FRB Governor Brainard Highlights Structural Changes on Five Year Anniversary of Dodd-Frank (with Lofchie Comment)
Governor Lael Brainard of the Board of Governors of the Federal Reserve System ("FRB") delivered remarks at the Bipartisan Policy Center and Managed Funds Association's event. Her remarks focused on the structural changes that resulted from the Dodd-Frank Act over the past five years.
Governor Brainard stressed that the largest structural change has been the execution of tougher requirements imposed on banking organizations "that are so big or complex that their risk taking and distress could pose risks to financial stability." Unlike the previously homogeneous approach which focused narrowly on the safety and soundness of an institution, Governor Brainard said the current reforms aim to address potential risks posed by an institution to the safety and soundness of the system as a whole.
Governor Brainard noted that the Dodd-Frank Act anniversary marks an opportune time to review the overall structural changes made since inception of the Act. She identified these changes as:
- Requiring large and complex institutions to (i) become subject to a "capital surcharge" calibrated to the risks of a firm's business; (ii) perform stress tests; (iii) be subject to a leverage ceiling; (iv) be subject to "countercyclical capital buffer" requirements; (v) hold a "high-quality liquid asset buffer calibrated to stressed financial conditions"; and (vi) defer executive incentive compensation to allow for a clawback for losses realized during the deferral period.
- "Making failure safe" by imposition of an orderly resolution plan that requires (i) a simplified and rationalized alignment of the institution's legal entities with their business lines; (ii) a demonstration of "operational capabilities for resolution preparedness"; (iii) that firms be able to maintain "requisite management information systems"; (iv) that firms develop "robust operational and legal frameworks" so that firms will continue to receive services during resolution; (v) the "amendment of financial contracts to provide for a stay of early termination rights of external counterparties"; and (vi) that firms operate with a "clean top-tier holding company structure" in which the parent company is not guaranteed by its subsidiaries.
Lofchie Comment: It is fair to say that there is a very substantial gap in perception between certain regulators and those that are regulated. Perhaps the higher capital requirements imposed on banks will make the system safer; on the other hand, the regulators should be concerned that, in the event of a market downturn, there will be no buyers ready to step in and purchase because the combination of capital requirements and bars on position taking make it impractical or even illegal for firms to take risk positions in a downturn. Thus, one wonders if we are moving towards a system that appears strong because firms have more paper capital, but is in fact far more brittle because of reduced liquidity.
It could be that the concerns expressed above are not testable. But multiple scenarios of a broader downturn under current capital constraints should be gamed out. Indeed, techies should be unleashed to produce such a game. It could be made fun to watch. Failing banks could be made to explode.