Karen Shaw Petrou’s memorandum to the Federal Financial Analytics clients on the political landscape for shadow-bank strategic risk.

TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: July 15, 2016

The Political Landscape For Shadow-Bank Strategic Risk

Although political platforms are at best ephemeral, those released ahead of the conventions nonetheless epitomize the policy challenge confronting U.S. financial-services firms in 2017: how “shadow” financial institutions will be governed and by whom. If Democrats take the White House and the Senate, FSOC will fire up its designation engines even if MetLife prevails on appeal. If Democrats also take the House in a donkey trifecta, then Dodd-Frank will be beefed up so that FSOC can not only designate companies, but also demand activity-and-practice rules and resolution protocols from now-recalcitrant functional regulators. If Donald Trump takes the White House and Republicans retain the House while Democrats take the Senate, then there’s a stalemate on shadow banking that leaves Dodd-Frank essentially intact, FSOC stifled, and the FRB nonetheless determined to do what it can where it can to address risk outside the biggest banks unless or until a Trump-like chair takes the gavel. An elephant trifecta in which the Senate also goes to the GOP would lead to a Dodd-Frank gut-job, but the low odds for such an outcome cause me to discount it for strategic-planning purposes. Thus, assuming that renewed systemic risk spares its hand, shadow-bank regulation in 2017 will present financial institutions – especially non-banks – with a new policy landscape with profound strategic-planning impact.

To be sure, minority senators in each of these scenarios could block substantive legislation. But, chastened by a demanding electorate, it remains to be seen if next year they will continue to do so. And, even if they do, whomever wins the White House will have a new team at the federal regulators and this new team will make a very big difference.

Who wins and loses? For big banks, there’s nothing but upside in a more equitable distribution of the systemic-risk burden — right now they bear all the pain without having been the sole cause of 2008’s blame. For non-banks like asset managers, insurance companies, hedge funds, and broker-dealers, the picture is of course quite different.

Based on who holds which office, each of these sectors is at significant strategic risk even though none of them poses systemic risk in the same way as the largest U.S. banks. The first political prophylactic in the shadows is thus for each of these non-bank sectors to identify its own systemic-risk weak points. Few have done so because all instead have done a masterful and often very persuasive job explaining why none is a bank and therefore how bank regulation makes no sense.

Where non-bank activities are different from bank activities, systemic risk may well be less, although critical issues such as the ability to handle operational risk are, in my view, still often ill-addressed by investor-and policy-holder protection rules in stress and cross-border scenarios.

Where non-bank activities are like-kind to banking, risks are no different than at banks except to the extent that the non-bank is farther from emergency support or panic-reducing protections like FDIC insurance. This distance, though, makes the heart grow fainter, not fonder, under operational, reputational, liquidity, and other stress and/or cross-border scenarios.

Markets and some firms may well expect the FRB and other central banks to ride to the rescue with market-maker-of-last-resort facilities. Indeed, FRB Gov. Tarullo’s solution to shadowy companies on Monday was not only to renew his call for asset-management liquidity regulation, but also to propose an express central-bank backstop. This is the perfect solution from a shadow-bank profit perspective: all the upside for them of moral hazard and all the downside systemic risk for the rest of us.

To anticipate each of the shadow-bank regulatory scenarios posited above other than a GOP trifecta, non-banks need quickly to identify their resilience and resolvability weak points, taking into account counterparties like CCPs and critical service providers where they’re at the same risk as everyone else in the same boat. Demonstrating that even significant operational, liquidity, reputational, geopolitical, or comparable risks can do no damage to those who can’t absorb it would go a long way to ensuring not only a reasonable shadow-bank regime that ensures long-term profitability, but also to a far safer U.S. financial system.

Shadow Banking, Strategic Risk
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