You Don’t Love It, But Can You Live with It?

Remarks of

Karen Shaw Petrou

Managing Partner

Federal Financial Analytics, Inc.

Before the

Conference of Counsel

Washington, D. C.

October 6, 2011


I would like to thank Mike [Bleier] for again inviting me to join you to discuss the pending regulatory landscape.  Over the past few years, pending is the nicest word many of you have had for this picture, which all too often seems to be swarming with monstrous creatures of, at best, uncertain provenance.

Of late, the landscape is also marked by seismic forces that are pushing up craggy peaks and depressing valleys of widely differing global regulatory standards for banks, nonbanks and financial markets.  While the U.S. clings to the ideal of global regulatory standards – in principle if not always in practice – other nations are going their own    way.  For years, the EU has quietly gutted the substance of the Basel standards by lax implementation; now, it’s also making substantive changes in the body of the Basel III standards.  At the same time, the EU is desperately bailing out its banks all over again even as the U.S. marches forward firmly on the path Congress set in Dodd-Frank, ending too-big-to-fail once and for all.

I’ve given several talks in the last few weeks about this asymmetry between the U.S. and global framework, arguing that it at the least forces a rethink of the U.S. principled commitment to Basel III.  We are going it alone in terms of sticking to the rulebook even as we set a new, solo path to the mountain-top of true market discipline for the biggest of the big.  This is a U.S. financial policy that reflects the unique structure of the U.S. financial-services industry.  Attempting to craft U.S. policy solely on the basis of Basel would be like setting U.S. foreign policy solely on the dictates of the United Nations.  In foreign policy, we follow both a national and international strategy; in financial regulation, we should do the same.

You’ve heard from a terrific group of distinguished speakers and senior officials, so I know you’ve heard great summaries and current updates of pending regulation.  I won’t, thus, spend my time going through the details of all the pending initiatives that pose strategic challenges.  Instead, I’ll use as the basis for my remarks the rules soon – perhaps as early as next week – to come from the Federal Reserve on add-on requirements for bank holding companies with assets over $50 billion and, should FSOC ever name any, systemic nonbank financial companies.  These rules are found in Section 165 of the Dodd-Frank Act and, taken in concert with companion global action, are the roadmap for the new systemic regulatory regime.

Because the Dodd-Frank standards are in several ways wholly inconsistent with the global ones, this assessment will, I hope, substantiate my concern:  the growing asymmetry between U.S. and global standards poses serious strategic and competitiveness challenges for financial institutions doing business here.  If action is not soon undertaken to redefine the U.S. regulatory landscape with the urgent need for a rapid recovery taken as our top priority, all of your firms will face years of unnecessary strategic risk even as the economy takes far too long to right itself.

Who’s Systemic and What’s the Cost

First, though, to a critical question: what’s the U.S. systemic regulatory regime and who will come under the FRB’s systemic regulation?  The law says tougher standards should apply to larger BHCs and systemic nonbanks than to firms that do not pose “similar risk,” possibly varying the systemic sanctions by firm and/or by type of financial institutions.

Who are these firms and what are their risks? Is the judgment to be based on size or the actual profile of a firm, given that smaller ones can and do present systemic risk based on their business model – think Reserve Primary Fund as a case in point.  Is risk to be judged on the broadest systemic criterion:  a threat to U.S. financial stability?  If so, then the vast array of BHCs over $50 billion don’t pose any more risk than smaller BHCs and so shouldn’t come under tough new rules.

The law also says the FRB can tailor or scale its systemic rules to address these questions – if and how it does so is, I think, the first-order question in assessing their impact on your firms.  For the very largest firms that are most likely to be deemed systemic no matter their risk, this scaling and the degree to which nonbank competitors are exempted poses competitiveness concerns.  For smaller firms, the challenge is the converse:  are they in or out of what will be very, very costly requirements?

And, how to judge risk and, thus, systemic regulation outside the BHC context?  The living-will rules bring foreign banking organizations into the U.S. systemic gambit even if U.S. operations fall below the $50 billion threshold, albeit with a kinder, gentler hand than initially proposed.  The living-will rules also look at the top-tier of a nonbank, thus applying at least some of the systemic standards well above the purely financial operations in a diversified company.  I assume this will be the same approach taken in the remainder of the systemic rules, but time will tell.

The Not-So-Little List

Now, to the second-order question:  what will the U.S. systemic rules do and how well do they fit with the global ones?  Let’s review the FRB’s bidding as dictated by Dodd-Frank.

  • Capital surcharge: This is obviously a very, very hot button.  The Basel Committee has promised a surcharge for global systemically-important banks (G-SIBs) that is now finalized in principle and will be set for implementation at the G-20 meeting in early November.  The FRB is strongly supportive of the surcharge – indeed, some in it wanted it to be even more punitive.  Thus, it seems likely that the G-SIB surcharge will be proposed for any U.S. BHC that triggers the Basel G-SIB criteria – whatever these prove to be.  But, what’s up for smaller BHCs in the U.S. and nonbanks?  My guess – and it’s just that at this point – is that the U.S. systemic standards will posit Basel III on its own as a surcharge for BHCs over $50 billion – recall they were once to be exempt from Basel II.  However, all systemic firms, including smaller BHCs, may be subject to a 15:1 debt-to-equity ratio and capital standards broadly redrawn to cover off-balance sheet assets (a dramatic rewrite of the U. S. leverage rules).  Nonbanks will likely be subject to a generic requirement that whatever capital they now hold would have to be increased, with the FRB deferring any specifics here until the broader issue of systemic rules for nonbanks gets off the drawing board.
  • Liquidity Surcharges:  This is a way tough one because the U.S. has nothing in this area beyond some 2010 inter-agency guidelines.  Liquidity risk is, though, a profound one with far-reaching systemic impact.  I expect the U.S. systemic rules to mandate the Basel III liquidity requirements for all covered BHCs and, over time, nonbanks.  A graduated approach for mid-sized BHCs would not be necessary if many of the flaws in the current Basel III standards are fixed (e.g., with regard to counting agency assets and undrawn FHLB commitments), but the shape of the final U.S. version of the Basel III rules here is a critical and an as-yet unanswered question.  Liquidity is often overlooked because of the furor over capital, but these standards are huge strategic drivers that warrant top-level attention and, I think, advocacy.
  • Concentration:  This is a sleeper standard that could wreak havoc at systemic BHCs.  In conjunction with the credit-exposure reports required in conjunction with the living wills and inter-affiliate transaction limits still in the works, Dodd-Frank requires big financial institutions to curtail their dealings with large customers.  This is a major, if often unrecognized, provision that contributes to the big-bank “organic” break-up cited as recently as this Monday by Chairman Bernanke.
  • Stress Tests:  Big BHCs know what’s cooking here because of the FRB’s capital-planning rule.  For the rest of you, start thinking much tougher hurdles before your firms can issue dividends, repurchase stock or otherwise make capital distributions.  This is the first real foray by the FRB from its board room into yours.
  • Risk Management:  Here are two words in law that can pack a mighty punch, depending on how the FRB implements tougher prudential standards for BHCs.  I expect the FRB to use general phrasing in the NPR to stipulate that any covered nonbank has to have what it would otherwise have to have in its business line and then some.

And, these rules are just for starters.  Although not mandated, the systemic rules also could include new:

  • contingent capital requirements (not likely in the near term);
  • enhanced public disclosures (way likely, especially for compensation);
  • short-term debt limits (a major concern); and
  • anything else the Board or FSOC deem fit to promulgate.

Where These Rules Collide

I’ve left out one very, very major requirement in Section 165:  recovery and resolution rules.  Here, we know what these rules look like, at least in part.  The FDIC has released the final version of the joint living-will requirements of Dodd-Frank, although the FRB’s standards have yet to be released, and they may well differ in nuance, if not in the letter of the rule.  That rule is, as you all know, a very strict standard aimed at ending TBTF.  Together with the orderly-liquidation provisions in Title II of the Dodd-Frank Act, I think the new law has dramatically decreased moral hazard, and most likely ended it here once and for all.  This is good as far as it goes, painful as it is.  However, it creates a fundamental disconnect – U.S. and global rules that punish large firms for the “negative externality” of TBTF even as the safety net is pulled out from under them.

Which is it?  Are systemic firms too big to fail and, thus, blessed with a cloak of invulnerability from taxpayers for which they should pay?  Or, are they to be broken apart and taxed for the benefit of TBTF even as U.S. law tells creditors, counterparties and shareholders not to count on it?  So far, U.S. regulators have decided to have it both ways – taxing U.S. BHCs and, soon, systemic non-banks, for the sin of size even as orderly-liquidation and living-will standards tell counterparties to fend for themselves.

I have often been challenged on this point on the basis that TBTF isn’t dead, it’s just resting.  The thinking here is that U.S. policy-makers won’t have the guts to do what’s in Dodd-Frank if forced to confront another systemic failure.  This could be true – it’s also true that soldiers can blink even if armed to the teeth.  There’s no way to know until the next systemic crisis – one I hope isn’t already upon us.

But, I know what the law says and I see what regulators are doing to implement it.  As I said, the end to TBTF is tough and clear, at least as writ in law and rule.  Regulators thus should have the courage not just of their convictions, but also in what Congress told them to do.  The systemic prudential framework should align with the systemic resolution one, not pile atop it into a burdensome behemoth of colliding rules at cross-cutting purposes wholly inconsistent with global standards in other key markets.