Is something missing from the U.S. regulatory toolbox?
WASHINGTON — As U.S. regulators take steps to rightsize the post-crisis regulatory regime — emphasizing risks posed by the largest institutions and tailoring rules for smaller firms — a key bloc of the regulatory brain trust still sees a weakness in its tool chest.
The current and former chairs of the Federal Reserve Board, speaking together on a panel at a recent conference in Atlanta, highlighted how other countries still have more effective policy levers to respond to macroprudential risks that can creep up out of nowhere.
"We’re not strong in having tools that we can turn off and on," Fed Chair Jerome Powell said at the American Economic Association conference, where he was joined by former chairs Janet Yellen and Ben Bernanke. "And frankly that’s just a fact of life for us,” Powell added.
Powell was echoing a point made by Yellen, his predecessor, who asserted that one of the shortcomings of the post-crisis regulatory reforms in the U.S. is that regulators were not given certain policy tools that are useful in other countries.
“I actually think in the United States we have a shortage of macroprudential tools,” Yellen said. “While we have made the system year in and year out more resilient, if we were to see a threat like house prices rising, we were concerned that a bubble is developing, many countries have tools that a financial stability board could invoke.”
Yellen added that the lack of such tools in the U.S. “worries” her, as does a provision in the Dodd-Frank Act that curbed the Fed’s emergency lending powers to make it harder for the agency to provide emergency liquidity to a failing institution.
“Although the Fed got new tools, if there were a problem in a systemic institution that would help to resolve a systemically important nonbank — say an investment banking sub of a bank holding company — we’ve lost some of the emergency lending powers that were used during the downturn,” Yellen said.
Powell agreed that the U.S. lacks some of the policy levers that foreign central banks and regulators have at their disposal, noting that the Fed instead has to rely on the tools it does have to ensure that the financial system is resilient against all manner of unforeseen losses. The stress testing regime, capital requirements and resolution plans could all be considered macroprudential tools in that respect, he said.
“Those are through-the-cycle measures that are always on,” Powell said.
Observers say relative the dearth of macroprudential policy levers in the U.S. goes beyond just a lack statutory authority. The disparity also stems from structural differences between the U.S. and other countries.
“The reason why U.S. regulators may not have tools that are available to others often can be attributed to differences in the constitutional, statutory, regulatory, structural and not insignificantly, cultural backgrounds of the countries,” said Jim Wigand, former head of the Office of Complex Financial Institutions at the Federal Deposit Insurance Corp. “What might be a useful tool in another jurisdiction may not be a permissible or optimal way of achieving the same outcome in the U.S. environment.”
One of the most significant differences is the breadth and reach of the banking industry. In Canada, for example, there are only a few dozen chartered banks and most banking activity is concentrated between the top five of them. In the United States, however, there are thousands of banks of varying size.
And most importantly, much of the financial intermediation that occurs in the United States happens outside of the regulated banking system — something that is generally not true of other countries. As a result, U.S. regulators would have difficulty identifying macroprudential risks even if they had better tools.
"There is no prudential regulatory authority outside the states over any nonbank lender, and state authority is very limited," said Karen Shaw Petrou, managing partner at Federal Financial Analytics. “Not only can bank regulators not meaningfully address emerging risks, but when they occasionally attempt to do so through the banking system, they create an asymmetric regulatory framework that does nothing but move the market into even riskier hands.”
The Financial Stability Oversight Council was created by Dodd-Frank to identify sources of systemic risk across the U.S. financial system and take steps to curb excesses where they can be identified. But Marcus Stanley, policy director for Americans for Financial Reform, said that in practical terms the only real authority vested in the FSOC is the ability to designate individual nonbank firms as systemically important financial institutions subject to enhanced prudential standards.
“The FSOC has no direct power anyway to do anything except designate people,” Stanley said. “It can only give recommendations or suggestions to the regulators.”
For example, regulators have recently raised concerns about corporate debt — a risk recently identified by the Fed in its annual risk report in November — but most of that debt is held through nonbanks, Stanley said.
“In terms of capital markets, you know, everyone’s going nuts about corporate debt, but 90% of that stuff is held outside the banking sector,” Stanley said. “Even though banks are crucial arrangers of the debt … 90% of it ends up in funds or securitized vehicles.
In 2013, the bank regulators, including the Fed, attempted to proactively quell risk in a financial sector when they issued guidance aimed at limiting banks’ exposure to leveraged lending. Even though the validity of that guidance was later called into question by a 2017 Government Accountability Office ruling that agencies overlooked congressional review procedures in drafting the guidance, the damage was already done. The result was the migration of leveraged-lending activity outside of the banking industry, Petrou said.
And nonbank regulators — the Securities and Exchange Commission, for example, or state regulators — simply don’t have the same prudential authorities that bank regulators have, she said.
“Assuming the SEC even wanted to control leveraged lending — say, under its collateralized loan obligation authority — it has no authority to do so under the law, because that’s not being done by broker-dealers,” Petrou said. “And even if it is — which it isn’t — there aren’t clear investor protection issues. There’s no capital [rules], there’s no safety and soundness authority. It’s a totally different framework.”
But there are some macroprudential authorities that regulators — specifically the Fed — have at their disposal that they have yet to use. The agency created a countercyclical capital buffer in 2016 that would allow it to require the largest banks to hold additional risk-weighted capital if they decided that systemic risks are meaningfully elevated. Fed Gov. Lael Brainard suggested recently that the time may be upon the Fed to deploy the buffer, though there is some uncertainty about whether or how the Fed might actually do that.
Gregg Gelzinis, a research associate for economic policy at the Center for American Progress, said the Fed also has the power to set minimum haircuts or margin for so-called securities financing transactions, or SFTs — transactions that involve the use of securities as collateral such as reverse repurchase agreements.
“This policy tool would limit leverage in short-term funding markets,” Gelzinis said. “It would help tamp down the ability of nonbanks to borrow heavily and inflate asset bubbles outside of the traditional banking sector. It would also improve financial stability by reducing potential fire-sale dynamics in these funding markets.”
The Financial Stability Board had been developing a standardized rule for SFTs as part of the Basel III agreements in the last several years, and former Fed Gov. Daniel Tarullo had laid out some ideas for how marketwide risk controls might be applied to the U.S. But the ideas never resulted in a proposal, and the notion appears to have fallen off the Fed’s agenda.
“They’ve been working on a regulation since at least 2015, but have not proposed it yet and the new Fed regime has perhaps buried it altogether,” Gelzinis said.
Part of the challenge is also the way the U.S. financial regulatory structure is constituted with many separate agencies — with varying leadership structures and degrees of political independence — sharing the myriad oversight responsibilities and jurisdictions.
Petrou said that notwithstanding various attempts to consolidate the U.S. financial regulatory arrangement, that arrangement is substantially more complicated than regulatory systems in other countries.
“It’s not the lack of tools to fix an engine,” Petrou said. “It’s that there isn’t a single engine. There are lots of cars and locomotives and scooters all over the roads.”