The financial system experiences a crisis “every five to seven years,” JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon told the Financial Crisis Inquiry Commission in January.
The financial system experiences a crisis “every five to seven years,” JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon told the Financial Crisis Inquiry Commission in January. By that measure, the next crash could come by 2015 -- years before new banking reforms are in place.
Many of the measures ordered by Congress and global regulators, aimed at cushioning the financial system in future crises, are years away from being implemented. The Basel Committee on Banking Supervision plans to give the world’s banks until 2018 to comply with limits on how much they can borrow. Parts of the Volcker rule, a provision of the new Dodd-Frank Act that would force firms to cut stakes in in-house hedge funds and private-equity units, may not go into effect for a dozen years.
Banks’ appetite for using borrowed money, known as leverage, for investing in complex, illiquid securities contributed to the worst credit crisis since the Great Depression. The pace at which curbs on leverage are likely to be imposed on the industry contrasts with the speed at which banks including UBS AG and Morgan Stanley are hiring to ramp up trading activities.
“Based on our experience of government’s ability to execute these things effectively and in a timely way, we are almost uncovered now from any future financial risk for at least another 8 or 10 years, and that’s a little scary,” said Roy Smith, finance professor at New York University’s Stern School of Business and a former banker at Goldman Sachs Group Inc.
The Dodd-Frank Act requires 67 studies and 243 new rules to be created, according to law firm Davis Polk & Wardwell LLP. The act creates a Financial Stability Oversight Council with 10 voting members, including a to-be-named insurance expert and heads of at least three regulatory agencies awaiting new leaders. The law’s Volcker rule, which bans banks from proprietary trading and limits investments in private equity and hedge funds, requires a study by the council before rules are drafted.
Financial crises have become a regular occurrence. The 2008 credit crisis followed the implosion of the technology stock bubble in 2000 and 2001, which came just a couple of years after the Russian government bond default and the collapse of hedge fund Long-Term Capital Management LP roiled global markets.
Lawrence Summers, director of the National Economic Council, said in an October speech to the Economist magazine’s annual Buttonwood Gathering that fixing the financial system could be compared to reducing fatalities in automobile wrecks. Mandating seat belts, guard rails and speed limits proved more effective in reducing damage caused by crashes than trying to prevent reckless driving, he said.
“In the same way, we need approaches to financial regulation that seek to make the world safer for ignorance and cupidity, which are inevitable, rather than relying on our ability to correct them,” Summers said in the New York speech.
Like placing seat belts on careless drivers, requiring financial institutions to hold more capital would help the companies better withstand even serious errors, Summers said.
Instead of mandating higher capital levels for financial institutions, the Dodd-Frank Act signed by President Barack Obama last month leaves the decisions to regulators such as the Federal Reserve. They, in turn, are taking cues from the Basel committee, a forum of 27 countries’ central banks and regulators that creates global rules that aim to prevent banks from seeking out countries with the most lenient regulation.
The Basel committee, which in December proposed a set of new guidelines for leverage, capital and liquidity, came under attack by financial companies and some governments who thought the limits would curb lending and hamper an economic recovery. The Institute of International Finance, an industry group representing more than 400 firms, released a report in June that said the proposed rules would erase 3.1 percent of gross domestic product in the U.S., euro region and Japan by 2015.
“They’re all saying the same thing, which is don’t kill the goose that lays the eggs you depend on,” NYU’s Smith said. “So they’re getting through to the Basel people, and they’re getting through to them in two ways -- one is to soften the expected blows,” he said. The second is “to extend them well into the future.”
The Basel committee agreed last month to give banks more leeway in the types of assets they can count as capital. The committee’s efforts to require banks to hold more liquid, or easy-to-sell, assets -- enabling them to better handle a sudden rush for funds -- were weakened by expanding the definition of what counts as liquid. And a planned leverage ratio, which would set an absolute cap on the amount of borrowing a bank could do, won’t be in effect until 2018, the committee said.
While leverage enables financial companies to multiply their potential gains on investments, it also makes them far more vulnerable to losses that can wipe out capital. For a company that borrows $20 for every $1 it holds in shareholder equity, a 5 percent decline in those assets can render the company insolvent.
Delaying reform until “2018 is like doing nothing because you know the world will change many times between now and 2018,” said Simon Johnson, former chief economist for the International Monetary Fund who is now a professor at the Massachusetts Institute of Technology’s Sloan School of Management. “You should worry a lot about the next round of the cycle.”
Not everyone is so concerned. Key provisions of the Dodd- Frank legislation, such as rules requiring over-the-counter derivatives to be cleared or exchange-traded, are due to be clarified in a year, said Bradley Sabel, a partner at law firm Shearman & Sterling LLP in New York who spent 18 years at the New York Fed. Derivatives are contracts with values derived from assets such as stocks, bonds commodities, currencies, or events such as changes in interest rates, creditworthiness or the weather.
Reforming the $615 trillion market in over-the-counter derivatives is itself a way to manage leverage, as the trades often replicate investments that are a multiple of the cost of the contract.
“It’s not like we’re saying, as Basel did about leverage, wait until 2018,” Sabel said of the Dodd-Frank Act’s provisions. “Within one to two years this stuff will pretty much be coming on line. I think that’s quite soon enough.”
