Although the U.S. and U.K. usually act as one on financial-regulatory decisions, there is now a profound difference between the two. The FRB has just finalized a stress test that requires the biggest BHCs to build a moat around their capital and keep it in the fortress in case of marauding markets. The U.K. likes tough rules too, but it is easing a few right now to prevent procyclicality – that is, a downward spiral of reduced credit availability that sparks liquidity problems that turn into solvency disasters. So far, the Fed is sticking to its guns, procyclicality be damned. We’re impressed by the Fed’s belated ferocity, but it’s ill-timed. Like the U.K., the U.S. now needs to stay its hand on some new rules, remembering that capital and liquidity buffers are put in place so they can be used under stress, not husbanded in the armory to comply with complex models and fancy macroeconomic formulas.
We’re not per se opposed to stress tests. Doctors rightly use them and marriages are mostly nothing but. Nietzsche said, that which does not destroy us makes us strong. So, knowing what could do real damage and, then, ensuring resilience is a right and proper thing for regulators to require.
But, is now the time to insist that U.S. BHCs prepare for nuclear winter? That’s how we read the new stress-test standards. This isn’t just because the scenarios in them are more than rigorous. It’s because of a little-noticed part of the final rule: new FRB disclosures in which the Fed will tell the world what it thinks of a BHC. We aren’t against transparency – quite the contrary, as the complexity-risk paper we offered a week or so ago makes clear. But, fearing what the FRB will say, every covered BHC will, we think, not just hold on to any capital it thought it might hand over to investors, but also to the resources it previously planned to deploy in the credit market.
Is this academic? Not judging by what’s already going on in the financial markets. The EU’s new capital-raising effort – grievously overdue, of course – is creating a vicious cycle of asset sales and credit retrenchment that turns a liquidity crisis into a solvency debacle. The U.S. isn’t there – yet – but the biggest banks are quietly just as scared, and thus putting just as much strain on the fragile recovery.
Proof of this is yesterday’s Bloomberg story on the unprecedented difference in yields between Ginnie Mae MBS and GSE ones. The reason is that the Ginnie paper is full-faith-and-credit USG and, thus, subject to a zero risk weighting; agency paper gets a twenty percent weighting and, thus, costs a lot more to hold. For assets with a 100 percent or higher risk weighting – pretty much everything else – the markets now are at best, skinny. Want a small-business loan? A mortgage outside the FHA? Get real.
What should the FRB instead be doing? Look across the pond, we say, to see how the Bank of England and FSA are selectively targeting some assets – e.g., small-business loans – and some buffers – importantly including the new liquidity ones. This isn’t forbearance – rightly a regulatory bug-a-boo. It is, we think, adroit macroprudential policy that seeks not just to prevent booms, but also to buffer busts.