'Macroprudential' Is Just a Buzzword Without Serious Reform
This blog was originally published in American Banker on 11/16/2015.
In remarks before a recent House Financial Services Committee hearing, Federal Reserve Board Chair Janet Yellen stressed the importance of using a "macroprudential" approach to regulation designed to promote the stability of the financial system as a whole. Unfortunately, full implementation of this approach may be easier said than done given our antiquated regulatory framework.
If regulators aim to promote the stability of the financial system as a whole, they have to possess both a sufficiently comprehensive and ongoing understanding of the system and the ability to apply their macroprudential vision in a uniform way.
On both fronts, our splintered multiagency regulatory framework, constructed largely during the Depression era of the 1930s, is a barrier to reaching this goal.
Key areas of the financial markets remain out of the Fed's reach. These include segments of the short-term wholesale funding markets which were at the epicenter of the last crisis, and the rapidly growing and highly concentrated asset management industry which has sparked financial stability concerns.
Other areas of the financial markets involve too many regulators. The highly intertwined derivatives and securities markets, for example, continue to be regulated separately by the Securities and Exchange Commission and Commodity Futures Trading Commission with the participants in these markets supervised by as many as seven different agencies.
Certain other parts of the financial system are all together unregulated or only lightly regulated. One important example is algorithmic and high frequency trading firms, which now dominate trading, raising market integrity and financial stability concerns and contributing to greater market volatility and "flash" events.
As a consequence of this setup, regulators continue to lack a sufficient understanding of the interconnectedness of the financial markets. The bilateral repo, securities lending and over-the-counter derivatives markets, all of which were at the heart of the last crisis and link market participants to each other in intricate ways continue to serve as just some examples of areas that remain opaque to regulators.
If understanding the financial system is difficult, acting to promote its stability as a whole is even more complex in the current regulatory construct. That would require buy-in from an alphabet soup of agencies at various levels of government on an issue by issue basis, and even then, important parts of the financial markets would likely fall through the cracks. Moreover, if regulators act in an uncoordinated way on a given issue, market distortions would cause risk to simply migrate into the less regulated or unregulated corners.
Meanwhile, the financial system continues to change. Market structure is evolving and becoming more fragmented and opaque, virtual currencies are emerging, marketplace lenders are gaining popularity, mobile technology is reshaping the payments paradigm, high frequency trading is operating in micro and nanoseconds and cyberattacks on financial institutions and market infrastructures are increasing in frequency and sophistication.
When the public wants to know who is in charge, the very unsatisfactory answer is everyone has some role, but no one is really in charge.
Efforts to better understand the markets are severely hampered by the existing framework. While the Office of Financial Research in Treasury is an important vehicle to address this, the OFR faces many challenges. To obtain necessary data, the OFR is required to first navigate a labyrinth of regulatory agencies, which are often reluctant to share information. And when information is exchanged, it is often not readily usable given the different data collection methodologies and objectives of the many agencies that may be involved in a given market segment.
While the SEC and the CFTC are making a commendable effort to take on some of the obvious challenges, they do not have a statutory mandate for financial stability, are hampered by resource problems, and are becoming ever more polarized, including on such basic issues as whether or not they should have an overarching financial stability focus.
To be sure, the Financial Stability Oversight Council is designed to address some of these issues, but the FSOC continues to be hamstrung because it is superimposed on top of a broken regulatory framework. The FSOC has too many members, each with their own mandates and interests and in some cases the agencies they head have not adopted a macroprudential focus.
Moreover, the FSOC lacks the power to require heightened safeguards and standards for certain types of risky activities and practices. Although it may make recommendations to functional regulators for tighter standards, those regulators may not view the macroprudentially focused recommendations as falling within their statutory mandate.
Instead of addressing these weaknesses of the FSOC, the Financial Services Committee last week approved legislation that Treasury Secretary Jacob Lew warned "would severely undermine and impair" the FSOC. We need a different way forward.
A report issued this past April by the Volcker Alliance provides exactly that. It proposes a plan to reshape the financial regulatory system that would create a more resilient regulatory framework better able to respond to the dynamic needs of the financial markets.
The proposal would reduce the number of voting FSOC members, insulate the council from outside political influence and strengthen its authority to address risky activities and practices. It also would combine the regulation of the highly interlinked markets for securities and derivatives and create a more rational framework for the supervision of financial institutions.
The proposed framework sets out a marker for reform but is not meant to monopolize the debate on a way forward. Congress should give the proposal serious consideration and focus on these important issues to establish a financial regulatory framework suitable for the 21st century. That will make a macroprudential approach more than a catchphrase.