You may not see it on the front pages of your newspaper, but close examination will reveal an extreme unease from banking regulators about the current trajectory on Wall Street.
The Office of the Comptroller of the Currency (OCC), not typically seen as a strident regulator, is warning about risky lending as low interest rates drive a reach for higher yields. Both the OCC and the Federal Reserve have decried the slippage in underwriting standards on particular loan products. Fed Chair Janet Yellen cited “pockets of increased risk-taking” in a speech yesterday. And the Bank for International Settlements (BIS), a consortium of the world’s central banks, cautioned this week about asset bubbles forming throughout the global economy.
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The housing bubble fueled the last financial crisis, but these current risk pools largely sit in our capital markets. Regulators agree that newly issued corporate debt, a record amount of it below investment grade, has built up well beyond comfort levels. Investors bought as many so-called “leveraged loans” — junk bonds that offer a higher return because of the higher risk of default — in 2013 than they purchased from 1997 through 2012 combined. Debt-to-earnings ratios for these high-risk companies have risen to a post-recession high. Demand has been so elevated, in fact, that the spread between “high yield” corporate debt and risk-free securities like Treasury bonds fell to all-time lows, making it even crazier to purchase chancy debt for a small additional reward.
Adding to the breakdown in underwriting standards, non-bank firms like hedge funds are performing a growing share of traditional bank activities, like providing corporate loans. As everyone seeks market share, lending quality loosens. These alternative lenders sit partially outside the regulatory perimeter, making it harder to ensure safety throughout the system. But they use the kinds of lending vehicles, like corporate bonds and derivatives, that oversight regimes can track and police.
You can argue that protracted near-zero interest rates have driven a lack of stability in the markets. Federal Reserve officials will have a difficult challenge creeping out of the corner into which they’ve boxed themselves. But that argument overlooks a couple of key points. Raising rates and thus subjecting the economy to permanently depressed output due to concerns about financial stability not only could prove counter-productive, but it also neglects the other tools available to address the problem. In particular, as Yellen said in her speech, macro-prudential supervision and regulation, through direct oversight of the market and interventions to limit risk, can effectively promote stability.
This means that the primary regulators responsible for the capital markets — the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) — carry increased importance, as the rolling ball of Wall Street risk has moved into their spheres.
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While Dodd-Frank did not go far enough to deal with a changing market environment, it gave these regulators some increased tools to identify problems and move to stamp them out. Unfortunately, neither the SEC nor the CFTC have taken full advantage of these tools under their new leadership teams in President Obama’s second term. If anything, they’re rolling back the regulatory apparatus, increasing danger for the rest of us.
SEC: Slow in Enacting Changes
SEC Chair Mary Jo White, a former federal prosecutor, came to the agency with a reputation for tough enforcement. But she had little regulatory experience, and predictably, that’s where the SEC has lagged its counterparts. Watchdog group Public Citizen recently examined the official “Agency Rule List” to track the SEC’s progress in writing regulations demanded by Dodd-Frank and found that well over half of the SEC’s proposed rules have missed deadlines over the past year.
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These delays include long-awaited action on asset-backed securities, exchange-traded funds, derivatives and market execution facilities, many of which comprise just the areas where risk has begun to accumulate. In addition, the SEC has for years avoided reforming the credit rating agencies, which gave their blessing to toxic securities that failed during the crisis. While there have been murmurs of impending action, they come far too late. “This is an unacceptable pace for rulemaking,” said Lisa Gilbert, director of Public Citizen’s Congress Watch division.
Even when the SEC does finish its rules, they often come with disconcerting loopholes. The agency finally completed work on a rule meant to limit derivatives trading by foreign branches of domestic banks, ensuring that all trades trigger the same restrictions and monitoring. The disastrous trades from AIG’s Financial Products Group and JPMorgan Chase’s “London Whale” would both fall under this regulation. But banks can avoid registration of their cross-border derivatives — therefore making the SEC’s work irrelevant — as long as they don’t explicitly guarantee them through the parent company. They can merely “de-guarantee” trades by routing them through a subsidiary that they implicitly agree to rescue should trouble arrive.
Even Mary Jo White admitted that the regulation would “not capture all the risks” of the cross-border derivatives market. The financial reform group Better Markets called the SEC’s effort incomplete, adding that it “invites Wall Street to game the rules.”
Making Rules Meaningless
By contrast, the CFTC mostly completed its Dodd-Frank rules under former Chair Gary Gensler. But since former Treasury Department official Tim Massad replaced Gensler in June, the energy in the agency has shifted to cutting breaks to regulated entities, as Wall Street has sought. For example, this week, the agency gave a longer period of relief for derivatives dealers to comply with data-reporting requirements, delaying reporting by as much as one year.
This represents the CFTC’s greatest need: acquiring the data necessary to study derivatives markets for risk. Though they regulate a market with a nominal value in the hundreds of trillions, the annual operating budget for the CFTC is only $205 million, about one-tenth the size of just the information technology department at a single global mega-bank. The agency simply doesn’t have the resources to measure the marketplace, and delaying data reporting only makes this worse. Without the ability to examine the data, the rules become effectively meaningless.
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Failures at the two major capital markets agencies mean that the regulatory umbrella cannot widen to scrutinize all the market participants and the risk they cause. It means that Wall Street firms can easily avoid the spotlight by finding crevices in the law to hide risky behavior. And with our interconnected financial system, it means that an unexpected blowout in one corner can migrate and cause widespread chaos elsewhere.
Monitoring risk with all available tools is critical to preventing another rendition of the financial crisis, with similar suffering throughout the economy. Right now, the regulators are not fulfilling their obligation to perform that task.
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