Even if the Dodd-Frank financial reform law is implemented flawlessly, two men in a position to know say it won't be enough to stop another financial crisis.
In separate speeches recently, venerable regulators from opposite sides of the Atlantic concluded that reforms to date are little more than Band-Aids.
"Have we, in the wake of the crisis, patched up the existing system, reformed the technical details, but left our model of capitalism unchanged and existing economic theories largely unchallenged?' Financial Services Authority Chairman Adair Turner asked in what can only be described as a financial policy tour de force.
"Have the technicians of financial regulation been radical enough in the reform of capital and liquidity? Have we significantly reduced the probability and severity of future financial crisis?"
Turner gave his answers — no, no and no — over 80 minutes with 14,500 words and 19 slides in a lecture Feb. 18 at Clare College in Cambridge, England.
Federal Reserve Bank of Kansas City President Tom Hoenig, in a speech with about 75% fewer words, made many of the same points.
"In spite of all that's been done and debated, the soundness of the largest financial institutions and the systemic risks they continue to pose is no better," Hoenig told a meeting of Women in Housing and Finance on Feb. 23 in Washington. "In my view, it is even worse than before the crisis."
So what should be done? Both men agreed: "Too big to fail" must be tamed and financial companies must hold more capital.
They tackled TBTF from different angles. Turner said the entire business needs to be simplified while Hoenig said the largest companies must be broken into smaller units.
Turner dismissed before-the-crisis conventional thinking, including the idea that more is better. "The size of the financial sector, the volume of trading, and the pace of product innovation, should therefore never be seen, as they were before the crisis, as always positive indicators of policy success," he said.
Then he said something that was never questioned before the crisis: "Not all financial activity is axiomatically beneficial."
Hoenig was just as blunt.
"If 'too big to fail' organizations cannot be effectively supervised, capitalized or resolved — which is exactly where I contend things stand right now — what option remains? "For me, the answer is firm: They must be broken up."
Hoenig does not buy the argument that size and diversification have made banks more stable. Rather, this trend has "created very large firms with very similar risk profiles that closely mirror the overall financial system and economy."
Hoenig would force the largest companies to break off risky lines of business much the way the Dodd-Frank Act, via the Volcker Rule, is pushing banks out of the proprietary trading business.
"We should vigorously pursue the restructuring of these firms in a manner that mitigates risk and that would influence the size and complexity of these firms," Hoenig said. "We must expand the Volcker Rule and carve out business lines that are not essential to the basic business of commercial banking or consistent with public safety nets, and then require that these lines be spun off into separate firms."
Turner concluded regulators should simplify the financial system, including how firms interact with one another.
"Policy may need to lean more aggressively against this interconnectedness, offsetting the externality which complexity in itself creates."
Hoenig agreed, saying it is clear the largest firms "have reached a level of complexity and size that defies good management and operational efficiency."
Both regulators applauded attempts to date to end public bailouts of big banks. For example, Dodd-Frank gives regulators new resolution powers, including the authority to make megafirms detail exactly how they should be wound down in the face of failure.
But Hoenig noted an "important weakness" in the framework.
"The final decision on solvency is not market-driven but rests with different regulatory agencies and finally with the secretary of the Treasury, which will bring political considerations into what should be a financial determination."
When push comes to shove, Hoenig said, regulators will cave.
"In a major crisis, there will always be an overwhelming impulse to avoid putting such institutions through receivership," he said. "Always, it is feared that public confidence will be shattered, creditors or depositors at other institutions will panic, and that there are too many connections that will bring down other institutions. In addition, important services will be lost and the international activities will be too complex to resolve."
Hoenig said these fears are overblown.
"The long-term consequences are much more severe if we fail to take action to end this cycle of repeated crises. In an environment where market participants are truly at risk, they will be much more likely to take steps to protect themselves, thus reducing the side effects of resolutions, and a failed institution's essential activities can be continued through bridge banks and other means."
Finally, both men argued that banks, particularly the largest, most complex companies, must hold more equity capital.
A lot more.
Tougher standards under Basel III, which call for not only more capital but higher-quality capital, are a good start, both men said. And Dodd-Frank does mandate the largest banks hold an extra cushion of capital, plus there will be yet another capital charge to avoid exacerbating a down cycle.
But all of that will be insufficient to prevent megabanks from taking the sorts of risks that endanger the world's financial system.
"In an ideal world we would increase equity requirements for all banks well above Basel III levels," Turner argued.
Hoenig couldn't agree more. "I also support stronger capital standards, especially in the form of a maximum leverage ratio based on equity capital," he said.
Why? Because supervision is ineffective.
Basel capital levels are based on "risk-weighted assets," meaning the riskiness of a bank's assets must be assessed and the riskiest ones require more capital.
Unfortunately, assessing risk is way harder than it sounds. Hoenig noted that both of Basel III's predecessors failed.
"Basel I and II were supposed to provide a better means for linking a bank's capital to the amount of risk it assumed," he said. "Along the way, we found that risk was very difficult to measure and that capital needs determined during normal circumstances were not enough for tail events or shocks that create financial crises."
The two men reached their conclusions — financial firms must put up more of their own money, and the largest companies should be shrunk and simplified — from very different places.
Hoenig is a regulator through and through; he joined the Kansas City Fed in 1973. But Turner only took the FSA job in 2008; he was a consultant with McKinsey & Co., a vice chairman of Merrill Lynch Europe and the leader of the Confederation of British Industry.
They could be wrong, but it's hard to be confident that current efforts are enough to forestall a repeat of 2008. It's been seven months since Dodd-Frank was enacted, and the Obama administration is leaving key regulatory jobs unfilled and Congress is threatening to cut some agency budgets.
It's possible Dodd-Frank is just the beginning of financial reform. While no new legislation is likely to pass before next year's presidential election, Congress may in 2013 take a harder look at the role megabanks play in our economy and whether they are being effectively managed and supervised.
It wouldn't be unprecedented. Congress followed up the 1989 law spawned by the savings and loan crisis with another reform law two years later.
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