Risk and regulation in the US financial system

How the US adjusts its regulatory regime will have global implications for Basel III standards and international financial cooperation


For years, Wall Street has complained that restrictions placed on industry—on capital, leverage and stress testing, especially on the largest financial institutions—after the financial crisis were too costly. Photo: Bloomberg
For years, Wall Street has complained that restrictions placed on industry—on capital, leverage and stress testing, especially on the largest financial institutions—after the financial crisis were too costly. Photo: Bloomberg

Despite the failure of the Donald Trump administration to repeal Obamacare (the Patient Protection and Affordable Care Act), financial markets and corporate America are waiting for the economic agenda. Corporate tax reform is high on this agenda, and so is the rollback of financial regulation. President Trump has signed an executive order to “do a number” on Dodd-Frank, the 2010 landmark law on US financial regulation that implemented many of the reforms proposed by Basel III. What is at stake, and what are the global implications of such a rollback in the US?

The context is clear. For years, Wall Street has complained that restrictions placed on industry—on capital, leverage and stress testing, especially on the largest financial institutions—after the financial crisis were too costly. Globally, the G-20 has also recognized concerns about excessive regulation, and the Financial Stability Board has been asked to assess and address their “unintended consequences”. Even Daniel Tarullo of the US Federal Reserve, the lead American regulator, agrees that it is time for a “healthy debate” on the regulatory system—cautioning, however, against any weakening that would shift risk back to taxpayers.

While the US debate is well under way, it is worth noting that the US economy is now booming, and the financial industry has helped move it to full employment and rising inflation. Despite the restrictions, the relative strength of US banks—with higher capital, liquidity, and risk management positions—has allowed them to expand their lending to a pace similar to that in pre-crisis years. As for the largest banks—a key focus of regulatory reform—JPMorgan Chase and Wells Fargo now hold significantly higher assets compared with 2008, and their heads are not consistently pushing for change. Jamie Dimon, chief executive of JPMorgan Chase, has said, “We’re not asking for wholesale throwing out of Dodd-Frank,” and this sentiment has been echoed by others, who appear to have adjusted to the new regime.

This helps, because it will be politically difficult to roll back legislated components of Dodd-Frank. It is composed of hundreds of regulations in thousands of pages, issued by multiple agencies, and its reworking will require the approval of several federal agencies. More likely will be administrative refinements to simplify the framework that can be worked out by new regulators, rather than by new legislation. Let’s look at where the debate is currently.

Among the most controversial components has been the Volcker Rule that aims to prevent large, federally insured banks from speculative financial bets. Will this be reversed? On this, even treasury secretary Steven Mnuchin recently told the Senate banking committee: “I support the Volcker Rule, but there needs to be proper definition around the Volcker Rule so banks can understand what they can do and what they can’t do.” Making it easier to distinguish between speculative activities (“proprietary trading”), which the rule intends to limit, and other types of “market-making” activities in which banks trade for clients, is likely to be the prime focus of change.

The debate also focuses on the size thresholds established for various regulations, such as the Volcker Rule. Arguably, Dodd-Frank should limit its application to the large financial institutions—its primary concern—and remove its restrictions on the smaller banks—especially the community banks—that don’t raise similar systemic risks. Hence, the emerging opinion is to raise the threshold for enhanced prudential standards well above its current level of $50 billion in assets, to $250 billion—the level above which institutions face annual stress tests.

There is equal political resistance to the measures adopted for the “too big to fail” financial institutions, which seek to follow Basel III standards for handling their failure. Among these, Dodd-Frank seeks to eliminate bailouts, through its Titles I and II, and transform the bankruptcy framework from courts to regulators—on the grounds that the large, complex financial firms raise global instability issues beyond the reach of the traditional courts.

In particular, political pressure now focuses on the Congress repealing Title II, which created the Orderly Liquidation Authority (OLA), with the power to unwind a systemically important firm, and give emergency credit, during a financial emergency. Former Federal Reserve chairman Ben Bernanke has argued that repealing Title II would be a major mistake as it would again raise the risks of overall financial instability with global implications.

Regarding federal financial agencies established by Dodd-Frank, the debate goes well beyond the OLA to include restructuring or abolish others. Among these is the Financial Stability Oversight Council (FSOC), composed of financial regulators, and responsible for deciding which company is treated as a “systemically important” (or “too big to fail”) financial institution.

Similarly, there is widespread resistance to the Consumer Financial Protection Bureau (CFPB), which has developed hundreds of new rules for mortgage lenders, banks, and other financial institutions to protect the consumer.

How the US adjusts its regulatory regime through staffing changes, executive action and legislation will have global implications for Basel III standards and international financial cooperation. While US banks are much stronger now, after building the quantity and quality of capital, European banks are not there yet. Significantly altering the trade-off between regulation and risk could change the global playing field for financial competition before the recovery from the financial crisis is complete.

Anoop Singh is an adjunct professor at Georgetown University.

Comments are welcome at theirview@livemint.com

More From Livemint