By Denny Gulino
WASHINGTON (MNI) – The Federal Reserve’s point man on financial
regulation Wednesday may have added to industry anxiety, saying
Dodd-Frank should be only a starting point, particularly for shadow
banking and enhanced capital standards.
Gov. Daniel Tarullo, speaking to the University of Pennsylvania Law
School, described the implementation of the Dodd-Frank Act as a
continuing challenge for the Fed and said a “cross-pollination” of
academic and legal experts is necessary to come up with the regulatory
concepts the law needs to accomplish its sweeping goal of financial
stability.
He compared the process to that which led to the body of anti-trust
law, based on principles set by Congress but formulated by regulatory
entities at the time heavily populated with academics.
With a couple of notable exceptions, he said, the law “does not
delineate the steps that should actually be taken to promote financial
stability.” There are, he continued, “relatively few Dodd-Frank
provisions that more less directly effect the policy changes intended to
reduce the risks to financial stability.”
Even the Volcker Rule, banning proprietary trading by conventional
banks, “will require considerable regulatory build-out before its
constraints will be clear,” Tarullo said.
It falls on regulators, sometimes combinations of cooperating
regulatory agencies, to fathom how to fulfill the law’s obligation,
which means more uncertainty for the institutions being regulated, he
suggested. In the area of shadow banking, he said, regulators have to
figure out how not to push transactions outside the sphere of
regulation, something Dodd-Frank does not address.
Tarullo went on to list some personal preferences saying the full
Federal Reserve Board will have to decide what to do in the months to
come. Among them would be a more narrow range of financial institution
mergers and acquisitions, no longer judged by their effects on firms and
shareholders, but on their possible implications for the financial
system as a whole, he said.
“The statute itself provides only limited guidance to regulators on
how to implement financial stability where it is established as a
standard, or how to weigh it against economic growth and other
considerations where it is used,” he said.
While setting financial stability as the overarching goal,
Dodd-Frank has to somehow be aligned, he said, with “much of the
theoretical work on financial stability of the last several years” that
suggests the financial system is actually “prone to instability for
reasons in addition to, and quite independent of, classic
too-big-to-fail concerns.”
Dodd-Frank, unlike previous law, assumes that the failure of any
systemically significant firm could have “direct counterparty impacts”
that “can lead to a classid comino effect.”
Therefore mergers and acquisitions by large firms have to be
measured by the possible risk they add to or subtract from the overall
financial system. “Because losses in a tail event are much more likely
to be correlated for firms deeply engaged in trading, structured
products and other capital market instruments, all such firms are
vulnerable to accelerating losses as troubled firms sell their assets
into a declining market,” he said.
Calculating how much additional capital should be held to offset
the risk posed to the entire financial system is not an exercise that is
realistic “at least in the foreseeable future,” he said.
Tarullo said he thinks the Basel Committee, in setting potential
surcharges to offset the additional risk and funding advantages of the
largest firms, used “frankly, a bit more caution than I think would have
been desirable, even given the uncertainties.”
It could be that financial stability considerations would seem to
dictate special advantages for the largest firms as well as
disadvantages. Prohibiting certain mergers would mean “that the current
small group of very large, integrated financial firms would have their
market positions essentially protected by the financial stability
considerations” and “such an outcome would be very ironic, indeed,” he
said.
So the Fed, he said, “is very much taking a case-by-case approach”
in reviewing mergers and acquisitions when large firms are involved. It
will be looking to see if the failure of the merged firm or even a
serious impairment “would likely impair financial intermediation or
financial market functioning so as to inflict damage on the broader
economy.”
In those cases, again, Tarullo said he would personally “urge a
strong, though not irrebuttable, presumption of denial for any
acquisition by any firm that falls in the higher end of the lost of
global systemically important banks.”
He said regulators should give large firms “a sense of which
mergers will face very close scrutiny.”
There is much that regulators as yet do not know about the very
subject Dodd-Frank focuses on. “For all the attention paid to financial
stability analysis in the last few years, it is still — relatively
speaking — a fledgling enterprise.” Even if regulators could reach a
“rough consensus” on what leads to financial stability, “translating
that theory into administrable standards and processes is a task that
will take years.”
** MNI Washington Bureau: 202-371-2121 **
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