Financial analysts urge caution in defanging Dodd-Frank

The Systemic Risk Council (SRC) created and sponsored by the CFA Institute recently submitted a very cautionary response to the Senate Banking Committee on Senate Bill 2155. The bill seeks to roll back certain systemic protections intended to help mitigate and soften the next financial crisis.  

Memories of the economic pain caused by the financial crisis have long faded, so naturally, many of the commercial interests in finance see an opening. Their stated concern is the added rules, protections and compliance costs have overshot, causing financial firms to be less efficient and less profitable.

{mosads}Curious reasoning when in fact markets and financial firms are back at record profitability. Nonetheless, Senate Bill 2155 is predicated on the assumption that the Dodd-Frank reforms have muted business and need a remodeling.

On several fronts, Dodd-Frank clearly threw in the kitchen sink on rules and reforms that went well beyond the original goal of dealing with the global financial crisis and systemic vulnerabilities. In the spirit of political compromise, many things were added or overcooked in an effort to get legislation passed through both houses of Congress.

To be fair, even systemic attributes of the legislation, that may have been bargained as part of the party-political game, do need adjustment. 

For example, the SRC does see valid concerns with truly small banks being captured into very expensive and unnecessary oversight and supports a recalibration on the assets threshold for such oversight.

The expansive nature of the Volcker Rule limiting the ability of banks to hedge and service clients has likewise been over restrictive on smaller institutions and community banks.

It is a fair point that Volcker was to catch and block enormous and risky proprietary trading activity of the foremost banking institutions, which brought additional stress on the system.  

However, the SRC is quick to point out that relative to the period when the Dodd-Frank Act reforms were first framed and enacted, certain aspects of the global systemic environment have actually deteriorated further.

In particular says the SRC, that whenever the next recession comes, the adverse effects on borrowers and the financial system are likely to be worse because the monetary policy arsenal is depleted, and the scope for timely fiscal stimulus is now highly constrained.

Given those conditions, the reality of any Dodd-Frank minimum capital reforms is that they should be higher, not lower for the world’s most systemically important institutions. Said differently, Too Big to Fail has not been resolved, and even a rash of medium-sized bank insolvencies can cause great systemic disruption and bring on the domino effect. 

In its letter to the Senate committee, the SRC urged caution in prudential regulatory moderations to medium-sized and large banks and other actions to water-down defenses put in place to mitigate the next disruption. The longer the distance from the last financial crisis, the more complacent we become, warns the SRC. Specifically, it endorses: 

• The threshold for applying enhanced prudential standards not be raised from $50 billion to as far as $250 billion (i.e., mega-bank size);
• The stress-testing requirements of significant intermediaries not be moved away from an annual cycle; and, if such change is made, that it be coupled with a grant of authority to banking regulators to conduct ad hoc stress tests in cases where any one of them believes that such tests are warranted by threats to the stability of the financial system or by an increase in uncertainty about the resilience of the banking system;
• The supplemental leverage ratio not be changed to exclude initial margin placed with Central Clearing Counterparties; and
• The reserves held by banks with the Federal Reserve be excludable from “total assets” only as a temporary measure where necessary given the mechanics of monetary policy.

Kurt Schacht is managing director of the CFA Institute’s Standards and Financial Market Integrity division. The CFA Institute is an international organization comprised of more than 150,000 members who hold the Chartered Financial Analyst (CFA) designation or are otherwise bound by its rules.