By David Dayen, a lapsed blogger, now a freelance writer based in Los Angeles, CA. Follow him on Twitter @ddayen
With Jack Lew now installed at Treasury, I decided to take a look at the annual report of the Financial Stability Oversight Council (FSOC), the Dodd-Frank creation that’s supposed to monitor systemic risk. We already know the leanings of the not-so-new regime at Treasury: they think Dodd-Frank worked to secure a more stable financial system, an opinion reiterated Tuesday at a Senate Banking Committee hearing.
Senator Sherrod Brown, co-author of Brown-Vitter, thought he found a nut by saying that the FSOC annual report identified “risk-taking at large interconnected banks” as a threat to economic stability (see UPDATE). He didn’t mention that this comes on page 146 of a 149-page report. And it’s not really taken all that seriously. The report asserts that the “synthetic uplift” from credit rating agencies on TBTF banks has declined, and then explains all of the reasons why Dodd-Frank ended TBTF. Under separate questioning yesterday from Elizabeth Warren, Lew said that “Our job right now is to implement … Dodd-Frank … I think this is not the time to be enacting big changes.” Bank size and complexity and the risk-exacerbating reality of too big to fail is not one of the seven major themes of the report, outlined in the executive summary. It’s clear that the TBTF part was a throw-in, and included merely to be rebutted. Anyway, their capital and liquidity recommendations amount to “keep doing what you’re doing.”
So what is the FSOC concerned about with the financial system? Some perfectly reasonable issues, like fire sales in the wholesale funding markets, particularly money market funds. But on this, as with most issues here, the FSOC covers their posterior by listing “concrete steps” they’ve taken to defuse the issue, when in reality little has been done. FSOC took over for the SEC when they failed to produce regulations at the end of Mary Schapiro’s term, and they issued proposed regulations in November. The public comment period ended in February, and FSOC has done nothing with them; the comments are “under review,” per the annual report. Meanwhile, FSOC has made clear that they would step aside if the SEC restarted their process, which could mean another year of wheel-spinning.
This is also true on housing finance reform, basically a fully owned subsidiary of the federal government. There is no indication of the real problem propping up the GSEs, namely the failure to fix the private capital markets for mortgages. Anyway, the boilerplate on winding down the GSEs and “promoting the development of standards and best practices in he mortgage markets” pales in comparison to the profits Fannie and Freddie are sending back to the Treasury (mostly through their market dominance), which will push against any alteration of the status quo. Mild issues like increasing guarantee fees and a couple CFPB rules get mentioned, but not protections against fraud or putback risk. In fact, there’s basically no discussion of fraud in the entire document, despite the continued lengthening rap sheet from financial crimes. You’d think this would rate as even a minor threat to the system.
Then we have the section on standard operational risks, like in a natural disaster or cyberattack. I’d dare say this is not worth the time of the FSOC and is more of a whole-of-government concern. The council highlights reference interest rates as a potential point of instability, but they only go so far as to cite the LIBOR scandal, ignoring more recent riggings to ISDAFix and oil market prices. The report merely recommends fixing LIBOR, when the crisis obviously goes much deeper.
The discussion of interest rate risk is worthwhile, noting the reach for yield that results from the low interest-rate environment. But the recommendations are basically to “stay attuned” to heightened risk among systemically significant institutions. This shows the weakness of the council that isn’t using the full powers of their mandate. I don’t think regulators benefit from an oversight entity just saying “hey, you watch that” at any sign of potential risk.
The seventh theme considered threats from Europe and abroad. But it’s the sixth theme that really got to me:
Notwithstanding the overall improvement in the U.S. financial system, concerns persist about economic and financial market impacts of long-term fiscal imbalances. In particular, the process of U.S. fiscal adjustment has raised questions about the manner in which long-term fiscal issues will be resolved. In 2012, financial markets continued to respond to fiscal and political uncertainty, though market volatility was impacted less than was the case during the debt ceiling crisis in 2011.
So under the direction of Jack Lew, the FSOC believes one of the major impediments to the financial system is the lack of a grand bargain. You’ll notice that “persistently high unemployment” doesn’t appear as a risk. As long as we’re talking about macro policy rather than the financial system, why isn’t that a preoccupation of the council? CBO’s recent estimates and the collapse of the austerity argument globally (indeed, Abenomics is specifically mentioned just a couple paragraphs later) show the absurdity of continuing to pump for a grand bargain, but darn it, Jack Lew was sent to Treasury for a reason.
I don’t think anybody expected Treasury to change measurably with the change in regime from Geithner to Lew, but it’s nice to get confirmation. FSOC just doesn’t look like a serious entity to me. Surprise, surprise.
It’s a long report, so if you’d like to dive into it, here’s the link.
UPDATE: Just for context, here is the transcript of the relevant questioning of Jack Lew by Sherrod Brown at Tuesday’s hearing, which shows a similar concern to what I have: that Lew and FSOC aren’t taking the issue of TBTF very seriously at all.
Brown: FSOC’s annual report cites risk-taking at large, interconnected banks, what we could call the too-big-to-fail banks, those six banks over $500 billion in assets, it cites risk-taking as a threat to our economy. The report says, and I’ll quote, “market participants may continue to perceive that some institutions receive special treatment by virtue of their size.”
You acknowledged at your confirmation hearing that this perception gives the mega-banks a funding advantage in the capital markets. That’s pretty clear. The FSOC report shows that the large mega-banks get a one or two notch up, if you will, boost in their credit ratings.
Standard & Poor’s said that Brown-Vitter, our legislation, which calls for higher capital requirements, will in fact eliminate the too- big-to-fail funding advantage they got. Dodd-Frank requires, as you know, FSOC to make recommendations in its annual report to promote market discipline.
So my question, Mr. Secretary, is why has FSOC failed to meet this requirement by recommending higher capital requirements for these six largest too-big-to-fail banks?…
But you said something else that the market implies that too-big- to-fail may still be around. It’s more than implying. It doesn’t really matter what Jack Lew or Sherrod Brown or David Vitter thinks about this, it’s what the markets think. And the markets continue to say that too-big-to-fail is alive and well.
Several members of FSOC have agreed that too-big-to-fail banks should have more capital. A recent Huffington Post report said the U.S. Treasury’s avoided publicly weighing in on this debate.
Your — your — this is not really a question, it’s more sort of summary statement, but your legal responsibility as FSOC chairman is to promote market discipline and eliminate the perception. The perception’s still there.
Dodd-Frank — as I said, you’re a sophisticated guy. You’ve seen what’s happened when one of the leading bank lobbyists, after the legislation was signed, said this is half time, and then put an even larger, more powerful legion of lobbyists on ways to weaken these standards.
At the same time, Basel III may be better than now, but with what it’s done with risk adjustment and risk assessment and all, you know that Basel III’s not going to be very strong capital standards. It’s minimal compared to what the market says we should do.
And I just hope you take this legal responsibility as chair of FSOC to promote market discipline and eliminate that perception of too-big-to-fail.