March 2015 – Despite Regulatory Advances, Experts Say Risk Remains a Danger to Large Banks

 

Article by Mayra Rodríguez Valladares, managing principal at MRV Associates, a capital markets and financial regulatory consulting and training firm in New York.

 

This article first appeared on NY Times

and is posted here with permission of the author.

– March 2015

Federal Reserve Conference at the George Washington University

With all the new laws and regulations since the financial crisis, it would be easy to believe that the banking industry is safer. Unfortunately, speakers at the Federal Reserve conference at George Washington University on Friday offered a range of reasons for why that’s not the case.

First, the regulatory framework remains fragmented. Not only do we have “a dual state and federal banking charter system,” as former Representative Barney Frank told the audience of regulators, bankers, lobbyists, consultants and academics, we also have three national bank regulators, 50 state bank regulators and two derivatives regulators, not to mention different regulators for securities, broker-dealers and insurance companies. Private equity and hedge funds remain largely unregulated. It is unreasonable to expect that all these entities would communicate, not to mention work well together, to detect the next crisis.

In his keynote speech, the former Federal Reserve chairman, Paul A. Volcker, said that he continued to ask people “if they like our regulatory system — and cannot find anyone who does.” He said that he and his research group, the Volcker Alliance, “will propose that the U.S. regulatory framework be streamlined,” but added that the proposal was likely to meet significant resistance from both the regulatory agencies and politicians, who all have a stake in the current structure.

Lack of openness throughout the financial sector, not just in banking, was also a significant problem that led to the crisis and will continue to thwart regulators in years to come. “During the crisis, it was very difficult to get access to information,” said Coryann Stefansson, managing director at PricewaterhouseCoopers. “It is a myth that you can get everything from a bank.”

But while the Basel Committee on Banking Supervision has revised its requirements for important bank risks disclosures, they are unlikely to go into effect until next year in the 28 member countries — and even then, enforcement will not be necessarily uniform.

And in the United States, a significant number of financial institutions that are not banks do not report financial data to the Treasury’s new Financial Stability Oversight Council. Among those who do report, reporting is not done in a uniform manner, which would enable regulators to have a consistent view of risk in the system. Current political pressure to raise the $50 billion asset threshold above which banks face greater regulatory scrutiny may make it harder to see how complex and interconnected some firms are.

At the conference, Paul Saltzman, president of the Clearing House Association, a trade group, said that bank stress tests were “an important Federal Reserve Bank regulatory tool.”

But many of those looking at the results from the latest stress tests and Comprehensive Capital Assessment Review were most interested in whether banks could pay dividends. In the meantime, they were not looking at how the tests depended on unreliable, inaccurate data that rendered capital ratios, living wills data and stress test numbers meaningless. For two decades, I have seen banks of every size struggling with data collection, validation, ratio calculations and use of models. Unfortunately, the Basel Committee on Banking Supervision confirmed my concerns in January. Its survey results showed that nearly seven years after the global financial crisis, banks’ technology is not robust enough to give risk managers and regulators a full view of how a bank is coping with its credit, market, operational and liquidity risks.

Another significant problem is that many of the systemically important banks have not changed structurally. Arthur E. Wilmarth Jr., a law professor at George Washington University, told conference attendees that even though “returns on equity for most large global banks are well below 10 percent,” banks like Goldman and JPMorgan Chase “are not changing their business models.” In fact, some banks like Citibank are increasing their risk exposures. “Citibank has increased its footprint in derivatives and commodities,” he said. “Citi does not have a good track record in trading.”

Unfortunately, large banks remain insufficiently capitalized to sustain unexpected losses, which could affect ordinary taxpayers. Anat R. Admati, a finance professor at the Stanford Graduate School of Business, said at the event that banks were “not the only risk takers in our economy,” adding, “Entrepreneurs in Silicon Valley take risks all the time.” Yet those entrepreneurs, unlike big banks, will not be bailed out by taxpayers, who share in banks’ downside but not in their upsides. Additionally, as Professor Admati said, “Capital ratios and stress tests are based on risk weights and complex models, which can have perverse effects such as biasing banks’ decisions away from worthy business lending and which can increase the interconnectedness and fragility of the system.”

Professor Admati said she was also concerned about how much market participants and even regulators “know about banks’ interconnections to each other and the extent of their derivatives positions.”

This unanswered question is what concerns financial reformers — and if taxpayers could learn about banks’ activities, it would worry them as well.