Monday, July 26, 2010

Dodd-Frank Volcker Provisions Wisely Leave Details to Regulators Says UK FSA Chair

The Volcker Rule clauses of the Dodd-Frank Wall Street Reform and Consumer Protection Act wisely leave it to regulators to apply the rules in practice, noted Financial Services Authority Chair Adair Turner, because drawing a legislative distinction between proprietary trading and customer facilitation is close to impossible in a world where securitized credit will still play a significant role. In remarks at a recent London seminar on the future of finance, the FSA He said that a key lever regulators should use in applying the Volcker provisions is appropriate capital requirements for trading activity in order to prevent banks holding credit securities in trading books with the inadequate capital support allowed before the crisis. The Volcker provisions of Dodd-Frank prohibit high risk proprietary trading at banks, limit the systemic risk of such activities at non-bank financial companies, and prohibit material conflicts of interest in asset-backed securitizations.

The FSA Chair cautioned that, even if proprietary trading of credit securities was largely conducted by institutions separate from commercial banks, important and potentially destabilizing interactions could still exist between maturity transforming banks and credit securities trading. A credit supply and real estate price boom could be driven by the combination of commercial banks originating and distributing credit and non-banks buying and trading it, he said, with the two together generating a self-referential cycle of optimistic credit assessment and loan pricing, even if the functions were performed by separate institutions.

The essential challenge, which remains unchanged post-Dodd-Frank, is that the tranching and maturity transformation functions which banks perform do deliver economic benefit, and that if they are not delivered by banks customer demand for these functions will seek fulfillment in other forms. Regulators must find safer ways of meeting these demands and constraining the satisfaction of the demands to safe levels, he emphasized, but cannot abolish these demands entirely.

Securitization may never return to pre-crisis levels, said the Chair, but the benefits of securitization virtually assure its continuance post-reform. Ideally, securitization should result in assets being held by end investors rather than by leveraged bank intermediaries. It should also remove the contractual maturity transformation of bank balance sheets, substituting instead liquidity through marketability.

These benefits of securitization were never actually delivered, said Chairman Turner, because, when the music stopped in 2008, a large share of credit securities turned out to be held on the trading books of banks that had originated and distributed credit with one hand then bought back other banks’ credit securities with the other hand. In his view, they were encouraged to so by utterly inadequate capital requirements against trading assets. Moreover, the shadow bank maturity transformation process, with conduits and mutual funds holding long-term assets against short-term liabilities and relying on market liquidity to allow sales to meet redemptions, turned out to be as risky as the contractual on balance sheet variety.

In the Chair’s view, these specific faults in the system can be addressed by better regulation. Higher capital and liquidity standards, applicable throughout the cycle, will themselves create a financial system less vulnerable to shocks. Moreover, the risk tranching and maturity transformation functions which banks perform do deliver value, he noted, even if the scale on which they perform them needs to be constrained.

In addition to higher capital and liquidity requirements, therefore, the regulatory response needs to involve the deployment of counter cyclical macro-prudential tools, which directly address aggregate credit supply. These could include automatic or discretionary variation of capital or liquidity requirements across the cycle, or constraints which directly address borrowers rather than lenders. Such policy levers may moreover need to be varied by broad category of credit, such as distinguishing between commercial real estate and other corporate lending, given the very different elasticity of response of different categories of credit to both interest rate and regulatory levers.

He also noted that the UK is committed to creating a new Financial Policy Committee, chaired by the Governor of the Bank of England, drawing on the analyses and insights of both central bankers and prudential regulators, and responsible for considering the overall evolution of credit supply, and for taking appropriate action against excessive credit creation. He called the creation of the committee a vital response to the previous gap in the regulatory system between a central bank focused on monetary policy alone, and a regulator focused on micro rather than macro issues.

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