How Stable is Wall Street?

Update 384 —  How Stable is Wall Street:
In a Downturn, Would TBTF Be Tested?

With the nation’s economy showing signs of cooling off, attention naturally turns to the epicenter of the last financial crisis.  How would the Street — and, as a result, the system — fare if things go much further south?

A key Congressional subcommittee heard from a Fed Governor and the new Director of the Office of Financial Research on the question yesterday.  The amount that we don’t know is by itself a cause for concern. We look at the problems involved and proposals under discussion. 

Best,

Dana

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Yesterday, the House Financial Services Subcommittee on Consumer Protection and Financial Institutions held a hearing entitled “Promoting Financial Stability: Assessing Threats to the U.S. Financial System.”  The two witnesses were Dino Falaschetti, the new Director of the Office of Financial Research (OFR), and Fed Governor Lael Brainard. 

The hearing comes as the longest economic expansion in U.S. history begins to show signs of fatigue, with several risks to financial stability now appearing — some new, some chronic and worsening.  Meanwhile, Trump-appointed regulators are engaged in what former Fed Governor Dan Tarullo call a “low-intensity deregulation, consisting of an accumulation of non-headline-grabbing changes and an opaque relaxation of supervisory rigor.” 

The pursuit of “low-intensity deregulation” is akin to the boiling frog fable; is the American economy being slowly overheated (deregulated)?  Former and current regulators as well as progressives in Congress seem to think so. It is in this deregulatory environment that we consider clear and present dangers as well as the systemic and TBTF risks that do not announce themselves in advance. 

Yesterday’s hearing was intended to shine a light on the emergent risks to financial stability.  More on the risks identified and the regulatory and legislative responses below… 

Known Financial Risk: Corporate Debt

In May’s Financial Stability Report, the Fed noted the “historically high” levels of corporate debt as a potential risk to financial stability.  While overall debt levels are a cause for concern, the creditworthiness of the borrowers in the corporate sector is deteriorating. The report explains, “growth in business debt has outpaced GDP for the past 10 years, with the most rapid growth in debt over recent years concentrated among the riskiest firms.” 

Per research by S&P Global, nearly 80 percent of outstanding subprime corporate debt — or “leveraged loans” — in the U.S. are “covenant-lite,” leaving lenders with inadequate protection in the event borrowers default. In response to a question by Subcommittee Chair Gregory Meeks, Fed Governor Lael Brainard remarked on the lack of proper covenants as a cause for concern; “What is notable is that the covenants on those leveraged loans have weakened relative to what they would have looked like historically. There are features that make them less secure and more opaque.” 

Subprime corporate debt and leveraged lending are issues we have covered before, and they were a main focus during yesterday’s hearing. Just the mention of “subprime” debt elicits painful memories for many, ten years after the subprime mortgage crisis precipitated the Great Recession.  Both Fed Chair Powell and Vice Chair Quarles have recently sought to allay concerns that there is any systemic risk to banks, arguing that much of the risk in the secondary market is outside of the financial system.  

But others are less sure about where the risk actually lies.  Gov. Brainard drew attention to this opacity in the leveraged loans market to regulators; “We [the Fed] need to have as much visibility as we can in those structures — and who is holding them.”

Progressive Regulatory Response 

• FSOC Reform
  
  Last October, the Financial Stability Oversight Council de-designated Prudential Financial Inc. as a systemically important financial institution, or SIFI. As a result, no nonbanks are currently designated as systemically risky and subject to enhanced oversight, leaving the shadow banking system free to operate in the shadow virtually without regulatory scrutiny.
  
  A Discussion Draft of a bill to reform the FSOC in a way that breathes new life into its critical regulatory and oversight function was considered during the hearing. The bill, sponsored by Rep. Chuy Garcia, would reform FSOC’s non-bank designation process by automatically designating nonbank financial companies based on a size threshold and one additional quantitative risk metric.  
  
  The bill also gives FSOC direct rulemaking authority over systemically risky activities, increases funding and staffing requirements for both FSOC and OFR, and increases transparency by requiring FSOC meeting transcripts to be released on a five-year delay, mirroring current practice for FOMC meeting releases. 
  
  During the hearing, Gov. Brainard said that nonbank activity continues to be an important source of systemic risk. But without adequate oversight and information, regulators are looking at a black box.  The Subcommittee’s Discussion Draft bill flips the default position of no designation to automatic designation, putting the onus on FSOC to de-designate, giving the Council and other primary regulators much needed visibility into non-bank financial institutions, while still leaving them with a de-designation off-ramp. 
  
  Not included in the formal Discussion Draft, but hinted at by market observers as a way to address problems with the current designation-first, data-later approach: an intermediate level of non-bank designation —  an antechamber for firms being considered for SIFI designation, providing regulators with adequate data and systematic reporting of the managed assets and liabilities of non-bank finance companies so as to provide better visibility into a firm’s proper SIFI status. 

• Countercyclical Capital Buffer 
  
  Gov. Brainard testified that corporate debt market risks could amplify any unexpected shocks to the economy, describing how a vicious cycle could occur: over-indebted businesses could face payment issues if earnings fall short; subsequently, they may pull back on investment and hiring, reducing investor appetite for risky assets. A counter- cyclical capital buffer operates as a kind of rainy day insurance for the sector. 
  
  Gov. Brainard made the case that large banks needed to augment their capital buffers, using the Fed’s countercyclical capital buffer (CCyB), because stress tests alone have limitations, banks can afford it, and it is the right time in the cycle to do so. She noted that the Fed Board voted to set the CCyB at zero earlier this year, even as many other central banks around the world have raised theirs above zero.
  
  Brainard’s colleagues at the Fed differ over whether or not the CCyB should be turned on. Back in July, at a Bipartisan Policy Center Event, Fed Governor Quarles argued that “our CCyB is effectively on because we have such high capital in the banking sector.” 
  
  Despite Quarles’ claims, on average, the six largest banks have less than $7 for every $100 in assets. Research by economists at the Minneapolis Fed suggests that this would not even be half of what would be needed to avert future bailouts. Given this, how can taxpayers rest assured that they will not be on the hook yet again when (not if) the next crisis hits? 

TBTF and the Data Problem

A lot of focus during yesterday’s hearing was on arguably transient market conditions like last week’s Repo market liquidity crisis rather than fundamental and on-going systemic risk issues. Gov. Brainard warned that while the Dodd-Frank Act’s far-reaching reforms have made the financial sector stronger than before 2008, we must remain vigilant and “fortify financial system resilience” before deregulation induces history to repeat itself.  

Although history can only tell us so much, reliable warning signs such as excessive leverage and subsequent exposure by banks and other less-regulated financial firms are beginning to emerge. This raises a crucial question: do we have not just the regulatory tools and levers to identify systemic interconnection TBTF risks and at-risk firms, but the data to diagnose?  

Without data, without designation, we remain subject to TBTF, another crisis, perhaps another bailout that is, to repeat history, having learned little.