Wednesday, May 2, 2012

Fed's Tarullo concerned momentum for regulation waning

The Fed's Daniel Tarullo, the governor in charge of supervision, expressed concern that the momentum for regulation is waning.

Thank goodness.

Regular readers know that your humble blogger thinks that the Dodd-Frank Act and the host of regulation it has spawn contain exactly two worthwhile initiatives:  the Consumer Financial Protection Bureau and the Volcker Rule.

These two initiatives share one common feature.  They both address a cause of the current financial crisis.

The rest of Dodd-Frank and the host of regulation it has spawn would have done nothing to prevent the crisis.  This is a serious shortcoming.

That this is true is not surprising since Dodd-Frank was passed before an extensive, detailed examination of the causes of the financial crisis was conducted.  Without understanding what caused the financial crisis, it was highly unlikely that Washington could create a regulatory solution that addressed the causes.

As Bloomberg reported,

Federal Reserve Governor Daniel Tarullo said regulators must press on with an overhaul of financial regulation, focusing especially on shadow banking and too-big-to-fail institutions. 
“My concern has been that the momentum generated during the crisis will wane or be redirected to other issues before reforms have been completed,” Tarullo said today in a speech in New York. It’s “sobering” that “so much remains to be done” four years after the collapse of Bear Stearns Cos., he said....
Actually, it is distressing how much effort has gone into exactly the wrong regulatory solutions.
“If we do not complete rigorous implementation of this complementary set of reforms, we will have lost the opportunity to reverse the pre-crisis trajectory of increasing too-big-to- fail risks,” Tarullo said. 
Responding to audience questions, Tarullo said that while it will probably be “several years before the full implementation of the major sets of reforms we’re talking about would actually be in place,” it is “reasonable” to “expect that sometime next year the basic outlines” of those rules will be clear.
Let me see if I understand where we are at.

The same bank regulators who failed in their primary mission of seeing and preventing a financial crisis are crafting a complementary set of reforms the brilliance of which will only become apparent next year.

Why do I not find that reassuring?
As part of those reforms, it is “widely agreed” that liquidity requirements are needed, such as the liquidity coverage ratio proposed by the Basel Committee on Banking Supervision, Tarullo said. 
The assumptions used to calculate the ratio should reflect “actual experience during the crisis,” he said, adding the ratio overstates the liquidity risks of commercial banking. 
Regulators should also consider adapting that proposal to make it “credibly clear that ordinary minimum liquidity levels need not be maintained in the midst of a crisis,” he said. 
Otherwise, it “might have the unintended effect of exacerbating a period of stress by forcing liquidity hoarding,” he said.
Clearly, I witnessed a different financial crisis that Mr. Tarullo.

The financial crisis I and the Financial Crisis Inquiry Commission witnessed saw banks around the globe hoarding liquidity because they could not determine which of their peers were solvent (and therefore capable of repaying a loan) and which were insolvent (and therefore highly likely not to repay a loan).

In fact, the FCIC said that it was this inability to determine solvency that forced the Fed to inject trillions of dollars into the banking system.

Last I checked, the Basel liquidity requirements did not require the banks to hoard all these trillions of dollars in assets maturing overnight.

This simply confirms that regulators who do not understand what caused the financial crisis are highly unlikely to develop regulations that would have prevented the current crisis or any future crisis.
While regulators have come up with a “well-defined set” of rules to address too big-to-fail, “the same cannot be said” for the fragility of the shadow banking system, Tarullo said....
A well defined set of rules that the Dallas Fed, Professor Simon Johnson and a host of others think is highly unlikely to work should we ever have another financial crisis.
“In periods of high stress, with substantial uncertainty as to the value of important asset classes, questions about liquidity and solvency could still arise, even with respect to well-regulated institutions,” Tarullo said. “It cannot be overemphasized that this systemic effect can materialize even if no firms were individually considered too-big-to-fail.”...
And why do questions about liquidity and solvency arise that could cause this systemic event to occur?  Because of the opacity of the financial firms and individual asset classes. 

Until ultra transparency is brought to every opaque corner of the financial system, this includes banks and structured finance securities, the financial system is susceptible to systemic collapse.

Well-regulated financial institutions are not a good substitute for financial institutions that are subject to market discipline because they provide ultra transparency.  Financial institutions that provide ultra transparency are subject to discipline not only from the regulators but also other market participants like investors.
Tarullo said in response to an audience question about the future of the mortgage market that “we’re not likely to see the restart of a sustainable, well-developed, well-functioning, private securitization market until there’s more clarity on what role” government-sponsored enterprises are going to play. 
Clarifying regulations is also necessary so that “private market actors” can also judge which securitization and financing activities will be profitable, he said. 
“It’s going to be hard to see more than moderate increases” in securitization by private firms, he said.
Actually, we have not seen and will not see a restart of the private label mortgage securitization market until investors are provided with ultra transparency into the performance of the underlying collateral.

This can only be delivered by requiring these securities to report on an observable event basis all observable events (including, but not limited to, payment, delinquency, default, or modification) prior to the beginning of the business day after they occur.

It is only with observable event based reporting that investors have current information on the underlying collateral performance and know what they own.

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