Time does not erase the tragedy of the financial crisis

Time does not erase the tragedy of the financial crisis
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Mark Twain once said humor is equal to tragedy plus time. But it is far too soon for any part of the great financial crisis tragedy to be funny.

Likewise, it’s far too soon to start dismantling key systemic protections of Dodd-Frank, which is what seems to be happening with proposals made in April by the Federal Reserve and the Office of Comptroller of the Currency (OCC).

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Perhaps 10 years on, it is easier to forget $11 trillion was lost in the stock market, and another $7 trillion was lost by homeowners. Eleven million homeowners went "upside down” with their mortgages.

  

Fifteen million people were out of work and unemployment soared to over 10 percent. The government spent, lent or guaranteed more than $20 trillion. We should not be laughing at this tragedy by softening systemic protections.

Bank capital ratio changes

The proposals made by the Fed and the OCC will increase leverage in the banking system. Here, in their own words, are key parts of the proposal to the Board of Governors:

  • Replace the current 2-percent leverage buffer that applies uniformly to all global systemically important banks (GSIBs) with a leverage buffer tailored to each GSIB, set at 50-percent of each firm’s GSIB risk-based capital surcharge;
  • For covered insured depository institutions (IDIs) replace the current 6-percent threshold at which such IDIs are considered “well capitalized” under the prompt corrective action framework with a threshold set at 3 percent plus 50 percent of the GSIB surcharge applicable to the IDI subsidiary’s GSIB holding company;

The Systemic Risk Council (SRC), which the CFA Institute created and now funds, responded to these proposals with a comment letter that lays out the dangers.

 

In short, regulators arguably should be strengthening, not weakening, the equity base of banks and should be doing so in the simplest way, i.e., via the leverage ratio.

Lowering the leverage ratio is reminiscent of former Citigroup CEO Charles Prince telling the Financial Times in July 2007 — ominously close to the top of the market — that his bank will keep dancing.

Volcker rule changes

Regulators also propose to relax the so-called Volcker Rule that prohibits banks from being hedge funds and engaging in proprietary trading. The excuse for the unwind is that it is too complex and costly for smaller, community banks and that even the biggest, systemically risky banks have learned their lesson and will be more careful now.

The SRC notes that the principle underlying the so-called Volcker Rule is that banks and their affiliated dealers were given access to Fed liquidity insurance and FDIC deposit insurance backed ultimately by taxpayers.

When the businesses of speculative and highly leveraged trading inside these banks got out of control, the taxpayers were forced to bailout depository institutions through TARP and other bailout tools.

The Volcker Rule said enough! Such commercial activities should not be covered under a government safety net. In our view, they present a real risk that we return to a speculative and leveraged trading environment within depository institutions. Here is a summary of the concerns laid out by the SRC:

  • The regulators’ proposals return nearly full discretion to the management of banking groups to determine what trades constitute “market-making” or “hedging” services provided to clients is a mistake.
  • Proprietary trading often looks identical to these other activities of market-making and hedging. Given the incentives bank managers face, racking up trading gains camouflaged as market-making and hedging will almost certainly occur.
  • Returning trade discretion to the manager would quickly erode the core substance of the Volcker Rule. At the very least, accompany such discretion with rigorous and clear metrics, checks and balances to document the true nature of trading activity.
  • The SRC has urged the Fed and its fellow regulators to explore other means of simplifying the Volcker Rule without effectively abandoning the policy itself. 

While a review of 10-year-old regulations for efficiency, effectiveness and cost is desirable, acting like the underlying systemic risks have vanished is a mistake. It is also a mistake to believe the commercial interests trying to convince us the protections are no longer necessary and impinging on economic growth.  

It is indisputable we are at record-levels of corporate profitability, including banks, and the markets have responded in kind. Has time turned financial tragedy into humor, or are we back at levels demanding a laser focus on systemic resilience? We aren’t laughing.

Kurt Schacht is the managing director of the Advocacy division of the CFA Institute, a global association of investment professionals.