On Tuesday, a couple of million protesters worldwide celebrated May Day, advocating for social justice, economic fairness, immigrant rights, and government reform. Today, Jamie Dimon and other bank oligarchs will have their own version of May Day.
Big-bank executives normally leave the grunt work of regulatory lobbying to their law firm or trade association mouthpieces. Today there will be a significant departure from that general practice, as CEOs of some of the largest U.S. banks, including J.P. Morgan Chase & Co, Goldman Sachs, Morgan Stanley and Bank of America will meet with Federal Reserve Governor Daniel Tarullo in New York.
The purpose of this unusual executive pow-wow? Short answer: to protect these banks' cushy bottom lines, consequences to the overall economy be damned.
The Federal Reserve has been charged with writing regulations implementing Sections 165 and 166 of the Dodd Frank Act. These provisions of Dodd Frank impose various risk-mitigation and capital-enhancement standards on large banks and non-banks that have been designated as systemically important financial institutions. The Fed issued a proposed rule a few months ago, and various provisions contained in the proposal have drawn the ire of the megabanks.
One of the chief complaints voiced by this group of banks has been over the SIFI Rule’s limits on counterparty exposure. Under Section 165 of Dodd Frank, a covered company can only have a maximum credit exposure to another company of 25% of the former's regulatory capital. The rationale behind this rule is straightforward and quite obvious given the recent financial debacle: imposing caps on counterparty exposure will reduce the likelihood of one financial institution's failure leading to the sequential failure of others, like a stack of falling dominos.
The Fed has taken this eminently sane restriction one step further, by imposing a more stringent 10% cap on counterparty exposure for companies having consolidated assets of $500 billion or more.
In decrying this requirement, the large banks have once again presented themselves as heroes of the status quo. The counterparty limits should be relaxed, we are told, because liquidity will suffer. The megabankers assert, with a straight face and apparently without compunction, that our financial regulators should continue to allow a handful of oligopolists to have trillions in notional or actual exposure to each other, despite the obvious overconcentration risks. We are asked to trust their ability to manage their own risks. The world has seen how well that strategy worked, and not too long ago at that.
First of all, the bankers' fears should be allayed because the SIFI Rule's counterparty restriction has numerous exemptions, limits and loopholes that lighten the regulatory load. Quite significantly, the SIFI Rule’s 25% and 10% limits only apply to net counterparty exposure, not gross counterparty exposure. After making deductions to the exposure figure based on netting agreements, guarantees, counterparty hedges, protection from credit derivatives and collateral (after haircuts), the 25% and 10% hurdles should not seem so difficult to overcome after all.
Moreover, the counterparty limits would have been solid policy even if they limited gross and not net exposure. The fact is that our major financial institutions are entangled, with each having a hand in another's pockets.
The too-big-to-fail problem is not simply about discrete, insular institutions. Congress decided to impose counterparty limits to account for the systemic risk that all SIFIs impose on each other and the market as a whole. All major financial institutions have liabilities that are contingent on payment streams from third parties. Therefore, the cost of a particular institution’s failure has wide-ranging negative externalities. One bank's risk becomes everyone's risk.
Process: This issue deserves to be vetted publicly (as we are doing here), not behind closed doors with a single governor of the Fed.
Substance: For eons, a basic tenet of prudential bank regulation to control concentration risk has been a limit on loans to one borrower based on the lending bank's capital. Why, then, should the same risk tool not be applied to the bank's esposure to counterparties. Answer: It should.
Prof. Cornelius Hurley