Stock market gyrations a reminder Wall Street banks need regulation

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The recent stock market gyrations should remind us that when seemingly placid markets correct, the downdraft can be powerful, and that placidity can rapidly transform into turbulence. This reminder is an important corrective to the rush to weaken the reforms that protect financial stability not yet 10 years after the financial crisis. Legislation now before the Senate, powered by the desire to relieve regulatory burdens on community banks, would in fact cut back the Federal Reserve’s power to regulate the largest banks. It would meaningfully advance the date of the next financial crisis. The damaging changes seem minor, a word change here or there, but the impact will be large.

Under current law, the Fed is instructed to establish enhanced “prudential standards” for the largest U.S. financial firms to “prevent or mitigate” risks to financial stability that the activities or possible failure of such firms can produce. The Fed is then given discretionary authority that it “may” tailor these standards in light of several enumerated risk-related factors and any other risk factor that the board deems appropriate. The proposed legislation replaces “may” with “shall” and thus converts the Fed’s discretionary authority into an obligation to engage in category-specific and perhaps even firm-specific tailoring of its prudential standards.

{mosads}This apparently minor change is likely to produce significant degradation of financial stability especially over the long run. The change would expose the Fed to litigation challenges to its enhanced standards, in particular whether they are adequately tailored. Similar language in related statutes has evoked a judicial demand for a quantified cost-benefit analysis that is costly to produce and inevitably open to challenge on its assumptions.

The statute thus empowers the largest firms which pose the biggest risks to bargain with the Fed for laxer standards with the threat of a well-resourced litigation challenge in the background. Over time this bargaining for laxity will produce a race-to-the-bottom dynamic that will dramatically increase the chance of another financial crisis.

To be clear: this legislative change would provide the largest banks, the so-called global systemically important banks, or “G-SIBS,” with the tool to undo much of the post-crisis regulatory regime that keeps the financial system safe. Each of them could separately litigate that the current regime as applied to their circumstance was insufficiently tailored. Since the proposed legislation would raise the threshold for the application of enhanced prudential standards from $50 billion to $250 billion, the case for tailoring, much less mandatory tailoring, is much weaker. Bear Stearns, it should be remembered, had only $300 billion in assets in 2006.

One general way to protect the Fed against spurious attacks on its authority is to make clear that quantified cost-benefit is not required for its prudential standard setting or its designation of other banking firms as systemically important. Of course the Fed will invariably make pragmatic use of the available evidence and generate some on its own, but the “benefits” of financial stability — the avoided costs of a financial crisis — or the marginal effect on stability of a rule change or application: These are the real stakes and quite beyond the capacity of judicial review.

The safeguard against arbitrariness is the internal governance of the Fed board, since any measures must command majority support among experts appointed by the president and confirmed by the Senate for long terms. These are actors who are accountable for maintaining a vital banking sector as well as financial stability.

There is one other area in which the proposed legislation would erode financial stability protection. This is the weakening of the stress test regime, which has been a vital addition to the regulatory toolbox. The financial crisis revealed that snapshot measures of whether firms comply with capital and liquidity standards are inadequate to protect financial stability. When economic conditions change, when market sentiment shifts, balance sheets can erode quickly.

“Stress tests” are a critical measure of the resiliency of individual firms and the financial system as a whole. The proposed legislation would eliminate the requirement that all significant financial firms undertake an annual stress test. It would also cut back the Fed’s capacity to set multiple cases of adverse circumstances to see how these firms would fare. The effect would be to make it harder for the Fed to insist that firms restrict dividend payouts or otherwise bolster their balance sheets against the possibility of a coming storm.

One major “lesson learned” from the financial crisis is that financial stability is a classic “public good.” Everyone benefits from it, everyone depends upon, but no one particularly wants to pay for it. Financial regulation protects us against the would-be free-riders. By hobbling the Federal Reserve, the proposed legislation opens the way to more free-riding and less financial stability.

Jeffrey N. Gordon is the Richman Professor of Law at Columbia Law School and co-director of the Millstein Center for Global Markets and Corporate Ownership. He is the co-author of Principles of Financial Regulation.

Tags Banking Congress Federal Reserve Finance Law Stock market Wall Street

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