Federal Reserve Bank of New York (“NY Fed”) President and CEO William C. Dudley articulated several principles to consider when evaluating the post-financial crisis regulatory regime and raised questions about the effectiveness of the Volcker Rule.
Mr. Dudley stated that the financial crisis exposed flaws in the regulatory framework – in particular, capital and liquidity inadequacies at large financial institutions. He cited “a number of important structural weaknesses that made it vulnerable to stress” including: (i) systemically important firms operating without sufficient capital and liquidity buffers, (ii) risk monitoring, measuring and controlling failures, (iii) significant problems in funding and derivatives markets, and (iv) fundamental defects in the securitization markets. These weaknesses, he noted, were “magnified by the lack of a good resolution process for large, complex financial firms that got into trouble.”
Mr. Dudley argued that while the industry “must resolve to never allow a return to [pre-crisis] conditions,” now is an appropriate time to begin evaluating the changes that were made to the regulatory regime. He articulated three principles to keep in mind for an effective regulatory regime:
- “Ensure that all financial institutions that are systemically important have enough capital and liquidity so that their risk of failure is very low, regardless of the economic environment.”
- “Have an effective resolution regime that allows such firms to fail without threatening to take down the rest of the nation’s financial system, and without requiring taxpayer support.”
- Ensure that the financial system remains resilient to shocks by preserving “the centralized clearing of over-the-counter (OTC) derivatives, better supervision and oversight of key financial market utilities, and the reforms of the money market mutual fund industry and the tri-party repurchase funding (“repo”) system.”
Mr. Dudley suggested that regulatory and compliance burdens could be made “considerably lighter” on smaller and medium-sized banking institutions because “the failure of such a firm will not impose large costs or stress on the broader financial system.”
Mr. Dudley also questioned whether the implementation of the Volcker Rule was achieving its policy objectives. Regulating entities under the Volcker Rule is difficult, he argued, because most market-making activity has “an element of proprietary trading” and the division between market-making and proprietary trading is “not always clear-cut.” Mr. Dudley said that while the evidence may be inconclusive, the Volcker Rule could be responsible for a decline in market liquidity of corporate bonds. Mr. Dudley strongly recommended Volcker exemptions for community banks.
Lofchie Comment: Mr. Dudley notes that the profitability of banks has dropped in light of their reduced leverage, but he asserts that they remain “profitable enough to cover their cost of capital.” What makes this remark particularly notable is the contrasting recent assertion of FDIC Vice-Chair Thomas Hoenig who claimed that (i) banks’ return on equity was low because they were too highly leveraged (a completely counterintuitive assertion that Mr. Hoenig did not fully explain) and (ii) that banks were less profitable than essentially every other industry (which would seem to suggest that banks were not profitable enough to cover their costs of capital, or at least that investors’ capital was better deployed elsewhere). Whatever is causing the decline in bank profitability (leverage too high or leverage too low), bank regulators should worry that the firms that they regulate are not making enough money to sustain themselves for the long term.