How Shape-Shifting Banks Foil Dodd-Frank Act

From: Bloomberg

Deutsche Bank AG (DBK) recently separated its U.S. investment bank from its bank holding company, removing it from supervision by the Federal Reserve.

So far, U.S. regulators have reacted passively to such moves by foreign banks to avoid the heightened capital requirements mandated by the Dodd-Frank Act.

That’s because Dodd-Frank failed to heed a fundamental law of architecture: Form must follow function. For financial regulation to be effective, it should focus on economic function, rather than legal form. If it doesn’t, institutions will quickly find new forms that free them of regulatory constraints. What walks like a duck and quacks like a duck must be regulated as a duck, even if it is legally a goose.

All too often financial regulation misses this obvious point. The result is regulatory arbitrage, as intermediaries alter their legal form to minimize their costs.

That would be fine if the costs of the risks carried by a large, complex investment bank — a prime example of a“systemically important financial intermediary,” or SIFI, thatDodd-Frank sought to regulate — were all its own. But that isn’t the case. When such institutions take risks, they can threaten the financial system and require public bailouts.

Emergency Liquidity

In a crisis, a SIFI could be forced into a fire sale that triggers a broad credit crunch. To avoid this outcome, the Fed typically would be called upon to provide emergency liquidity –an insurance subsidy that fosters more risk-taking in good times.

Indeed, when Lehman Brothers Holdings Inc. failed, the two largest U.S. investment banks, Goldman Sachs Group Inc. (GS) andMorgan Stanley (MS), converted their legal status to bank holding companies, gaining access to the Fed’s discount window. The central bank obliged them and many other institutions to an astonishing degree because the costs of a further collapse of the financial system made that the optimal response at the time.

Other spillovers from such regulatory arbitrage are no less significant. If a SIFI’s insolvency threatened a run on its counterparties, resolving it under Dodd-Frank rules could force less risk-prone intermediaries to bear the costs. Over time, that process would promote a risk-taking race to the bottom.

The form versus function dilemma extends far beyond investment banks and, in some cases, even beyond SIFIs. It drives shadow banking as a whole. Why are money-market mutual funds still permitted to offer depositlike instruments –creating the risks of a run — without being subject to bank rules? Why were bank holding companies allowed to minimize capital by creating off-balance-sheet mechanisms (such as“special investment vehicles”) that were prone to panic? Why was the world’s largest insurer, American International Group Inc. (AIG), allowed to shop for a weak regulator (the now-shuttered Office of Thrift Supervision) that was ill-equipped to understand its business?

Once we allow form, rather than function, to guide regulation, the classic problem of “time consistency” becomes acute. Time consistency refers to the overwhelming incentives, in bad times, for policy makers to renege on the commitments they made when things were going well.

Imagine that a group of intermediaries has engaged in regulatory arbitrage to reduce their capital buffer or to take liquidity risks (say, by excessive reliance on short-term funding) that jeopardize the stability of the financial system. Suppose that regulators respond by warning that — in a future crisis — they won’t provide emergency liquidity or other bailout funds to such intermediaries. Unfortunately, the regulators’ threat is largely empty, because carrying it out could lead to economic catastrophe and both parties know this to be true.

Time Consistency

As a result, the promises of policy makers often lack the credibility needed to discipline systemic risk-taking. This time-consistency problem is particularly challenging for advocates of so-called narrow banking, a regulatory approach that focuses almost exclusively on form, rather than function.

Under a narrow banking rule, government crisis backstops –such as Federal Deposit Insurance Corp. guarantees or Fed discount lending — would be available only to narrowly defined depositories that provide the economy’s basic payments mechanism. These banks would then be tightly regulated like public utilities. Outside this protected sphere, anything goes.

Narrow banking sounds attractive because it seems to focus the losses in bad times on those non-narrow banks that took the risks in good times. If that were the case, the resulting incentives would help make the financial system safer. But would it really work that way? Not if people doubt the official commitment to let intermediaries outside the narrow banking world fail en masse.

Even if legislation forbade bailouts (as Dodd-Frank does), would a modern government stand by in a full-blown financial crisis if doing so threatened another depression? Probably not. Indeed, one reason to establish thoughtful rules governing an official lender of last resort — such as the Fed — is that some part of government inevitably will play this role in a crisis. As a consequence, it’s better to do so through an institution of established integrity that limits the potential for corruption and fraud.

If regulation by function rather than form is critical, why do we often fail to pursue it? Part of the answer is that it’s quite difficult to do. Another, no less troubling, part is that regulated financial entities are politically powerful. In some cases, they can persuade Congress and their regulators to exempt them from discipline. If the costs of that protection ultimately are borne by a large, diffuse group of taxpayers only in a crisis, taxpayer resistance can be overcome in good times.

Market Discipline

The most straightforward solution to this problem is to regulate financial instruments and markets (say, through collateral and margin requirements), rather than just regulating institutions. Another is to promote transparency and infrastructure that empower greater market discipline. Dodd-Frank makes some progress along these lines by shifting derivatives trading to clearinghouses. And the Fed has pushed for years to reduce the systemic risks emanating from the critical market for collateralized short-term funds (repurchase agreements).

But not all systemic risks are easily amenable to this approach. History shows that increased regulation of instruments and markets also will create incentives for innovations that avoid it. Such innovations may be quite profitable, even as they undermine efforts to limit systemic risks.

Have the great financial crisis, the extraordinary policy responses, the deepest postwar recession and the dismal recovery altered these historical tendencies? Not if Deutsche Bank and other foreign banks’ version of regulatory arbitrage proves representative.

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