WASHINGTON Individual rules put in place after the financial crisis have made some large banks safer, but the flood of new and complex rules is in notable cases making the overall system riskier while harming innovation, according to a provocative new paper by Federal Financial Analytics.
The paper, released Wednesday, cites examples of how the federal response could impede growth as well as make the system more vulnerable in a future crisis and the results more severe.
"There are so many alarming signs that risks are imminent and that the cumulative impact of the rules requires urgent attention," said Karen Shaw Petrou, managing partner with Federal Financial Analytics, in an interview. "Taken together, these risks may pose systemic risks on their own."
Petrou argues that policymakers are too caught up in "pointing fingers" rather than examining the danger signs resulting from rules mandated by the Dodd-Frank Act, Basel III and other measures. The paper lists seven ways regulatory policies could hurt the system rather than provide remedies:
1. Slow Economic Growth
While the stagnant growth following the financial crisis is mostly due to factors other than regulatory policy, the paper says certain rules are exacerbating it. The paper pinpoints a new liquidity rule that requires large banks to hold enough "high quality liquid assets" to withstand a crisis. But forcing large banks to hold trillions of such assets and keep them on their balance sheet reduces their incentives to lend or help boost economic growth, the paper says. Additionally, it argues, the sheer cost of bank compliance with new rules reduces banks' capacity to support growth.
2. Risk Migrating from Banks to Nonbanks
As banks face pressure to become smaller and less complex, much of their risk is headed towards less regulated nonbanks. Though that problem is widely recognized, policymakers have done little about it. When the next crisis hits and that is inevitable, the paper argues regulators may be unable to see that risk building, or do little about it when it occurs. The paper notes some examples of trouble signs from this transfer of activities, including hidden risks particularly from peer-to-peer lending as well as potential concentrations in sectors that lack the infrastructure of the largest banks.
3. The Loss of a Key Source of Liquidity
Traditionally, the biggest banks have fulfilled a market-making role, helping with liquidity in times of stress. "But new liquidity, capital and proprietary trading rules have limited the extent to which banks can hold large volumes of assets to insulate markets," the paper says. As a result, the paper argues the system may not be as resilient in times of stress.
With banks less able to serve that function, some Federal Reserve Board officials and other policymakers have suggested that the central bank should be allowed to support nonbanks to prevent systemic risk. But the paper says that undermines the point of Dodd-Frank and other policies designed to prevent more taxpayer support of the system.
"To the extent this is needed or done, then a key goal of the post-crisis framework ending taxpayer risk through provision of central-bank support without offsetting prudential regulation will be significantly endangered," the paper says.
4. Heightened Taxpayer Risk
Meanwhile, the paper sees other signs of greater taxpayer risk resulting from federal policies. As a result of new liquidity rules, banks are bulking up on sovereign and agency obligations like those of the housing government-sponsored enterprises. But almost seven years after the government seized Fannie Mae and Freddie Mac, policymakers are no closer to resolving what to do with them. And Treasury is now explicitly on the hook should the GSEs need another bailout.
"The more financing backed by explicit or implicit taxpayer guarantees, the greater fiscal-policy risk in concert with the potential for systemic risk if markets come to doubt the willingness or ability of sovereigns to support their offering," the paper says. "In the EU, this was called the 'doom loop', but it also has been evident in the U.S. where weakness at the GSEs played a significant role in the 2008 financial crisis and the lack of a solution to the GSEs' structure prolongs stagnation in residential-mortgage finance."
5. Banks are Paradoxically Encouraged to Take Imprudent Risks
Despite rules expressly put in place to discourage undue risk-taking, some regulations may actually encourage it, the paper says. The leverage capital requirement, for example, has been hailed by regulators because it is simple and difficult for banks to game. But because it is not risk-based, banks face "capital incentives to take greater credit and trading risk in hopes of meeting market demand for sufficient return to investors," the paper says. It also notes that the $50 billion systemic threshold imposes significant additional costs on institutions that are not necessarily systemically important, which may encourage greater risk-taking to make up for the added costs. The same is true of the capital surcharge for the globally significant institutions, which may force the largest banks to make up costs elsewhere.
"Many of these rules have tremendous benefits in theory," Petrou said in the interview. "But in practice, they are driving behavior to run the roulette wheel."
6. Operational Risk Concerns Hamper Innovation
Despite all the attempts to make the system less vulnerable to shocks, it almost appears to be the opposite. A rogue trader or a single cyber-attack at a large company not even a bank can wreak havoc in the markets.
Regulators are putting pressure on banks to keep track of so-called "operational risk" but it is costly for banks to do.
"These operational costs may undermine the ability of traditional banks to innovate in areas like new retail-payment products and technologies," the paper says.
7. The Accelerating Divergence in International Regulation
Lawmakers have long worried that international regulators will not follow the get-tough approach of U.S. officials when it comes to financial regulation, resulting in a disparity that drives business overseas. Such divergence could increase the opportunities for regulatory arbitrage, reduce the flows of capital and continue to let some countries serve as tax havens or shelters for high-risk transactions, the paper says.
Overall, Petrou warns that policymakers need to move urgently to address these problems or they will exacerbate the risk or more bailouts or other problems down the line.
"The situation is dangerous," she said. "Something's going to blow. Which of these things, I don't know. But the world's a dangerous place and this paper shows there's a lot less room for error."