Karen Shaw Petrou’s memorandum to Federal Financial Analytics clients on leverage as holy writ.

TO: Federal Financial Analytics Clients

FROM: Karen Shaw Petrou

DATE: August 14, 2015

In our new papers on custody-bank deposit capacity and the $50 billion systemic BHC threshold, we focus in part on how relevant rules give a competitive edge to all the non-banks operating beyond the full force of these costly standards. In the American Banker analysis of the regional-BHC paper, a public advocate reasoned that the rules are right and our paper is wrong because there shouldn’t be shadow banks. He went on to say that, if everyone were equally regulated, then the cost of new rules wouldn’t matter, especially given their offsetting benefit of preventing financial crises. To which I say: shadow banks matter because there are shadow banks like it or not, the cost of rules matter because costs have consequences like them or not, and every single rule is not in and of itself a safeguard from financial cataclysm.

Indeed, the assumption that every provision in Dodd-Frank and all the rules thereafter are essential is to apply Scriptural exegesis to provisions subject to far more earthly origins. It goes without saying that nothing Congress does is perfect and the same holds true for the complex compromises crafted by regulators buffeted by inter-agency conflicts and political pressure. Some things these policy-makers do actually merit a second look.

The leverage rule has assumed the political proportions of the First Commandment. Revered as a sinecure against systemic risk, the leverage rule is actually pretty stupid even though its purpose is not. Its premise is that all assets are equally risky, which of course is not true nor has it ever been. The need for an admittedly dopey rule is the expectation – pretty much right, as history has shown – that banks and their regulators will game rules for bottom-line or national advantage wherever they can. Because the leverage rule is far from perfect and risk-based capital can be arbitraged, a well-calibrated capital regime that anticipates risks and correlates reward is a balancing act. Regulatory theologians, though, cannot agree to any solution they think puts our feet on the primrose path.

The problem we examine in the custody paper is an ideal case study of the dilemma posed by undue faith in the simple leverage rule. The U.S. leverage rule — much higher here for the largest banks — applies to excess reserve holdings at the FRB – riskless if you think the U.S. central bank is good for it – in the same manner and amount as to highly-leveraged loans for wholly-suspect borrowers. Any number of finance dissertations – not to mention hard market experience – tells you this isn’t so.

Our paper thus assesses what happens if the leverage rule applies to excess reserves. We show that it makes it a lot harder for U.S. banks to take cash deposits from institutional investors looking for safe havens to ensure their own resilience under stress. Clearly, the financial system is safer if institutional investors like money-market funds have ample liquidity with which to honor redemption claims, and the funds they hope are liquid are cash housed at banks then placed at the FRB rather than in shadow liabilities invested who knows where in who knows what.

Would custody banks get to play with excess-reserve assets in dangerous ways if the leverage rule didn’t apply? Of course not. Could the FRB go bust? Maybe, but I for sure hope not. Would the financial system be more risky if giant investors acting on behalf of others lacked the equivalent of a bank vault in which to house their liquidity cushions? For sure.
I get it that policy is political. One may thus need like the advocate cited above to say hell no to every proposition favored not only by robust analytics, but also by big banks. The thinking here is that, give big banks an inch, they’ll swallow whole the United States Capitol– rotunda and all — and a few Congressional office buildings as an after-dinner snack.
This theory gained tremendous traction at the start of this Congress when big banks really thought themselves on a roll and took out the “Lincoln Amendment” even as they eyed other, still more controversial provisions that showed signs of being repeal-ready. Sen. Warren famously raised a Paul Revere-like cry befitting her state and battle lines were drawn that remain fully garrisoned to this day. But, each side in this battle is fighting over slogans, not substance. The “light-touch, principles-based” regulation banks pressed for and enjoyed – until they didn’t – was disastrous. So, too, though are the extremes of new rules where the punishment doesn’t fit the potential crime. Regional BHCs aren’t as risky as giant complex, cross-border ones. The leverage rule should be a backstop, not a binding constraint. And, most of all, banks should be allowed to function as effective financial intermediaries. If not, welcome to the shadows.

Leverage