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23 January 2013

Financial Reform Appears Stuck in the Mud

If developments so far in January are any indication, stricter financial rules under the Dodd-Frank Act and the Basel III global banking standards will be slow in coming this year.

This article originally appeared on CME Group’s website.

As the U.S. election neared in November, irrespective of the outcome of the race between Barack Obama and Mitt Romney, it was a given that Dodd-Frank Act financial reform was here to stay. Even with President Obama, a Democrat, retaining the White House for another four years, it’s unlikely that significant financial reform would be a priority for the administration, especially with pressing issues such as gun control and immigration reform.

[Related: Financial Reform: ‘Slowly I Turn, Step by Step’]

While it’s still early, if January so far is anything to go by, proposed political appointments and recent developments with Dodd-Frank and Basel III banking standards do not point to stringent financial sector rules. Some may consider this a win for banks, but just as many consider these recent moves of questionable value to or even negative for the economy in the long-run.

Dodd-Frank: The Volcker Rule and the Financial Stability Oversight Council

Much has been already written for and against the Volcker Rule which is likely to be finalized in the first quarter of 2013. Proprietary trading or investments in hedge funds and private equity were ostensibly not the cause of the crisis, but permitting banks to be engaged in these activities has certainly enabled them to get extremely large.

Finalizing the Volcker Rule is important, if nothing else so that market knows what the rule is. Yet, it is important to realize that even without it being finalized, many banks already have been selling proprietary trading units, hedge funds, and commodities businesses in preparation for the Volcker Rule.

Dodd-Frank rules that truly need to be finalized are those pertaining to the roles, responsibilities, and the extent of power of the Financial Stability Oversight Council (FSOVC), which is chaired by the Secretary of the Treasury. So much attention is directed to banks, which while very important, misses the fact that we may be simply transferring financial risks from banks to other financial institutions and not reducing systemic risk, a major goal of Dodd-Frank.

Long Term Capital Management, Bear Stearns, Lehman, AIG, Bernard L. Madoff Investment Securities LLC, and MF Global are some of the key examples of non-banks that have critically impacted the U.S. and even the global economy.

According to Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the FSOVC is authorized “to determine that a nonbank financial company shall be supervised by the Board of Governors of the Federal Reserve System and shall be subject to prudential standards, in accordance with Title I of the Dodd-Frank Act, if the Council determines that material financial distress at the nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company, could pose a threat to the financial stability of the United States.”

After much delay, Richard Berner was appointed quietly on January 2 to head the Office of Financial Research, part of the FSOVC. Berner, a Harvard College and University of Pennsylvania graduate will be tasked with directing the OFR, marking the first time the U.S. will seriously have a centralized entity whose responsibility is to collect and analyze data of all financial institutions in order to identify those which could pose a systemic risk.

If the FSOVC declares an entity as a systemic risk — which requires the approval of two-thirds of its members — the council, with a primary lead from the Fed, would be responsible for establishing capital, liquidity and leverage requirements.

If the institution in question cannot meet the requirements, the FSOVC would be responsible for its orderly dissolution. The true role and power of the FSOVC will depend much on the new Treasury Secretary and his philosophy about financial reform. Some of us hope to be pleasantly surprised, but for now, the top priority of Jack Lew, President Obama’s nominee for Treasury Secretary, would more likely to be the debt ceiling rather than financial reform.

Basel III: The Liquidity Coverage Ratio and What’s Next

On January 6, the Basel committee announced a final rule for the Liquidity Coverage Ratio. As I detailed in a recent report, “You Call that Liquid?” this finalized rule, which now includes some mortgage-backed securities, corporate bonds and equities, even with a haircut, is a watered-down version of the original one proposed in 2009.

[Related:The Weakening of Basel III” (video)]

Why does this liquidity rule matter so much, you might ask? It’s because this rule will now serve as guidance to the banking regulators — specifically the Fed, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency — when those regulators release a Notice for Proposed Rulemaking later this year.

Given the U.S. banking regulatory agencies’ involvement in the Basel committee since the early 1970s, it is unlikely U.S. regulators would deviate much from what has been agreed upon in Basel. This means that once the agencies release their NPR on liquidity, there is a chance that more lobbying in the U.S. could water that rule down even more. Even when banks rely on sovereign debt as liquid assets, not to mention rely on mortgage-backed securities, corporate bonds or equities, any significant market or operational risk events could render banks illiquid overnight.

Now that the Basel committee has finalized the Liquidity Coverage Ratio, it still has at least two major objectives for the rest of the year. First, the committee will move to finalize the Net Stable Funding Ratio which after the Liquidity Coverage Ratio is the second component of the liquidity standard. The purpose of the Net Stable Funding Ratio is to make sure that in the longer-term, banks have better asset liability management. Given what has happened with the Liquidity Coverage Ratio, it is most unlikely that this ratio would be made stringent.

Secondly, the Basel committee has to finalize the Significant Financial Institution (SIFI) buffer. This was the part of the Basel III framework, but its final form was postponed from 2010. The Basel committee has released several times the approximately 29 firms which are considered global SIFIs. Moreover, each jurisdiction can name its own domestic SIFIs. How much the additional surcharge will be has yet to be finalized but likely to happen this year.

There are two major areas which I personally would really like the Basel committee to focus on if there is ever any possibility of financial reform:

First, Basel II Pillar I has guidance on how to measure operational risk. Despite the many challenges that that Pillar I segment has, it was left untouched in the transition to Basel III. Yet if you think of all the insider trading, money laundering, fraud and model mismanagement that transpired in 2012, these are all tremendously good reasons why operational risk needs to be taken seriously by banks. A breach in the day-to-day running of a firm due to people, processes, systems/technology and external threats can quickly threaten a bank’s liquidity and solvency, not to mention its reputation.

Additionally, until Pillar III is implemented and supervised uniformly, most investors will remain in the dark about a bank’s true on- and off-balance sheet risks. Pillar III gives internationally active banks guidance on the level of transparency necessary about how a bank identifies, measures, controls and monitors its on- and off-balance credit, market and operational risks.

In this manner, the Basel committee hopes that with in-depth transparency, the market can signal what it thinks of the financial health of a bank. Basel defines the market as all types of investors, regulators, rating agencies and individuals like you and I who should be given information about all the risks that a bank has and how it manages them.

Yet, given that U.S. banks are not fully compliant with Basel II, they have not had to release this level of disclosures. Even in Europe, where Pillar III disclosures are required, not all banks release the same information, nor are they supervised or enforced uniformly.

Given anemic economic growth in the U.S. and the recessionary state of most of Europe, 2013 is unlikely to be the year of stringent financial reform. Banks and their well-financed lobbies will argue that “now is not the time” to do anything that can reduce banks’ ability to lend. This argument supposes that indeed it is financial reform that hinders lending, as opposed to an anemic global economy or banks’ desire to use whatever liquidity they have to invest on higher-yielding financial products and derivatives.

In the U.S., pressure on President Obama to address gun control, housing policy, and immigration reform, along with job creation, means that realistically that financial reform will not be a priority this year.

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2 Comments to "Financial Reform Appears Stuck in the Mud ":
  • Missing
    barney

    24 January 2013

    Interesting cry for help from the CME.  On the bright side it still has an Illinois based president, and bankers are not exactly popular. 

    by the way, what does "Proprietary trading or investments in hedge funds and private equity were ostensibly not the cause of the crisis, but permitting banks to be engaged in these activities has certainly enabled them to get extremely large."  mean ?

  • Comment_img_3437
    mrv123

    24 January 2013

    Thanks for commenting.  To be clear, I do not work for the CME, and all views on its site or this one are my own.  By banks being able to engage in a whole host of activities outside of banking, they have become much larger than they were under Glass-Steagall.  Many have become Too Big To Fail and Too Big to Manage.  MRV Associates

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