How We’re Tackling Systemic Risk in the Financial System Today

I had the good fortune yesterday to participate in a briefing with a few lawyers from Quarles and Brady, a mid-sized firm based in Wisconsin that handles corporate law. We were there to talk about compliance issues facing the financial services industry in 2016—and you’ll be happy to know that compliance officers will have no shortage of, shall we say, interesting challenges in the year ahead.

We began by talking about the profound effect that the Dodd-Frank Act has had on banks in the last five years. The lawyer leading that part of the discussion, James Kaplan, stressed that Washington’s new demands for banks to hold capital (so they won’t fail and need a taxpayer bailout), plus regulators’ insistence on de-risking the assets on your balance sheet—those two forces taken together have “pretty dramatically” changed the business of banking today.

Banks now hold twice as much capital in reserve (as a percentage of assets) than they did before the financial crisis, Kaplan said. That has led to slower profit growth, and “certainly less return on equity” because banks need to keep more equity salted away as reserves.

Kaplan stated the situation succinctly, and I don’t dispute that it isn’t ideal for banks—but as I’ve argued before, that situation is what Dodd-Frank was meant to achieve. We had unchecked growth in lending in the 2000s, which led to banks with balance sheets full of worthless assets. We then created a regulatory climate that essentially forces banks to drive down the highway of commerce with the parking brake still on. They grow more slowly, and less profitably.

The truth is that many people in the U.S. political spectrum, from Bernie Sanders to Donald Trump, don’t see any of that as a bad thing. Our financial sector became an oversized part of the economy in the last 20 years, with disastrous results by 2008. The heavy-handed regulatory approach to banks that we have now simply curbs that growth. I see why the banking sector dislikes Dodd-Frank (from compliance officers exasperated with endless regulatory reviews, to traders unhappy they don’t get huge bonuses any more), and the law has plenty of specific flaws that need correction. But a sour public opinion about Wall Street—that’s not against the law. Many times isn’t not even a bad idea.

I did ask Kaplan one specific question about the Federal Reserve’s goal this year to develop more specifics for its Countercyclical Capital Buffer—the rule meant to require that large banks hold even more capital in reserve, whenever systemic risk to the financial system overall reaches “abnormal” levels. So, I asked, does the Fed even know what an abnormal level of systemic risk looks like?

The short answer is no. Kaplan noted that the ultimate arbiter of abnormal risk will be the Financial Stability Oversight Council, that conclave of regulators created by Dodd-Frank to meet and ensure that Washington has a uniform approach to financial regulation. The FSOC does meet and publish various reports, so we’re off to a start. But definitions of abnormal systemic risk have not been articulated so far. “This is something that will have to flow from their brains,” Kaplan said. We eagerly await the cranial torrent.

Kaplan did raise good points about how financial regulators might try to identify abnormal systemic risks: that they will look for events and behavior that resemble the run-up mortgage lending in the 2000s, where the banking sector as a whole (from mortgage brokers to banks repackaging loans to Fannie Mae and Freddie Mac guaranteeing those loans) threw all caution and risk tolerances to the wind. Anyone working in finance 10 years ago remembers those reckless days. Reckless behavior is what the FSOC will want to avoid.

That insight will give compliance officers some sense of how to prepare for what the feds might do with the banking sector this year—but if regulators do move in that direction, I don’t know that the overall strategy is terribly wise. To me, it sounds like regulators preparing to fight the last crisis all over again, when the next crisis is usually something quite different.

I look at the world today and worry about deflating oil prices or a Chinese economy nowhere near as healthy as its government reports. Threats like them could cause panic on Wall Street that subsequently squeezes the banking sector (some would say we’re already well underway on the Wall Street panic part)—but they are very different than the systemic risk of reckless lending.

Good point, Kaplan replied when I mentioned those risks. The challenge, he said, is that threats like them are more “black swan” in nature, and hard to prepare for.

Really? We’ve been developing our shale oil technology since the 2000s and had surging U.S. oil production for years. China’s corruption, and its government willing to stretch the truth when politically expedient, have been around for decades. They are not black swans. Neither are most other risks challenging the United States and the financial system today, if we just look around and think smartly.