Banking Regulation

Author: Ronald Fink
D’Arista, professor emeritus: Putting capital in place was the worst thing we could have done. Systemically, it’s a disaster.

In a chapter devoted to shadow banking, the IMF’s latest Global Stability Report urged regulators to take “a more encompassing approach to regulation and supervision that focuses both on activities and on entities and places greater emphasis on systemic risk.” Some experts go further. They contend that Basel III and related efforts, such as the Dodd-Frank Act in the US, do little to reduce systemic risk because they don’t adequately address the interconnectedness of banks, and so will continue to fall short unless key parts of the current reform agenda are rethought.

One institution’s failure can still threaten to take others down, these critics say, as was the case with Bear Stearns, Lehman Brothers and AIG in the lead-up to the crisis. And, they contend, the potential for a painful game of financial dominos remains in place as a result of the exposures big banks have through loans and other credit they have extended to other banks, including derivatives contracts or short-term loans known as repurchase agreements—or repos for short. 

New reports required by the Federal Reserve from the 33 US and foreign institutions considered under Dodd-Frank to be too big to fail show, for example, that Morgan Stanley has the biggest counterparty exposure, at 65% of its assets. Six other “globally systemically important banks” (G-SIBs) have exposures to other banks that are in excess of 10% of their assets. Goldman Sachs’ exposure to other banks is the second-largest, at close to 40%.

Dodd-Frank was supposed to address this through the Volcker Rule, which gets banks out of the business of owning hedge funds, and with it, a lending activity known as prime brokerage. And these changes may help reduce counterparty risk going forward.

The law’s provisions regarding derivatives may also help reduce such risk by requiring banks to post collateral to back their positions and sending more derivatives transactions through exchanges or clearinghouses. Like the Volcker Rule, however, the derivatives rules only recently went into effect.

In addition, Dodd-Frank requires regulators to take into account banks’ use of repos and derivatives when determining how much debt they have. And the Federal Reserve has proposed a capital surcharge on too-big-to-fail institutions that rely heavily on such credit for their short-term funding. But the Fed just began in January tracking how much exposure the 33 G-SIBs have through such holdings.

Worse, some observers worry that those measures will fall short even when fully implemented. “It’s not enough,” asserts University of Massachusetts economics professor Gerald Epstein, who, with his former faculty colleague Jane D’Arista, has also written a paper on Dodd-Frank’s provisions that address counterparty risk, entitled “Dodd-Frank and the Regulation of Dangerous Financial Interconnectedness.” In it Epstein and D’Arista note that the specific provisions require “rigorous enforcement and vigilant oversight.”