Earlier this week, the FRB got its head handed to it by Democrats on Senate Banking because its new advance notice of proposed rulemaking not only came long after big banks got way into physical commodities, but also because the Board’s focus to date has been solely on the possible safety-and-soundness implications of this non-traditional activity. Senators instead pressed the Fed on policy concerns, leaving it seemingly flummoxed that anyone would think that matters like concentration, market manipulation, or price integrity were of moment to a prudential supervisor. If, as the Fed seemed to think, the bank holding company or its subsidiary insured depository institutions weren’t likely to fail due to a physical commodity, why worry? Why worry, though, lies at the heart of how BHCs are now to be governed.
What makes a big bank that owns an oil tanker different than any other ship-owner? Therein lies the tale I told two weeks ago when I described the evolving big-BHC regulatory model as “utilitarian.” By virtue of being a bank, a company is increasingly told to be a safeguard of public interest, profits be damned. This may or may not be fit or proper – more on that to come. But, for sure it’s a new business model with which big BHCs must reckon if they want to earn returns above those comparable to public utilities.
At the January 15 hearing, Democrats were distressed by many aspects of big-bank physical-commodity operations. One key issue is the extent to which any of this is compatible with also owning an insured depository institution. This, as the Fed witness rightly said, is a matter of law, not rule if Congress says big BHCs can be affiliated with physical-commodity activities in various ways, can the Fed just say no?
If physical-commodity activities are inherently anathema to banking, then Congress should say so, not rely on banking agencies to pick and choose lines of business based on amorphous public-interest concerns. But, does this mean that regulators should let banks do what they want unless or until Congress compiles a new list of no-nos? Of course not. The challenge here is not defining which activities are in the “public interest.” Which public? What interest? Rather, the question is which activities pose risk not just to each big bank, but also to broader financial stability or the FDIC which, as backstop to the insured deposits in a BHC affiliate, has a right to say to what purpose they should be put. Some activities may be too risky to conduct in concert with gathering insured deposits, yet not so dangerous as to bely BHC investment when funded through debt or other wholesale funds. How to tell the difference?
In my view, the solution lies in a synoptic view of big- BHC risk exposures. A critical mistake the FRB, in concert with other banking agencies, made before the crisis was not caring much about high-risk mortgages if securitization sent them on down the line. The thinking was then that securitization absolved assets of risk. Of course, this was nonsense because banks large and small owned hundreds of billions in obligations backed by these same mortgages, not to mention the debt and MBS guaranteed by the GSEs deeply at risk due to disastrous mortgage securitization practices. And, even if a rare bank didn’t own subprime whole loans, MBS, GSE debt, or FHLB consolidated obligations, many had counterparty exposures to firms with huge bets on the sector – think Bear Stearns, AIG, Lehman. And, even when a mortgage went into an MBS, that didn’t mean it has really gone. Billions in litigation risk and put-backs prove the costly point.
In short, it isn’t just asset quality per se that poses risk, but how an asset touched by a bank can come back to haunt it. Seeing this ahead of time is the tricky bit not only from a prudential, but also a policy perspective. Congress is wrong to delegate these hard questions to the Fed, but the Fed can’t just duck them because the law is incomplete or out-of-date. For all its talk of macroprudential regulation, horizontal review, and the like, the FRB has yet to take to heart a critical lesson of the financial crisis: risk comes from hard-to-spot places – that’s why it’s so toxic – and often comes in ways unanticipated in traditional safety-and-soundness supervision. A very modern, complex industry needs a forward-looking regulator, not one hiding in the old rulebook.