-
It's time for our regulators to think broadly about what our financial system needs and then take a stand. Simply grinding out Dodd-Frank proposals that no one understands — like the risk-retention proposal and the Volcker Rule release — is not the answer.
November 16
WASHINGTON — Often the best approach is the simplest.
That's something U.S. regulators — overtaxed by implementing Dodd-Frank and Basel III — should consider as they release hundreds of thousands of pages of new regulations, according to a
Petrou is hardly a new critic when it comes to the financial reform effort Congress passed in July 2010 and new capital and liquidity rules under Basel III.
But rather than simply criticize, she is seeking to offer solutions that policymakers could use in the near term to eliminate "complexity risk," the threat to the system posed by the seemingly endless piling on of more rules and regulations.
"You can't beat something with nothing," Petrou says in a sit-down interview with American Banker. "It's frustrating for me — analytically, to just keep saying [to regulators], 'This is wrong with that. This is wrong with that. This is wrong with that.'"
Regulators, she says, make a fair point when they say, 'Ok, well, then what? Do you want us to go back to the way things were before?'"
She agrees that's clearly not an adequate solution. "'If not this, then what?' is a really fair question."
Her solution, detailed in the 24-page paper, essentially comes down to ways to make the financial system simpler and easier to understand. She calls for simpler capital and liquidity standards, better disclosures (including a bank's Camels supervisory rating) and ending regulatory conflicts that simultaneously say the era of "too big to fail" is over while also punishing institutions that may be perceived in that category.
She developed the paper, Petrou says, because of the challenge over the past year in advising clients on the strategic impact of the new rules amid so much uncertainty.
"There are key drivers that we don't know," says Petrou. "So we can't give good strategic advice. We can't. We won't fake it. They wouldn't bet the ranch and we couldn't advise them to. And so far, our clients have listened to us."
But it is in this vein of uncertainty that she tries to clear the regulatory muck, narrowing her focus on a number of critical areas like capital, liquidity and the orderly wind-down of systemically large companies.
To her, the underlying problem rests in a phrase she coins as "complexity risk," which she warns may well be "the most significant impediment to financial market-recovery and robust economic growth."
She rests part of the blame on regulators who more often than not proceed with each reform in "silos," often working independently of each other.
"The markets are indeed highly-engineered and very complex, and you're afraid if you do something on one end something important will fall off the other and it paralyzes decision making," she says. "The regulators have led a combination of hope for consensus and for a cross-border consistency that have undermined their ability to take near-term substantive, obvious reforms. They're kind of looking for the 99-part solution."
Detailed in her paper is a number of problems areas — and potential fixes.
Capital Standards
Petrou sees significant problems with what regulators have already proposed under international Basel III capital standards, which rely in part on risk weightings to various assets. The riskier an asset, the more capital must be held against it.
While good in theory, Petrou says, the current proposal shows why such complex maneuvering remains deeply flawed. For example, sovereign debt is weighted as a "risk-free" asset, even though events in the European Union have made it clear that may not be true.
While policymakers rightly focus on capital as critical to the system — Petrou calls it a "vital constraint," the sheer complexity of the rules has opened them to manipulation, undermining their effectiveness.
"If the bank gets to fudge the books by running fancy models that prove nothing anywhere, anytime, anyhow is risky then the fundamental purpose of the capital standard is completely violated," she says.
The most recent example of this is Belgium bank Dexia, which was ranked the 12th soundest bank in Europe three days before it failed.
The solution, she says, is to improve the quality of regulatory capital and make it easier to understand.
"Regulators should rely only on retained earnings, common equity and a limited class of comparable instruments" to qualify as capital, the FedFin paper says. "A simple minimum capital-to-assets ratio (including both on- and off- balance sheet assets) should be imposed to offset model risk, regulatory errors in risk weightings and similar factors."
Because a simple leverage ratio might encourage riskier activities, however, Petrou says regulators should also set a benchmark portfolio of assets from simple to complex, and then require banks to disclose how it weights each risk — an idea first aired by Citigroup Inc. CEO Vikram Pandit.
"There is no way in hell that you can look at any bank and figure out how robust the risk weightings," she says of the current system.
Global regulators have begun to take steps to ensure that risk weighting across banks and across nations are more transparent, but they are still a long way from finishing.
One attempt at getting at this issue was proposed by the Basel Committee on Banking Supervision to utilize a global leverage standard. But with current plans by the EU to forego implementation of the standard, it may be futile, says Petrou.
If others don't follow suit, she says, "then we are either an island in the middle of a storm the usual defense of U.S. rules being tougher than anybody else's or we're a ship adrift in a very stormy sea."
Correlation Risk
Another key problem is correlation risk, which results because certain rules incentivize institutions to hold all the same assets. The proposed liquidity ratios are mostly untested, correlating risk in just a few asset categories.
"A sovereign really could be risk free, but if markets panic you still have systemic risk because everybody's doing exactly the same thing at the wrong time based on these regulatory incentives, not market driven ones," she says.
The way both the capital and liquidity rules are now written, regulators, she says "not only encourage, but force banks, if they are not already giant in sovereign debt, to get still bigger."
But that is only one cause of concern when it comes to the liquidity rules, Petrou says.
She's discouraged by the fact that liquidity rules — like other regulations — are bank-centric in nature.
"Liquidity risk is a much broader risk," she says, pointing to Bear Sterns, Lehman Brothers Inc. and AIG, which failed because they were illiquid. "It's not just banks that pose systemic risk when that happens."
To be sure, she isn't suggesting abandoning liquidity rules, just making them simpler and relying on tested ratios and more disclosure.
"I'm saying do this first," she says. "Benchmark the risk weighting, impose a near-term simple solution, and use new liquidity standards without the prescriptive ratios that I think are very unproven, and minimize the cross-cutting impact, and disclose a lot more so the market can judge who's got what.
"If you disclose simple ratios, you're not in danger of sharing proprietary or confidential information."
The paper says regulators should identify "key drivers of liquidity risk" and seek to develop best practices for each potentially catastrophic scenario, along with supervisory ratios to guide liquidity-risk management. Rather than promulgating "arbitrary, static standards," the paper says firms would have to disclose how they would fare under such scenarios.
"Over time, this supervisory framework could be built into specific, binding ratios," the paper says.
(U.S. regulators recently announced they are already working on making several changes to the proposed liquidity rules by Basel.)
The "Too Big to Fail" Dilemma
Petrou has long criticized the new regulatory system for trying to have it both ways. On the one hand, the Dodd-Frank law is meant to spell the end of "too big to fail" institutions, mandating various requirements to ensure the government can no longer bail them out.
Yet other rules, such as the proposed Basel III capital surcharges, appear to reinforce, rather than eliminate, the perception of "too big to fail."
Instead of laying on more and more costly and complex regulation, supervisors should instead just focus on "living wills," in which systemically important firms tell regulators how they can be dismantled in the event of a crisis.
While U.S. regulators have already finalized such a requirement, international regulators have not followed suit. Instead, the Financial Stability Board released a report on key attributes of an effective resolution regime, but European regulators appear far behind the U.S.
"Regulators should thus proceed with the living-will requirements, stiffening them where necessary by ensuring that [systemically important financial institutions] can also recover under unanticipated operational stress," the paper says. "But, this is a substitute for all the rules premised on TBTF 'negative externalities,' not a requirement to be added atop them."
In the case of an additional proposed 2.5% counter-cyclical buffer under the Basel rules, she argues against regulators moving ahead without further study.
Regulators chose asset growth to the relation of gross domestic product as the trigger for the capital add-on, but admitted they were unclear if this was the appropriate measure to use. The buffer is used to minimize the pro-cyclical nature of boon times and lows.
"If regulators aren't sure, they shouldn't do it," she says. "It's not like they've got everything else in such perfect place, and so well-tested, and tried and true, that they can play around with one more thing. Think some more. Get the other stuff, the easy stuff, the stuff you know that needs to be done first."
Additionally, there are certain macroprudential tools like stress testing and "horizontal" supervision that Petrou examines.
Some of the tougher recommendations she makes includes public disclosure of banks' Camels ratings — which regulators and banks both oppose — and more stringent standards for board of directors, something she says is vital.
"The most important criterion is forcing boards to make hard decisions that may go against what the CEO might want," she says. "That's what a board is for. Giving them the information and forcing them to confront the complexity of an institution and if they can't, then they shouldn't be directors or the company shouldn't be that complex."
But perhaps most worrisome to Shaw Petrou is what may happen if these criticisms fail to get addressed.
"We've lost three years since the crisis [and now] just beginning to erect this complex edifice," she says. "The odds are frightening that something really bad will happen before it's erected or even after it's erected because of all the flaws remain in it because of the complexity risk."
