Obama’s parting ‘gift’ to the financial industry


By Peter J. Wallison.


A White House meeting which took place in early March could have wide-ranging implications for the future of U.S. financial markets. Although regulators are supposed to be independent of the president and his policies, all principal federal financial regulators were summoned a few weeks ago to the White House to meet with President Barack Obama about the implementation of the Dodd-Frank Act. In the past, Obama has ignored appearances of impropriety and has successfully pressed regulators to follow his policies. This most recent meeting should be taken as a warning sign for the financial community that it will face serious new regulatory challenges before the end of the Obama administration.

Before the meeting with the president, the Fed prepared the way for strict new regulations on banks, proposing to limit interbank lending to 15% of capital. This applies to banks the erroneous Dodd-Frank notion that interconnections between financial institutions caused the breakdown and panic in 2008. In reality, despite the chaos that ensued after Lehman’s bankruptcy, no other large financial institution failed because Lehman could not meet its obligations. The Fed’s action, however, signals that Dodd-Frank will be used aggressively in the months ahead to cement in place President Obama’s regulatory legacy.

But this is only the beginning. There is a real danger that prudential regulation — in which regulators control credit allocation and risk-taking and impose capital requirements — will be extended to the rest of the financial system. In effect, under the guise of creating “stability,” a prudential regulatory system will replace today’s unfettered financial market with a regulator-managed market in which risk-taking is controlled by the government.


A focus on “shadow banks”


This is not far-fetched idea. Both the Treasury and the Fed are members of the Financial Stability Board (FSB), a mostly European group of finance ministers and central bankers, deputized by G-20 leaders (including President Obama) in 2009 to reform the international financial system. For several years, the Board has been developing theories for imposing prudential regulation on “shadow banks” — a term it uses to define and regulate financial institutions that are not subject to bank-like regulation, including broker-dealers, asset managers, mutual funds, hedge funds and insurance companies, among others.

In his most recent message to Financial Stability Board (FSB) members, in late February, FSB board chairman Mark Carney noted that “the FSB’s priorities for 2016” will be “the full and consistent implementation of post crisis reforms,” which include the prudential regulation of shadow banks.

Although large financial firms — such as broker-dealers, hedge funds insurers and money managers of all kinds — have received most of the attention as shadow banks, the FSB has made clear that small firms will not escape prudential regulation. In the FSB’s definition, a firm is designated as a shadow bank if it participates in “a complex chain of transactions, in which leverage and maturity transformation occur in stages.”

Normally, maturity transformation — the risky business of converting short-term deposits into long-term loans — applies only to banks. But as defined by the Financial Stability Board, maturity transformation will affect any size financial firms if they play a part in a series of transactions that eventually convert a short-term loan into a long-term credit. Thus, a firm that makes short-term loans to an auto dealer would be taking part in a maturity transformation if at some future time the dealer sells its auto loans into a securitized pool.


Obama’s regulatory legacy


Almost six years after the passage of Dodd-Frank, it seems likely that the prudential regulation of shadow banks is intended to become part of the Obama legacy. That’s the reason for the White House meeting with the regulators. Such a plan would fit well with the FSB chairman’s expectation that all its members — including the Treasury and the Federal Reserve in the U.S. — will implement the Board’s reforms in their respective jurisdictions this year.

In America, this would be the job of the Financial Stability Oversight Council, led by Treasury Secretary Jack Lew. It is not yet clear exactly how the Council will follow Obama’s plans, but there is little doubt that it will try. In the past, the Council has made sure that all decisions and directives of the Financial Stability Board are implemented in the U.S. For example, it designated as Systematically Important Financial Institutions (SIFIs) the same three insurers — AIG, Prudential and MetLife — that were designated as SIFIs by the Board. Unfortunately, with a compliant judiciary, it’s possible that the broad language of the Dodd-Frank Act could be used for this purpose.

If the financial community wants to avoid prudential regulation, this is the time to make its objections known to Congress and the regulators.

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