WASHINGTON Nearly four years since the passage of regulatory reform legislation, policymakers have largely failed to curb risks outside the banking system, increasing the chance for significant financial instability in the future, according to a new paper by Federal Financial Analytics.
The paper says that regulation of the banking system and the so-called "shadow" banking arena is increasingly imbalanced, posing a threat to the economy as risky activities shift to mostly unregulated institutions.
"The increasingly stringent rules applied almost exclusively to the very largest U.S. banks are combining with rapid market change to create a major risk to financial stability and even macroeconomic prosperity," writes Karen Shaw Petrou in a 17-page paper that is being presented at the Federal Reserve Bank of Chicago's annual banking and regulatory symposium. "This risk arises because like-kind activities are increasingly not regulated in like-kind fashion. Regulation largely follows form that is, the charter a firm selects not function the services provided and the risks presented."
She defines the "shadow" banking system broadly, pointing specifically to the retail finance sector, which offers cash-equivalent deposit products, payment services, and asset securitizations. She also cites wholesale finance, which includes a wide swath of corporate services and products, including asset management, securities-financing transactions, hedge funds, broker-dealers and commodities trading.
Petrou isn't arguing that bank rules should apply to nonbanks to close the regulatory gap nor that new or pending rules for financial institutions should be revoked.
Rather, she is making the case that policymakers should take steps to anticipate market realignment and recalibrate their actions to ensure that "like-kind activities are subject to like-kind rules" regardless of the institution, especially as nonbank institutions continue to play a major role in financial markets.
Petrou is not alone in making this argument. Several top Federal Reserve officials, including Chair Janet Yellen, have expressed their concerns that tough new rules, like the "enhanced supplementary leverage" requirement for the top eight U.S. banks, could wind up pushing finance outside of the banking system.
Fed Govs. Daniel Tarullo and Jeremy Stein have echoed a similar sentiment but have focused their worry on repurchase agreements, securities-financing transactions, and the potential benefits of a "universal margin" to add safeguards to the sector.
Thus far, however, U.S. policy has focused primarily on imposing new rules on the biggest banks and gradually designating nonbank systemically important financial institutions through the Financial Stability Oversight Council. The council has designated three firms to date: American International Group, GE Capital and Prudential Inc.
"Because several large nonbanks were spark plugs to the 2008 Great Recession, policymakers have generally recognized that 'shadow' firms may pose profound risk," Petrou writes. "However, actions remain largely bank-centric, creating still stronger drivers of financial activity outside of the regulated-banking sector that is unlikely to be reversed when or if regulators finish designating systemic nonbanks or building out prudential standards for particularly important business lines."
She offers two recommendations to mitigate risk to shareholders and those to the broader market, each directed to financial services firms and the policymakers building the guardrails.
Petrou advises firms to take a forward-looking approach to their regulatory analytics, rather than digging through the rulebook to find out what steps they need to take to comply once a new rule is finalized.
"At the least, firms facing unique rules will know this first and win first-mover advantage as they divest newly unprofitable activities," Petrou writes. "At best, first-mover advantage will define innovative products offered with policy advantage."
Regulators, on the other hand, should pause and reassess all the work that has been accomplished thus far to define systemic risk on a firm-by-firm basis, and instead look to the activities that these firms offer that may pose risk to consumers, investors and financial stability.
"Policymakers must thus as a matter of urgency identify which activities pose the greatest risk, what rules mitigate them, and how the like-kind requirements can be applied across the spectrum of like-kind financial institutions," Petrou writes. "Law often allows action now, especially in the U.S., so lack of authority is scant rationale for lack of definitive action."