Why We Need to Reform Financial Regulation

By Markus Demary

The US Republican Party plans to repeal the Obama-era financial regulation. While their approach will bring regulatory relief to financial firms, it will also increase the risks of financial crises. Introducing regulatory relief through a small banking box would be a better way of making the financial system more efficient.

 

Reforming financial regulation from time to time is necessary. Existing rules do not effectively apply to new business developments and technologies and they might become inconsistent to global approaches to financial regulation. Alternatively, reforms are necessary for making the financial system more resilient to shocks. That is why it is necessary to scrutinise the existing regulation on a regular basis. This approach is pursued in the European Union with the public consultations on the bank capital requirements regulation, on the cumulated effects of financial regulation and on the creation of a Capital Markets Union. These are approaches – with industry and consumer advocates’ cooperation – to improve the existing regulatory system. The US Financial CHOICE Act, which passed the House of Representatives on June 8, 2017,1 represents a different approach, however, it is the replacement of the old regulatory system with a much older one.

 

A Small Banking Box is Worth Discussing

Still, the Financial CHOICE Act contains some valuable ideas worth discussing.2 Many experts have good reasons to be critical about the US response to the financial crisis of 2008 coded in the Dodd-Frank Wall Street Reform and Consumer Protection Act. For one, Dodd-Frank has raised the regulatory burdens for financial firms, it restricted the access to loans for households and it added a lot of complexity to the resolution process of failing banks.3 Regulation also made the European financial system more complex. Therefore, the European Union is discussing a so-called small banking box, which aims at decreasing the regulatory complexity for smaller banks. The lighter regulatory environment is based on the fact, that these banks are less exposed to the risks of the global financial system because of their focus is to finance their local community.

A small banking box might therefore be correct for these unintended consequences of Dodd-Frank.

Similar to the idea of a small banking box, the Financial CHOICE Act aims at providing regulatory relief to a subset of banks. While the subset consists of smaller and systematically insignificant banks in the small banking box, it is well-capitalised banks in the Financial CHOICE Act. Banks qualify for the lighter regulatory environment through the option of a “Capital Election”. Thereby, banks with an unweighted equity capital ratio (leverage ratio) of more than 10 percent would be able to switch to a less strict regulatory framework than Basel III. This approach is similar, but different from the idea of a small banking box because the lighter regulatory environment can also apply to larger banks. The “Capital Election” idea is based on the assumption that highly capitalised banks should be able to absorb losses without the need for regulatory intervention.4 While this might hold for smaller banks, it does not hold for larger banks that are highly interconnected with the rest of the financial system through their assets and liabilities. The lighter regulatory environment can reinforce risks to the financial system, if it will be applied to larger banks.

However, as long as banks are small and not too much interconnected to other parts of the financial system, a small banking box might reduce the compliance costs for these smaller banks without increasing the risks for the financial system. Many of the smaller banks cannot employ a large staff of experts to deal with complex regulations, but Dodd-Frank forced them to employ expensive experts or to shut down business, which needs a lot of regulatory knowledge. It is harmful for smaller banks that many of the existing regulations with all their complexity target larger banks, while they apply to all banks, independent of their size. A small banking box might therefore be correct for these unintended consequences of Dodd-Frank.

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The small banking box makes sense from the microprudential point of view – that is, from the perspective of the single bank risk.5 However, it neglects the macroprudential view, i.e. the effects of herd behaviour on the financial system or cluster risks in banks’ balance sheets due to common risk exposures. That is where the Basel III equity capital regulation provides instruments to address such macroprudential risks. Addressing these risks is still important, but banks that operate exclusively in their local community might be overregulated under this approach. Therefore, the regulatory relief within the small banking box should not be based solely on the equity capital ratio of the banks, but on the absence of any systemic importance through size, interconnections or common risk exposures.

A small banking box without an assessment of the systemic unimportance of banks would undermine the macroprudential approach. It would then increase the risk that the banks operating under “Capital Election” would be heavily involved in real estate financing with non-recourse loans. In case of a debtor’s default, banks have only access to the property but not to the remainder of the borrower’s assets. Therefore, the US banking sector is more vulnerable to losses from bursting real estate bubbles compared to the European economies where non-recourse loans are less common.

 

Resolution Rules Need to be Reformed

The Financial CHOICE Act seeks to abolish the Orderly Liquidation Authority (OLA), based on the Dodd-Frank Act, as a resolution institution for failing banks. Instead, banks in distress should be liquidated via the normal bankruptcy code.6

In normal insolvency proceedings, for example in case of a failing non-financial firm, creditors use a judicially controlled process to decide on the resolution of the remaining assets. This way, the resolution measures are financed via the sale of assets of the company in distress.7 The liquidation of financial firms is more complex, because their assets and liabilities are connected to other parts of the financial system.8 Disruptions of the payment system, for example, will stop the economy from functioning smoothly. While this approach may be appropriate for smaller distressed banks, which are unconnected to other parts of the financial system, it is not suitable for the resolution of a major investment bank. The latter is very likely highly connected to other parts of the financial system through its assets and liabilities. A normal insolvency proceeding of a large investment bank would that way be impossible without repercussions and contagion effects on the financial system

The Financial CHOICE Act seeks to abolish the Orderly Liquidation Authority (OLA), based on the Dodd-Frank Act, as a resolution institution for failing banks.

Because of the impossibility of liquidating large banks without disruptions to the financial system via the bankruptcy code, creditors can expect that the government will protect them with public money. This will cause the ratings of these large banks to experience an upward bias. The decline of their refinancing costs is called the too-big-to-fail subsidy in the literature. There are estimates that this subsidy consists of a rating improvement of 2.2 rating notches on average.9

One expected effect of the resolution rules in Dodd-Frank is that the too-big-to-fail subsidy for large banks would be lower than under the bankruptcy code. This would also reduce the competitive advantage of larger banks over smaller banks because the latter do not profit from this implicit subsidy. Therefore, the abatement of the OLA is incompatible with a small banking box. A better approach would have been to restrict the OLA to large banks, while applying the bankruptcy code would stay at the centre of resolving failing smaller banks.

The OLA is needed because the very short maturities of an investment bank’s liabilities on the interbank market are highly interconnected. Freezing these liabilities could lead to liquidity shortages among creditors and even disruptions to the settlement of payments. However, repercussions on the financial system could also occur through the sale of assets on a large scale. This would cause the prices of comparable assets to fall, which then could lead to balance sheet losses at other banks.8 Therefore, the so-called systemically important functions of a major bank cannot simply be resolved in a bankruptcy process, but they must be in an orderly fashion over a longer period of time.

A restriction of the bankruptcy code for smaller and unconnected banks that qualify for a small banking box would be a more effective approach. Since the failure of these banks put only small risks onto the financial system, they can be liquidated without major repercussions on the financial system.

 

The Financial CHOICE Act Should Only Apply to Smaller Banks

The Financial CHOICE Act may be conclusive if it only applies to smaller banks, which are less connected to the other parts of the financial system. Although the Dodd-Frank Act is not perfect in all respects, it provides a regulatory framework that is able to mitigate macroprudential risks. Instead of rushing to repeal Dodd-Frank, Democrats and Republicans should better have aimed for a reform of the Dodd-Frank Act by applying a small banking box. A lighter regulatory environment for smaller banks operating on the local level would lessen their compliance cost and it would improve the financing of the economy without endangering the stability of the financial system.

 

Featured Image: US President Donald Trump signing an executive order on financial system regulation at the White House in Washington, Feb. 3, 2017. © Reuters

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About the Author

Markus Demary is a Senior Economist in the research unit financial and real estate markets at the Cologne Institute for Economic Research (Institut der deutschen Wirtschaft Köln) and a lecturer for Behavioral Finance at Ulm University. Markus studied economics at the Rheinische Friedrich-Wilhelms-Universität Bonn and holds a doctoral degree from the Christian-Albrechts-Universität zu Kiel.

 

References

1. See Alan Rappeport, 2017, Bill to Erase Soöme Dodd-Frank Banking Rules Passes in House, The New York Times, June 8, 2017, https://www.nytimes.com/2017/06/08/business/dealbook/house-financial-regulations-dodd-frank.html
2. See HCFS – House Committee on Financial Services, 2017, The Financial CHOICE Act: Creating Hope and Opportunity for Investors, Consumers, and Entrepreneurs, A Republican Proposal to Reform the Financial Regulatory System, https://financialservices.house.gov/UploadedFiles/2017-04-24_Financial_CHOICE_Act_of_2017_Comprehensive_Summary_Final.pdf
3. See Markus Demary, 2017, The US Should Not Roll Back Financial Regulation, LSE Business Review, http://blogs.lse.ac.uk/businessreview/2017/09/06/the-us-should-not-roll-back-financial-regulation/
4. See Markus Demary, 2017, The US Should Not Roll Back Financial Regulation, LSE Business Review, http://blogs.lse.ac.uk/businessreview/2017/09/06/the-us-should-not-roll-back-financial-regulation/
5. See Markus Demary, 2017, The US Should Not Roll Back Financial Regulation, LSE Business Review, http://blogs.lse.ac.uk/businessreview/2017/09/06/the-us-should-not-roll-back-financial-regulation/
6. See Ben Bernanke, 2017, Why Dodd-Frank’s Oderly Liquidation Authority Should Be Preserved, https://www.brookings.edu/blog/ben-bernanke/2017/02/28/why-dodd-franks-orderly-liquidation-authority-should-be-preserved/ [abgerufen: 20.06.2017]
7. See Sabrina, Pellerin and John Walter, 2012, Orderly Liquidation Authority as an Alternative to Bankruptcy, Federal Reserve Bank of Richmond Economic Quartlerly, Vol. 98 (1), 1-31
8. See Sebastian Schich and Sofia Lindh, 2012, Implicit Guarantees for Bank Debt: Where Do We Stand?, OECD Journal: Financial Market Trends, Vol. 2012, Issue 1, S. 1-22
9. See Andrei Shleifer and Robert Vishny, 2011, Fire Sales in Finance and Macroeconomics, Journal of Economic Perspective, Vol. 25, No. 1, 29-48