Complacency with Big Banks Risks a Severe Hangover

The Government Accountability Office's report on market perceptions of government support for big banks had barely been released before a number of journalists — not to mention financial lobbyists — jumped on the finding that the subsidy currently enjoyed by systemically important banks is negligible compared to its size between 2007 and 2012.

The results of the study should not be interpreted as a sign that large U.S. banks have recovered from the global financial crisis and could stand on their own without government support. As Cornelius Hurley, director of the Boston University Center for Finance, Law & Policy, explains, it is unsurprising that in an era of "incredibly low interest rates, exceptionally high bank deposit balances and economic growth, the market would interpret banks as less risky than they were during the crisis." Also, given that most Dodd-Frank and Basel rules have yet to be fully implemented, it is too early to say whether new regulations contributed to the reportedly negligible subsidy.

But when interest rates start to rise, banks' assets may decrease in value, and their deposits may fall as customers look elsewhere for vehicles that will pay them higher rates. This movement would negatively impact banks' liquidity. Moreover, any unexpected geopolitical shock or multiple corporate defaults could immediately increase banks' risk very quickly.

We cannot foresee how politicians will react the next time there is a banking crisis. As Douglas Holtz-Eakin, president of the policy think tank American Action Forum, said in his testimony before the Senate Thursday, "The federal government has a dubious history of intervening in times of economic distress to save certain firms or otherwise mitigate their losses … this history is inconsistent, not hewing to any rule or regularity."

It is precisely because we do not know whether the government would opt for a bailout that bank regulators must continue to confront the significant challenges posed by U.S. banks. Most importantly, banks remain incredibly large and interconnected to each other and the economy at large. According to the National Information Center, there are over 100 banks in the U.S. with assets over $10 billion, and 40% are over $50 billlion.

Unfortunately, the banks are also very opaque. U.S. bank regulators, taking guidance from the Basel Committee on Banking Supervision, continue to allow the large banks to use their own credit risk inputs for to calculate regulatory capital. For market and operational risks, these same banks are even allowed to use their own proprietary models. Neither the credit risk inputs nor the models are disclosed to the public.

There are also signs that banks have failed to learn from the detrimental effects of the global credit crisis and pleas from bank regulators. This year, large banks are loosening their credit underwriting standards and are extending leveraged loans to companies. They can do this largely because they are increasing the number of collateralized loan obligations they can sponsor. These bonds, backed by hundreds of typically leveraged loans, are difficult to value because of the lack of uniform, dynamic data.

Additionally, large banks continue to exhibit incredibly weak operational risk management. Operational risk is the threat of a breach in the day-to-day running of a business because of people, processes, systems, and external events. Since big banks have yet to make ethics a top priority, not a day goes by that one does not see examples of operational risk. Market rate manipulations and incorrect foreclosure procedures continue to plague banks and their reputation.

Banks' lack of reliable, quality data to monitor their counterparties also continues to be a problem even after six years after the crisis. This is the fault not only of individuals but also of the weak systems created to warehouse the data in a centralized place so that they are readily available to a bank's risk managers and equally importantly, to bank regulators.

It is imperative to the health of the global economy that regulators do not lose sight of banks' risk-taking and ensure that banks are more adequately capitalized to sustain unexpected losses. Anat Admati, a professor of finance and economics at Stanford University's Graduate School of Business, argued passionately before the Senate that "requiring that banks fund themselves so that those who benefit from the upside of risk bear more of its downside brings about more safety and corrects distortions."

As the U.S. economy continues to grow and the financial crisis is relegated to the dustbin of history, big banks are taking bigger chances. The challenge for regulators now is to remember that when the party gets going, it is difficult to stop the champagne flowing. Yet if regulators do not find a way to cork the bottles, the next day's inevitable hangover will be foisted on taxpayers who were not even invited to the party.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World and the New York Institute of Finance.