With battle lines deeply dug in over so many recent rules, two new studies are important, timely reminders that rewriting rules doesn’t always mean eviscerating rules. Sometimes, it’s a vital corrective to unintended consequences all too evident as proposals turn into rules that turn into a new, destructive market dynamic. It might seem to make nothing more than common sense to recognize that rules need reconsideration, but as the occasional victim of diatribes following what I thought were just pragmatic recommendations, it’s reassuring to see a study from one of the current rules’ architects, Daniel Tarullo, and another from the Fed lay out the need for meaningful revisions to two high-impact rules: big-bank stress tests and – just in time for still more of them – liquidity rules.
First to Mr. Tarullo’s paper. In addition to being the instigator of much in the Dodd-Frank Act and the rules thereafter, Mr. Tarullo inaugurated big-bank stress tests in 2009. Banks then denounced them, but they weren’t exactly in the best of bargaining positions after the 2008 great financial crisis. So, stress tests began as an urgent reality check. But, proving the regulatory-rewrite point, over a decade later they took on a new purpose in concert with still more importance by virtue of the new stress capital buffer inexorably and often ineffectively linking stress testing to the bank regulatory requirements that barely existed in 2009.
In 2009, we needed stress tests because capital rules were essentially toothless. Capital rules are now fanged and set to grow still more ferocious. This might seem to make stress-testing better, but Mr. Tarullo shows convincingly why it’s worse. He looks hard at the gradual integration of stress testing and capital requirements, finding it has numerous unintended consequences.
Once, forward-looking stress-testing was an important complement to point-in-time capital standards. But, moving through the fifteen years since stress-testing began and new rules grew ever stronger, the Fed’s annual exercise has become a rote and opaque-model-driven exercise that no longer anticipates the dynamic nature of likely stresses and regulatory interactions. This is due to what he calls organizational inertia at the Fed and effective advocacy by the largest banks. I would add that the complexity of stress-testing and its capital consequences have created a class of stress-test bureaucrats who readily cycle back and forth between the Fed, consulting companies, and the biggest banks in ways far more advantageous to themselves than to disciplined, innovative, and – yes – tough tests.
And what of the liquidity regs? As regulators continue to pronounce, new rules are coming that will in part fiddle with the outflow ratios that set requirements for offsetting balances of high-quality liquid assets (HQLAs). This is said to be necessary because banks under acute liquidity stress in March of 2023 couldn’t handle the flood of uninsured depositors heading for the nearest exit leading to what the agencies deemed a systemic cascade. Maybe so, but it was surely a grievous supervisory error. And, as it turns out, maybe also a crisis waiting to happen thanks to flaws in the structural design of liquidity rules. Making them tougher to address SVB and Signature’s reduced obligations thus might well not make liquidity regulation better.