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New Rules, Old Risks

Regulation has undergone a major overhaul in the wake of the crisis, and leverage is leaving the system. But no amount of rule-writing can banish risk from financial markets — nor should it.

  • Imogen Rose-Smith

Future of Finance

THE SCENE WAS REMINISCENT OF THE DARK DAYS OF the financial crisis. A senior banker was called before Congress and asked to explain how his bank had lost billions of dollars making highly leveraged bets. But this wasn't October 2008. It was June 13, 2012, nearly two years after President Barack Obama had signed into law the most sweeping set of financial reforms since 1933, and the man called to testify was America's premier banker, Jamie Dimon.

During the market meltdown that brought the financial services industry to its knees and triggered a global recession, JPMorgan Chase & Co. emerged as the most credible, and creditworthy, of the major U.S. banks. The feds turned to JPMorgan to rescue Bear Stearns Cos., the first major casualty of the crisis. Dimon, the CEO with the fortress balance sheet and no-nonsense style, became the respectable voice of the financial services industry and led a pushback against tighter regulation, calling in particular for a lenient application of the so-called Volcker rule's curbs on proprietary risk-taking at banks.

Then early this year Bruno Iksil, a London trader working in JPMorgan's chief investment office, amassed a major position in an obscure credit derivatives index, purportedly to hedge risk across the bank. By April some hedge funds had begun betting against the so-called London Whale, and speculation mounted that Iksil's trades were losing money. Dimon, who initially dismissed the market chatter as "a tempest in a teacup," acknowledged one month later that JPMorgan would lose at least $2 billion on the trades, and he replaced the head of the bank's chief investment office. By July the loss had surged to $5.8 billion, and it could still grow. 

   
The New Maze of Global Regulation Governments have overhauled financial regulation in the wake of the crisis, making the new rules more rigorous, more global &mash; and more complex. The new system involves emerging powers like Brazil and China as equal partners alongside the U.S., Europe and Japan. National implementation still varies widely. The Dodd-Frank Act has added two new agencies to an already crowded landscape.
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The incident raised a major question: After four years of summit meetings, regulatory conclaves, landmark legislation and detailed rule-writing — all of it aimed at ensuring that the financial system would never again crash the global economy or force taxpayers to underwrite costly bailouts — how could a bank as powerful and supposedly well run as JPMorgan suffer a hit like that in such a short period of time? Had anything really changed for the better?

The answer is not simple. Yes, major reforms have been undertaken by the U.S., Europe and other leading economies over the past four years, and they are having a significant impact. Banks today hold much more capital as a cushion against potential losses than they did before the crisis, and they are being compelled to curtail or exit some risky activities, like prop trading. Governments are shedding some much-needed light on the $648 trillion derivatives market by requiring that many contracts be traded through central clearinghouses. Regulators are gaining new powers to wind down bankrupt financial firms, and governments have established new supervisory bodies to monitor risks to the financial system as a whole rather than risks to individual institutions.

What's more, governments seem likelier to tighten the regulatory net than to loosen it. Recent disclosures that some banks sought to manipulate Libor, the most widely used interest rate benchmark, unleashed a public outcry and led some politicians, regulators and even former bankers to call for a separation of retail and investment banking. Working groups in the U.K. and the European Union are considering this potential remedy.

The new regime is far from perfect, though. The largest banks are more dominant than ever today, leaving the too-big-to-fail problem and the risk of even costlier public bailouts still hanging over governments and markets. The new regulatory framework is highly complex, as exemplified by the 848-page Dodd-Frank Wall Street Reform and Consumer Protection Act. Many detailed rules are still to be written, and regulators have yet to demonstrate that they can implement and police the new rules effectively. Already, the framework has produced some unintended consequences. The new liquidity rules in the Basel III capital accord encourage banks to hold sovereign debt, stoking even greater risks in Europe's sovereign debt crisis, according to some analysts.

In short, the global regulatory overhaul is still a work in progress. Although much has been done, it's far too early for the authorities to claim "mission accomplished" or for investors to feel terribly secure.

"Right now I don't think any one of us who is realistic would say we know with certainty that five years from now the financial system will be safer and more stable and more efficient," says E. Gerald Corrigan, co-chairman of the risk management committee at Goldman Sachs Group and former head of the Federal Reserve Bank of New York. "We are not there yet."

The broad outlines of the new regulatory framework were set out in the early days of the crisis, when authorities in the U.S. and Europe effectively decided to reform the financial services industry along existing lines rather than attempting to rebuild it. Working through the Financial Stability Board, which the Group of 20 nations enshrined as a global agenda-setter and regulatory coordinator, the authorities dismissed structural remedies such as a modern-day Glass-Steagall Act, which had separated commercial and investment banking in the U.S. until the late 1990s, and instead sought to erect stronger guardrails on the current system.

The biggest barriers come courtesy of the Basel Committee on Banking Supervision, which has mandated an approximate doubling of capital requirements for banks by 2019 under the Basel III accord. The Switzerland-based body has raised the core tier-1 capital requirement to 7 percent of risk-weighted assets from 4 percent previously, tightened the definition of what counts as capital and tacked on a 2 percent surcharge for banks deemed systemically important.

The authorities have also broadened the scope of regulatory purview. The newly created Financial Stability Oversight Council, made up of the heads of the myriad U.S. regulatory agencies and headed by the Treasury secretary, and the European Systemic Risk Board, an FSOC equivalent chaired by the head of the European Central Bank, now meet to monitor risks to their respective systems, including issues of leverage and the interaction of banks with lightly regulated segments of the markets, such as hedge funds. The Bank of England has established the Financial Policy Committee, which will perform a similar oversight role for the City of London.

Other aspects of the new regulatory approach can be best seen in the U.S., where Congress has mandated a raft of reforms under the Dodd-Frank Act.

That legislative tome spans everything from hedge fund regulation to corporate disclosure about minerals sourced in conflict zones, but its key elements include the implementation of Basel's rules in the U.S.; adoption of the Volcker rule; the requirement that most derivatives trades go through central clearinghouses; a mandate that banks draft living wills to guide how they can be wound down after a failure; and resolution authority for officials to close large institutions that run into trouble. The aim is to reduce the risk of another collapse like that of Lehman Brothers Holdings or, failing that, to create a clear template for dealing with future failures.

"The basic idea behind the Dodd-Frank legislation and the Basel capital rules was to make the financial system more resilient," says Michael Barr, a professor at the University of Michigan Law School who helped shape those measures while serving as assistant Treasury secretary for financial institutions in 2009–'10. "The key issues now: Are we going to move forward and implement that framework in a robust way, and are we going to take care of the remaining risks in the system?"

Some observers have their doubts. "Four years have passed since the 2008 crisis, over two years have passed since Dodd-Frank was enacted, and the reform process is still only at best midway through completion," says Sheila Bair, former chairman of the Federal Deposit Insurance Corp., who now co-heads the Systemic Risk Council, a bipartisan private sector group formed to monitor regulation. To date, only three rules have been finalized, Bair notes, and "the ones that have been finalized, as well as the ones that have been proposed, are extremely long and complex and difficult to decipher."

Other reforms never made it off the drawing board. Regulators have been determined to prevent another run on money funds like the one that occurred after the Reserve Primary Fund broke the buck back in 2008. U.S. Securities and Exchange Commission chairman Mary Schapiro pressed hard for a new rule requiring money funds to adopt either a floating net asset value or hold a capital buffer to cushion any losses, but she had to abandon the proposal last month in the face of heavy industry lobbying.

Some critics say the reform process was flawed from the start. Simon Johnson, a professor at the MIT Sloan School of Management and former chief economist at the International Monetary Fund, asserts that consolidation since the crisis has created even bigger banks that make the system more vulnerable than ever. Some banks, JP Morgan among them, are bigger now than they were at the start of 2008. "The situation now is much more dangerous than it was in the buildup to 2007," Johnson says.

NOTWITHSTANDING THE CRITICISMS, THE REFORM process is having a major impact on parts of the financial system, notably banking.

Leverage, a root cause of the crisis, is leaving the system because of the stringent new capital requirements combined with the weak global economy. At the end of 2011, for example, Goldman Sachs had global core excess liquidity — reserves of cash or cash equivalents, highly liquid securities and other central-bank-eligible collateral — of $171.6 billion, or 18.6 percent of its total assets of $923 billion. Four years earlier it held only $60.56 billion against $1.1 trillion of assets, a ratio of just 5.4 percent. JPMorgan, which only began breaking out global liquidity reserves in its 2010 reporting, had a reserve of $379 billion at the end of 2011, or 16.7 percent of its $2.27 trillion in assets. The bank has been able to absorb the London Whale's big losses without any apparent threat to its stability (though its stock price has taken a hit).

There has been a "substantial deleveraging of the banking sector relative to precrisis. The goal of regulation is to reduce leverage and thus make the banking sector less vulnerable to shocks, which can spread through the financial system and the real economy," says Stefan Walter, a principal in Ernst & Young's financial services regulatory management practice who served from 2006 to 2011 as secretary general of the Basel Committee and previously headed the New York Fed's financial sector policy and analysis unit. He points out that provisions in Basel III can boost capital requirements as high as 12 percent of assets for big banks during times of high financial stress. "The heavy lifting on correcting the banks and their problems has been largely accomplished," says Thomas Huertas, former member of the executive committee at the U.K.'s Financial Services Authority and now a partner in the financial services group at Ernst & Young.

In general, there are plenty of signs of a tougher regulatory attitude. In the U.K., previously the much-vaunted home of light-touch regulation, the authorities reacted vigorously to admissions by Barclays that bank employees had sought to manipulate Libor, particularly at the height of the 2008 banking crisis. The FSA joined with the SEC and the U.S. Commodity Futures Trading Commission to impose a total of $451 million in fines on the bank, and top officials at the Bank of England forced the resignation of Barclays's chairman, Marcus Agius; its CEO, Robert Diamond Jr.; and Diamond's top lieutenant, Jerry del Missier. The affair has increased the likelihood that the authorities will take a tougher stance in coming months when they adopt new reforms resulting from last year's Independent Commission on Banking, which recommended that banks ring fence their retail lending arms from their investment banking businesses.

Tighter regulation isn't a panacea, though. The new regulatory framework adds layers of fresh complexity to the system, and some skeptics believe this creates opportunities for financial institutions to circumvent the rules. The imposition of so many changes in such a short period of time is also bound to lead to unintended consequences, critics contend.

Basel III introduced liquidity requirements for the first time, on the theory that if banks had a higher proportion of easily tradable securities among their assets, the banking system would be less vulnerable to a run in times of crisis. The new rules have led European banks to load up on government bonds in the midst of the region's debt crisis. The result has been a balkanization of the European capital market, with Spanish banks holding Spanish government debt, Italian banks holding Italian debt and so on. If the debt crisis worsens dramatically, what consolation will there be if a failing counterparty is not American International Group but the Greek government?  

JPMorgan's big derivatives loss is another case in point. In his testimony before Congress, Dimon explained that the bank's chief investment office embarked on the losing trade in response to the need for all banks to reduce risk-weighted assets to comply with Basel III. It didn't work out that way.

Some observers worry that the shift to centralized clearing of derivatives may be setting the stage for one of the biggest unintended consequences. The change is meant to increase transparency in the market and reduce the risk of failure, because clearinghouses require firms to post margin for their derivatives trades. The hope is to avoid a calamity like the collapse of AIG, which was brought down by its bad derivatives bets. But because clearinghouses concentrate the credit risk of countless counterparties, the danger to the system if something goes wrong with the clearinghouse could be far greater, skeptics warn. "It's like going from coal energy to nuclear energy," says Heath Tarbert, former special counsel to the U.S. Senate Banking Committee, who heads the financial regulatory reform working group at New York–based law firm Weil, Gotshal & Manges. "It is probably cleaner, but if there is a meltdown," the damage will be a lot worse. Adds Ernst & Young's Huertas, "One has to be very sure that those central counterparties are robust."

In other ways, the new regulatory framework may foster fragmentation, rather than concentration, in the financial system. Higher capital requirements, combined with restraints on proprietary trading and investing, are set to limit the extent to which banks can act as providers of capital and takers of risk, particularly in Europe, where banks have traditionally provided the vast bulk of credit. This opens up opportunities for other types of lenders and investors, including hedge funds, private equity firms, specialty finance companies and even institutional asset owners. "We are in the early stages of seeing that shift play out," says David Rubinstein, CFO and European CEO at BlueMountain Capital Management, a New York–based credit hedge fund firm. "We are actually participating in the initial phase of the transformation of the credit markets by providing both equity and debt financing to nonbank companies that lend directly."

Hedge funds are participants in the so-called shadow banking industry — that is, the lending and risk-taking that take place away from bank balance sheets. Regulators are still grappling to get a better grip on risks in this area and promote greater transparency in the sector. Stronger banks should help the shadow banking system be less of a threat, but there is no guarantee that this will happen. "If you have a more resilient banking sector, then credit intermediation is less likely to be curtailed" in a future crisis to the extent that it was in 2008, says Ernst & Young's Walter. "That is a function of leverage, interrelatedness and liquidity." At the same time, he adds, the creation of bodies like the Financial Stability Oversight Council means that "at least now there is a framework for looking at sources of systemic risk beyond the banking system. Although stronger capital is necessary, it needs to be reinforced through better risk management, governance, supervision and resolution planning."

That is a good thing because today's fragile economic climate contains plenty of risks. "The list of known problematic factors is fairly long," says Huertas. "It starts with macroeconomic concerns, fiscal concerns, both in the U.S. and Europe. It continues with long-standing structural issues, such as Fannie and Freddie in the U.S., money market mutual funds and the resolution of the euro zone crisis."

One element common to almost all the regulatory reform efforts is the idea that better monitoring will help prevent, or at least limit the impact of, another financial crisis. That presumes, of course, that regulators will be able to see a crisis coming and will have the strength and willingness to do something about it. That may be a fair presumption in today's uncertain climate, when regulatory vigilance is high. But what happens when good times return, as they inevitably will?

Former Citigroup CEO Charles Prince was maligned for saying just before the subprime crisis erupted in 2007 that "as long as the music is playing, you've got to get up and dance." It's probably too much to expect regulators to shut down the dancing while the party is still on, says Alan Blinder, a Princeton University economist and former Fed vice chairman whose book about the crisis, After the Music Stopped, will be published in January. "There will always be speculative bubbles, and I am dubious that the FSOC will be able to do anything much about them," he says.

The debate about regulation is bound to rage on. The stakes are huge, and the new framework has yet to be completed or tested. More important, questions about what type of regulation to impose, or how much, will never get definitive answers. Risk is inherent in financial markets. It's at the core of what every investor does every day. As Paul Volcker, a fearless regulator in his days as Fed chairman, put it in a speech in Washington last year, "We cannot and should not contemplate a financial world so constrained by capital requirements and regulation that all failures are avoided and innovation and risk-taking is lost."

Encouraging risk while guarding against disaster is a delicate thing. For now, investors can only hope that authorities will manage to strike the right balance.  •  •