resilient. And, with an eye toward strengthening market function, authorities continue to push for central clearing of derivatives (CCPs).

Overlapping with these goals—and extending to nonbanks—is the recent move to establish standards for margin requirements in securities transactions: that is, the maximum amount that someone can borrow when using a given security as collateral...

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Dodd-Frank: Five Years After

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (hereafter, DF), the most sweeping financial regulatory reform in the United States since the 1930s. DF explicitly aims to limit systemic risk, allow for the safe resolution of the largest intermediaries, submit risky nonbanks to greater scrutiny, and reform derivatives trading.

How to celebrate its fifth birthday? Well, if you are like us, it will be a sober affair, reflecting serious worries about the continued vulnerability of the financial system.

Let’s have a look at the most noteworthy accomplishments and the biggest failings so far. Starting with the successes, here are our top five:

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Regulatory quakes and tremors

If there were a regulatory Richter scale that measured the shaking of the financial system, the 2010 Dodd-Frank Act would register about 8, while the 2011 Basel III framework might be a bit above 7.  (For reference, the 1906 San Francisco earthquake was a 7.8). Fortunately, this shaking is mostly for the better – helping to make the financial system more resilient in the long run.

The new “Bailout Prevention Act” of Senators Vitter and Warren also might be an 8 on the shaking scale, but it would be a true disaster, because it undermines the Fed’s role as crisis lender of last resort. In contrast, the Senate Banking Committee’s new discussion draft of a “Financial Regulatory Improvement Act of 2015” is probably a 2 or a 3. If enacted, it will be “felt slightly by some people” but probably won't do much damage...

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