When reformers in 2009 concluded that the way to prevent future crises is to muzzle the big, bad banks, they went after what they thought was the “baddest” thing big banks did: trading OTC derivatives. As is often the case with crisis cures, this remedy has significant, potentially-lethal side-effects: the solution to big-bank OTC books was a few derivatives powerhouses designed to be big, but not bad because of the new, presumably-stringent regulatory framework to be established at the same time for financial market utilities (FMUs). In a report yesterday, we pointed to BNY Mellon’s latest operational risk as a stark reminder of how quickly bad things can happen in the global payment, settlement, and clearing systems. BNY’s problems passed without systemic consequences, but that’s in part because it’s a very big bank and counterparties assumed – rightly – that it would straighten out its $1.6 trillion or so in payments. Would counterparties rest quietly if a non-bank FMU faltered, or – far more frightening – failed due to fragile operational infrastructure or illiquidity? U. S. legislation is pending to roll back what little FMU regulation there is – a potentially strong contender for quick action if careful thought is not given to the components of critical infrastructure and what’s needed to ensure it’s there when wanted.
As we lay out in this new report, a little-noticed provision in the Hensarling “Financial Choice Act” would apply the same deregulatory brush to FMUs also deployed for U.S. SIFIs. As other FedFin reports have detailed, the Choice legislation essentially repeals all of the SIFI sections of Dodd-Frank, freeing non-banks from FSOC’s thrall and replacing pretty much all of the BHC rules with a ten percent leverage-capital requirement. The legislation also sharply curtails the FRB’s emergency-liquidity powers in Section 13(3).
In concert with repealing SIFI designations (found in Dodd-Frank’s Title I), the Hensarling package also repeals the FMU designation authority in Title VIII. With Title VIII repeal would come an end to statutory access to the FRB for designated FMUs. Alongside broader 13(3) restrictions, these changes essentially leave FMUs unregulated as well as high and dry in a liquidity crisis.
If all of this were enacted, we would get non-banks without much prudential regulation, large BHCs under a leverage rule that forces them out of capital-intensive businesses such as settlement and clearing, and non-bank payment, settlement, and clearing providers left to the devices of the SEC and CFTC (agencies will little prudential power and a lot less appetite to use it under the Trump Administration). Banks will hunker down, non-bank FMUs will prosper, and in the businesses banks leave that non-banks eschew, critical parts of the U.S. financial infrastructure will be served – if at all – at great risk.
A clear case in point described in our new report is the government-securities settlement business. This is a low-margin, high-volume, operationally-intense business conducted by fewer and fewer big banks until, as of this summer, just one big one was left in this globally-critical arena: BNY Mellon. The problem in the government securities settlement market isn’t BNY Mellon’s occasional operational problems. They are of course worrisome, but a far worse one results when one institution stands at the vortex of trillions of dollars in global financial transactions on which everything up to and including the sanctity of U.S. sovereign debt depends.
The unintended impact of these new rules is transformation of the operational infrastructure on which financial stability depends at least as much as it does on solvent banking organizations. Indeed, as I’ve testified before Congress, all the capital in all the world at the very biggest banks is for naught if critical systems fail due to lax procedures or – now far more likely – external attack. Indeed, more operational risk-based capital – at least as currently formulated – has the perverse effect of increasing operational risk because the capital rules include strong disincentives for costly operational-risk mitigation.
With banks either out of key FMU operations or in them at greater risk due to far less competition, who will keep the lights on? For government-securities settlement, the FRB once contemplated creating a new mega-bank utility – an idea that didn’t take off in 2005 and is doomed now under all the new rules and Congressional opposition. For Treasury repos, the Fed has contemplated a new CCP – an idea that has yet to be realized and, even if it now advances, would pose significant risks in the absence of any U.S. authority over a new non-bank FMU of this size and criticality. For payments, we’re already seeing numerous non-bank entities provide what Dan Tarullo recently called “shadow” retail payment products at worrisome risk, with blockchain and other technologies laying pipe to take over the wholesale side of the business. CCPs are of course now vital links to derivatives clearing, although their regulatory and resolution infrastructure is, to be polite, still incomplete.
Each of these solutions to weaknesses in a critical payment, settlement, or clearing system is totally ad hoc and thus dangerous on its own. The broader prospect of full-bore deregulation of FMUs in a framework that still strangles GSIBs may be intentional, but it’s even more threatening to financial stability. We need quickly to contemplate critical financial infrastructure, understand its regulatory and economic structure, decide what risks result, and then ensure that nothing done in the name of reform wreaks havoc.