What We're Reading in Financial Regulatory Reform, February 14

We hope that you enjoy the following selection of readings this snowy Valentine’s Day!

The Bipartisan Policy Center’s Financial Regulatory Reform Initiative (FRRI) highlights news articles, papers and other important work which illuminate current and new thinking within financial regulation. We circulate these articles to provide a full view of cutting edge ideas, reactions and positions. The views expressed in these articles do not necessarily represent the views of the initiative, its co-chairs, task force members or the Bipartisan Policy Center.

Compiled by Aaron Klein, Peter Ryan and Justin Schardin

---

Letter to Regulatory Agencies Regarding Treatment of Collateralized Loan Obligations under the Volcker Rule
By 17 Democratic Members of the House of Representatives

“We are writing to express our support for interpretive guidance on the Volcker Rule’s definition of an ‘ownership interest’ that protects the intent of the Volcker Rule, while also recognizing that certain traditional creditor-protective voting rights should not, by themselves, cause senior debt securities of collateralized loan obligations to be treated as equity interests.” Read the full letter here.

---

Congratulations to Loretta Mester who was named this week as the next president of the Federal Reserve Bank of Cleveland! We thought this would be a good time to revisit her 2011 working paper with Joseph Hughes on scale economies at large banks.

Who Said Large Banks Don’t Experience Scale Economies: Evidence from a Risk-Return-Driven Cost Function
Joseph P. Hughes, Rutgers University, and Loretta Mester, Federal Reserve Bank of Philadelphia and the Wharton School, University of Pennsylvania

“Our results suggest that while reducing the size of banks would raise the costs of production holding output mix constant (the scale effect), once these banks adjusted their product mix, there would be cost savings. Whether this is socially beneficial, however, depends on whether the product mix offered by the largest banks was beneficial… We find evidence of large scale economies at smaller banks and even larger economies at large banks. Our results indicate that these measured scale economies do not result from cost advantages large banks may derive from too-big-to-fail considerations.” Read the full paper here.

---

Regulatory Reform, Stability, and Central Banking
By Paul Tucker, Harvard Kennedy School and Business School

“A distinction needs to be made between banking and capital markets. The core programme for reforming banking is coherent: reduce leverage, opacity and interconnectedness; improve liquidity; and transform resolvability. … The story is somewhat less compelling on the markets. There is less coherence, faltering vigour, and conflicting views about how different national regimes should apply to inherently international markets. Arguably there is also more time, but not much. Jurisdictions need to enrich the statutory objectives of their securities regulators, or endow macro prudential authorities with wide and flexible powers to take action to forestall threats to stability—whether structural or cyclical—from anywhere in the financial system.” Read the full paper here.

---

Structural Reform of the EU Banking Sector
By the European Commission

“Today’s proposals are the final cogs in the wheel to complete the regulatory overhaul of the European banking system. This legislation deals with the small number of very large banks which otherwise might still be too-big-to-fail, too-costly-to save, too-complex-to-resolve. The proposed measures will further strengthen financial stability and ensure taxpayers don’t end up paying for the mistakes of banks. Today’s proposals will provide a common framework at the EU level − necessary to ensure that divergent national solutions do not create fault-lines in the Banking Union or undermine the functioning of the single market. The proposals are carefully calibrated to ensure a delicate balance between financial stability and creating the right conditions for lending to the real economy, particularly important for competitiveness and growth.” Read the press release here. The full text of the proposed rule can be found here.

---

Industry Comment Letter on Proposed Liquidity Coverage Ratio Rule
By The Clearing House Association, American Bankers Association, SIFMA, Institute of International Bankers, International Association of Credit Portfolio Managers, Structured Finance Industry Group and Financial Services Roundtable

“We believe that the Basel LCR [Liquidity Coverage Ratio] strikes an appropriate balance between accurately capturing liquidity risk and the concerns raised by banks in their comments leading up to the Basel LCR with respect to, among others, the measurement of that risk and the scope of oversight and related compliance requirements. Consequently, we are concerned that the U.S. Proposal deviates so significantly from the Basel LCR. These deviations detract from the goals of clarity and transparency across markets, competitive equality, and minimizing opportunities for regulatory arbitrage and the potential balkanization of national markets. Moreover, in some cases the deviations are so fundamental that they would impede liquidity regulation and related disclosure as a Pillar III market-discipline tool and create substantial technological challenges for Covered Banks with international footprints.” Read the full comment letter here.

---

The Basel Committee’s Revised Leverage Ratio Relaxes Its Calibration Requirements, But Preserves Its Value
By Standard and Poor’s Ratings Services

“Under its final calibration, we believe the ratio remains a useful complement to risk-weighted metrics in the regulatory framework, and continues help identify outliers. However, despite some improvements in its calibration, we remain of the opinion that the excessive reliance on any single capital metric could lead financial institutions to ignore the build-up of specific risks. We consider it crucial that standard-setters maintain their focus on increasing the effectiveness of, and confidence in, regulatory risk-weighted capital ratios to avoid excessive reliance on the leverage ratio alone.” Read the full report here.

---

Why Was the Housing Bubble So Much More Damaging than the Dot.Com Bubble?
By Jared Bernstein, Senior Fellow at the Center on Budget and Policy Priorities

” Exploding debt bubbles just take a lot more time to mop up than equity bubbles. … But the point is that bubbles are deeply damaging. Some less so than others maybe, but even there, a longer term perspective of the lasting damage is sobering. No one’s saying we shouldn’t have a business cycle. They’re endemic. But there’s no reason why it has to be a shampoo cycle: bubble, bust, repeat.” Read the full post here.

---

Reviving the Reputation of Financial Innovation
Justin Schardin, Associate Director, Financial Regulatory Reform Initiative

“There is no definitive answer as to whether financial innovation is inherently beneficial. This is not only because of the difficulty in measuring and tying together the impacts of specific innovations, but also because of the inherent subjectivity of valuing outcomes. … Rather than seeing financial innovation as either inherently virtuous or predatory, we need to ask questions that help us analyze potential implications of any given financial innovation, and try to set up a structure that maximizes benefits and minimizes costs.” Read the full blog post here.

---

For more information on FRRI, including recent research and upcoming events, please visit https://bipartisanpolicy.org/projects/financial-regulatory-reform-initiative.