Karen Petrou’s memorandum to Federal Financial Analytics Clients on solving the riddle of new rules for old banks.

TO: Federal Financial Analytics Clients

FROM: Karen Shaw Petrou

DATE: August 7, 2015

Applying Hegelian theory to a capitalist problem—how to regulate big financial institutions—let me posit a thesis, antithesis, and, then, a synthesis of these two propositions. I will call the thesis the Better Markets assertion: all rules are needed because any new financial crisis is too awful to contemplate. The antithesis to this is the CEO rebuttal: maybe so, but I’ve got a company to run. The FedFin synthesis is laid out this week in two white papers that take on what happens when policy dictated by the thesis runs hard into the reality dictated by the antithesis: perverse, unintended results that combine to make financial markets riskier and financial institutions weaker all at the same sorry time.

Each of these white papers is funded by cited third parties, and both represent FedFin’s thinking on the problems we were asked to assess. The first of these papers takes on a little-noticed, seemingly-technical issue: the application of the leverage ratio, especially the enhanced supplementary U.S. one, to central-bank placements from U.S. custody banks. Let me quickly work this paper’s thinking, data, and conclusions through Herr Hegel’s construct:

  • Thesis: As Better Markets would surely say, the leverage rule is the be-all and end-all of big-bank regulatory capital because everything a big bank does is sure to be risky and none of their models or internal controls can be trusted. For good measure, risk-based capital is complex, untrustworthy, and subject to both regulatory error and model manipulation.
  • Antithesis: Both U.S. custody banks and their customers have businesses to run, not to mention other rules with which they must also comply. For example, large investment companies must be far more liquid and hold more cash which they want to place at custody banks. Cash-equivalents are in scarce supply and alternatives to custody banks cannot be quickly (or perhaps also safely) constructed.
  • FedFin Synthesis: Applying the leverage rule to excess reserves eliminates at least $182 billion in cash-deposit capacity that institutional investors may well need and should surely want to ensure resilience under liquidity stress and market volatility. Market distortions caused by the combination of all of the new rules (leverage, liquidity, stress testing, etc.) taken together with broader market factors (e.g., negative return on sovereign obligations, geopolitical risk) means that reduced cash capacity at U.S. custody banks exacerbates—not reduces—systemic risk.

Our second white paper takes on a higher-profile and even more political problem, whether Dodd-Frank’s systemic add-on rules should apply to all BHCs with assets over $50 billion. Again over to Herr Hegel:

  • Thesis: Anything that isn’t a community bank is a big, bad bank that needs really tough rules.
  • Antithesis: My bank is not of the size or complexity that warrants systemic regulation, nor is it so inter-connected, international, or essential to market function as to make the cost a meaningful offset to risk.
  • FedFin Synthesis: Dodd-Frank’s systemic rules have direct costs—at least $2 billion to our sample—and significant qualitative ones that will lead to still more market dependence on shadow lenders and non-bank deposits. Ironically, the rules in our view make it more—not less—likely that the federal government would have to support a regional BHC in distress.

The problem with the thesis in each of these cases is that it’s unprovable—that is, one cannot now tell which rules or even if all of them in fact will avert financial cataclysm. I don’t think so—all too many financial colossi are outside the reach of all of the rules. Even if I’m wrong, though, so sweeping a thesis is a poor platform for effective public policy because it’s so over-powering in its reach as to squash all signs of contradictory effect.

The antithesis is, if anything, even more flawed as a single-sided precept. It is true that businesses must be run to suit their shareholders, but any business—banks very much among them—with taxpayer support and other negative externalities must be regulated to ensure that public support is not solely for private profit. However, when rules run the business—increasingly the case for the larger banks—then the antithesis packs a punch.

Better Markets has made only some inroads with its synoptic view of big-bank regulation, just as bank CEOs have made only limited progress with arguments based on the need to protect their business model. This has left policy-makers in stalemate—even the most reasonable moderate proposals are stifled by opposing, intractable forces.
I hope the synthesis we propose for these two critical regulatory issues helps to bridge the gap between these forces, leading to more constructive debate and, even better, near-term action.

Please let me know what you think about each of these papers and the next theses we should take on to craft a better dialectic.

Custody Banks Deposit Capacity