The Fed balances regulatory efficiency and market discipline in Dodd-Frank review

• The Dodd Frank Act was introduced in the aftermath of the global financial crisis to drastically reform the risk-based capital framework and increase regulatory oversight to avert another catastrophic collapse in the financial system
• Kartik Athreya explains that without a clear Dodd Frank’s Orderly Liquidation Act (OLA) and Living Will process, the fundamental regulatory framework is not complete
• He also believes there is a need to settle who owns what information in this era of digital connectivity, so people can start thinking about the appropriate regulatory response

US President Donald Trump’s administration and the Republican-led Congress are in full deregulation mode. The US Senate in March passed a bill that seeks to repeal key elements of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd Frank). The Economic Growth, Regulatory Relief, and Consumer Protection Act sponsored by Republican senator Mike Crapo sailed through the Senate with strong bipartisan support and is now in the House of Representatives and expected to pass into law as early as the end May 2018.

The Dodd Frank Act was introduced in the aftermath of the global financial crisis (GFC), to drastically reform the risk-based capital framework and increase regulatory oversight to avert another catastrophic collapse in the financial system. Under the Act, banks with total gross assets of at least $50 billion are designated systemically important financial institutions (SIFIs) and subject to the Federal Reserve (Fed) supervised Comprehensive Capital Analysis and Review (CCAR) and annual stress tests.

And to address the potential impact of collapse of individual financial institution, Dodd Frank’s Orderly Liquidation Act (OLA) calls for implementation of the Resolution (Living Will) Plan programme, again supervised by the Fed, to minimise the impact on the wider system and to shift the burden of resolution or liquidation to immediate stakeholders such as bond- and share-holders instead of the state and public tax-payers as was the case during the GFC.

Instilling market discipline

Some regulators see the OLA as a signature part of the Dodd Frank Act. Kartik Athreya, executive vice president and director of research at the Federal Reserve Bank of Richmond explained that without a clear OLA and Living Will process, the fundamental regulatory framework is not complete.

Kartik Athreya,

Executive vice present and director of research,

Federal Reserve Bank of Richmond

Randal Quarles,

US Federal Reserve Governor and vice chairman of Supervision

“The marketplace must understand that financial firms can be resolved without resorting to assistance. It is precisely once that understanding has permeated and it determines the terms on which these firms are able to acquire funding and financing is when we can start reflecting risk in a meaningful way,” he said.

Athreya heads the research department at the Fed in Richmond, and his team’s work on the linkages between macroeconomics, systemic risks and regulation informs policymakers in the areas of bank supervision and financial stability.

“Regulators are looking to make these rules more efficient, transparent and simpler without compromising safety and soundness of the system. There is a desire for a more differentiated approach and the Fed has been responsive while preserving safety and soundness,” he said.

The counterbalance to onerous regulation is proactive market discipline. For there to be appropriate regulation, there must be equally strong discipline by private sector players. And the presence, perceived or real, of a public safety net may work against it.

“But we have to be humble about what regulation can help achieve. Historically, in banking research we have focused on how to set up institutional framework to make sure that private sector players monitor each other appropriately because we do find it improbable that we can have a well-functioning financial system if we have an overwhelming safety net coupled with the necessarily comprehensive regulatory apparatus required in that case,” Athreya emphasised.

He added: “Banks’ role in financial intermediation entails maturity transformation, and the latter is often accompanied - absent of deposit insurance - by the possibility of instability. And the risk of maturity mismatches can come from anywhere.”

There is a common view among politicians, including Democrats, and regulators that the Dodd Frank Act, in its current form is aimed primarily at “too big to fail” institutions and is hence onerous, inflexible and puts excessive burden on the entire banking system to comply with, especially the smaller regional and community banks.

Caution in the face of increased risks

Even progenitor and co-author of the Act former congressman Barney Frank on hindsight conceded that smaller banks with assets of less than $10 billion should be exempt from some of the lending restrictions and the Volcker Rule, while the threshold for qualifying SIFI should be raised from the current $50 billion to between $110 and $125 billion. The proposed new law will set the threshold significantly higher at $250 billion.

Banks with assets of less than $100 billion would be exempt from current oversight requirements. However, banks with assets of between $100 billion and $250 billion will have to wait for another 18 months if the law passes before they too can be freed from similar requirements. But the Fed could still subject them to periodic stress tests and other specific oversight measures.

Frank criticised the new threshold as too high as some financial institutions whose failure led to the GFC had substantially less assets then, and would today be excluded by the new requirements.

While the Fed appears to take a softer stance on relaxing the SIFI threshold, application of lending restrictions and the Volcker rule on smaller banks, it is somewhat more divided and reluctant to revisit more fundamental capital and liquidity rules.

Lael Brainard,

US Federal Reserve Governor and Chair of the Committees on Financial Stability,

Federal Reserve Bank Affairs, Consumer and Community Affairs and Payments,

Clearing and Settlements

Fed governor Lael Brainard who chairs the Committees on Financial Stability reportedly voted against Fed chairman Jerome Powell and governor Quarles on a proposal to replace the leverage ratio, a capital backstop for SIFIs, with a more dynamic and institution specific ratio. She also warned against relaxing rules as the risk of financial instability rises.

Brainard cited high asset valuations and levels of business leverage as signs of heightened risks and argued that regulations to ensure market discipline have been successful in mitigating them.

“We continue to assess the overall vulnerabilities in the US financial system to be moderated by historical standards in great measure because post-crisis reforms have strengthened the regulatory and supervisory framework for the largest US banking firms,” she said.

Athreya reinforced that point: “We have gone ten years without anything catastrophic happening. It (GFC) was exceptionally costly societally which makes the cost of regulation looks very trivial by comparison. The GFC has been followed by subsequent sub-par growth, and it takes very little of the sub-par growth to dwarf the cost of regulation.”

He also warned that the productivity slowdown in the US may impact longer term financial stability. This despite recent positive economic performance indicators of 3% top line economic growth and sub-5% unemployment.

“Productivity growth has been fairly slow in the wake of the great recession. It will have direct implication on the conduct of monetary policy and indirect effects on the ability of monetary polity authority (the Fed) to achieve its mandate of price stability and maximum employment. It especially affects the ability of the central bank to respond to crises because of the so-called zero lower bound problem.”

Regulating innovation and data ownership

Moving beyond the issue of deregulation, what does Athreya think of the regulator’s role in regulating innovation? Especially, in line with the broader trend of digitalisation and increasing connectedness or connectivity over digital platforms, what are the challenges for regulators in terms of regulating and facilitating innovation?

“From a research perspective, as a basic principle, it makes sense for the private sector to take the lead in innovation in banking and financial intermediation services. The central banking system is at its best when it plays a constructive role in facilitating and coordinating, for example, between parties trying to decide on platforms, for payments networks and so on,” he commented.

“What is very exciting on the landscape is the broader technology of blockchain. It could greatly enhance society’s ability to do record keeping of a variety of forms. By itself that is a very hard thing to object to,” he added.

With greater digital connectivity it also means easier access, collate, analyse and use personal data, what safeguards can central banks put in place?

“Even before the regulatory approach is ultimately settled, there is a deeper issue of the property right to the information itself. The US and Europe seem to have coalesced, at least at the moment, around different default positions on who owns what information (in US the company who has consent to collect the information owns it, while in Europe the customer is the ultimate owner). This question needs to be settled first,” Athreya quipped.

“Once that is settled, we can think about the appropriate regulatory response because any regulation then has to take into account the incentives of who owns that particular asset. It’s premature in the US to decisively talk about the appropriate regulatory framework. Although the conversation is already being pushed to the front. The legal landscape has to move first to settle that issue,” he concluded.