Karen Petrou: The Fed Just Puts Ribbons on Rags
Four months after announcing plans for minimal changes to its stress tests, the Fed last Thursday screwed up its courage and proposed a couple of them. The remaining, still-small changes will come after the Fed rests up, but none of this seemingly-strenuous effort addresses the fundamental problem with both capital regulation and the testing designed to ensure it suffices: none of these rules make total sense on its own and all of them taken together are a cacophony of competing demands and ongoing collisions with other standards. Prettying up the stress-test rule is thus only putting ribbons on a ragged assemblage of ill-fitting pieces in clashing colors with large, large holes.
Now-ousted VCS Michael Barr promised a “holistic” capital construct during his 2022 confirmation hearings, but he nonetheless clung tightly to one-off rulemakings without any cumulative-impact analysis. Mr. Barr thus opposed last week’s stress-test changes, but for all the wrong reasons. He thought they went too far; in fact, they don’t go anywhere near as far as they could and should.
The new stress-test proposal most substantively says that banks will henceforth be judged by a three-year rolling average of their tested capital levels, rather than on the current, volatile annual schedule. But, averaging numbers that don’t make sense tells one nothing about the utility of each test. Think about a household with two chihuahuas – average dog weight about ten pounds. Next year, a Labrador romps in, and the average goes up, but the yard can still hold three thirty-pound dogs – what the second-year average says you have. Now in year three, you get a mastiff. The average goes up more than a bit, but you appear to have only four fifty-pound dogs even though the mastiff knocks out every fence you’ve got in year three. No worry, though […]
FedFin on: Antitrust Policy
As required by an executive order (EO) from President Trump mandating both review and then repeal of any rules that adversely affect competition, the FTC is seeking public comment on which rules to target and whether these standards could be modified or must be rescinded to meet the President’s goals. This process will clearly invite new scrutiny of the bank-merger process, also likely to lead to comment from banking organizations seeking relief in areas such as de novo chartering requirements and access to brokered or reciprocal deposits….
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Karen Petrou: The Fed Has Given Itself Nothing But Bad Choices
Much has been written of late about the pickle in which the Fed finds itself due to the President’s quixotic trade war. The Fed is indeed facing a dilemma setting monetary policy, but it confronts a Rubik’s Cube trying also to ensure financial stability. The reason: the more the Fed fights inflation, the less it can secure the financial system and the more it is forced to secure the financial system, the less able it will be to conduct monetary policy. This vise results from the Fed’s huge portfolio, yet another example of why the Fed should have reduced its portfolio as quickly as possible after both 2008 and 2020. Since it didn’t, it now has only bad choices if Treasury-market illiquidity turns toxic.
This negative feedback loop is the result not only of the Fed’s cumbersome trillions, but also of its unwillingness to make another hard decision: meaningful action to address identified systemic risks. Had the Fed heeded its own warnings going back to 2020, it might have done something to reduce Treasury-market dependence on high-risk, leveraged hedge funds. To be fair, the Fed cannot directly regulate hedge funds and the SEC lacks prudential authority, but both agencies had lots of ways to curtail systemic risk long before basis-trading hedge funds came to hold at least $1 trillion in assets.
So far, hedge-fund deleveraging is proceeding in a reasonably-ordered way, but risks such as these have a bad habit of cascading. Jamie Dimon already anticipates this, but he also thinks the Fed will step in. So too does at least one senior Fed official already willing to say so. The Fed can and probably will undertake yet another bailout, but macroeconomic stability could well be the price of this financial-market rescue.
Why? The Fed’s portfolio was rightly […]
Karen Petrou: Why Regulators Will be Flat-Footed if Bad Now Turns Soon to Worse
One of the comforts with which bank regulators will doubtless console themselves after last week’s market rout is that the largest U.S. banks have the capital not only to withstand this, but also the probable, profound consequences of the President’s punitive tariffs. However, because U.S. regulators mismeasure capital resilience, this confidence is misplaced. Using the economic-capital approach I recently endorsed shows that, while U.S. banks still are strong, they are not fortresses.
FedFin recently analyzed two new studies demonstrating that geopolitical risk is hard on bank solvency. To this, one of course can say that there’s no real-world need for exhaustive studies of dozens of countries over decades – common sense buttressed by history makes this all too clear. These hard lessons and the data that describe them do, though, make clear that it’s more than worth revisiting the United States after the Smoot-Hawley tariffs to get a sobering idea of the negative feedback loop between geopolitical risk, macroeconomic hazards, bank vulnerability, and – back to the beginning, geopolitical risk. Any talk of the 1930s is alarmist and also inapplicable in numerous respects, but it is the most pertinent example of geopolitical risk over the past century and thus demonstrates the need now to be very, very careful – not something this White House appears to be good at.
Economic-capital measures are a more robust platform to assess bank resilience than regulatory capital and are thus of particular pertinence at this dangerous moment. Regulatory-capital measurements are so complex and often prove internally contradictory even before one tries to integrate capital resilience with liquidity strength. The liquidity rules are also complex constructs based at least as much on regulatory imagining as on actual circumstance, with none of these abstruse requirements deigning to consult the market for its opinion on franchise value […]
FedFin Assessment: Will There be Banking Battles in This Trade War?
In this report, FedFin provides its first assessment of how the sweeping tariffs on trade-in-goods set last night by the White House are likely to affect financial-services firms. We address first-order effects from trade-in-goods disruptions and resulting macroeconomic consequences as well as the extent to which this trade war – and it’s already a trade war – may spread to trade-in-services that disrupt the course of cross-border finance, transborder data flows, and even financial stability….
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FedFin on: Stablecoin Regulatory Framework
The chair of the House Financial Services Committee, Rep. French Hill (R-AR), the Digital Asset Subcommittee’s chair, Rep. Bryan Steil (R-WI), eight other Republicans and three Democrats have introduced House legislation to create a long-awaited federal framework for dollar-denominated payment stablecoins. The bill differs substantively from Senate language, especially with regard to the scope of federal authority and the extent to which stablecoins might come to supplant bank deposits. However, the bills are similar in many respects and are likely to become still closer as House and Senate consideration continues ahead of final agreement and enactment into law later this spring….
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