April 22, 2015

Regulation In the Form of Big Bank Coercion

Hester Peirce

Former Senior Research Fellow
Summary

One of Dodd-Frank's aspirations was increased competition to dilute the power of large financial institutions. The status quo, however, plays right into impatient regulators' hands. It's easy to force changes in the global financial industry by nudging-gently or otherwise-large banks to fall in line with regulators' wishes. Bank regulators are not shy about exercising this kind of control. As convenient as such regulatory strong-arming might seem to be, it sidesteps the regulatory processes designed to ensure accountability, public input, and transparency.

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One of Dodd-Frank's aspirations was increased competition to dilute the power of large financial institutions. The status quo, however, plays right into impatient regulators' hands. It's easy to force changes in the global financial industry by nudging-gently or otherwise-large banks to fall in line with regulators' wishes. Bank regulators are not shy about exercising this kind of control. As convenient as such regulatory strong-arming might seem to be, it sidesteps the regulatory processes designed to ensure accountability, public input, and transparency.

The most recent example-reported last week by the Wall Street Journal-is an effort to force contractual changes in securities lending and repurchase (repo) agreements. These short-term borrowing arrangements among financial institutions can aggravate liquidity demands during periods of financial stress. As the Journal's Katy Burne reports, if regulators get their way, "firms trading with a troubled financial institution would agree to temporary waivers of certain contractual rights they currently enjoy, such as the ability to terminate their contracts early, buying regulators and the firm time to arrange a lifeline."

The Financial Stability Board (FSB), a fraternity of financial regulators from different countries, is behind the latest effort. The FSB concocts global regulatory prescriptions for the financial industry. Although the FSB lacks the authority to directly regulate private companies, its members dutifully apply FSB prescriptions in their home countries. The FSB uses a peer review system to ensure follow through. The FSB explains that it "operates by moral suasion and peer pressure, in order to set internationally agreed policies and minimum standards that its members commit to implementing at national level."

U.S. regulators typically adopt regulations that include the FSB standards. The rulemaking process, however, requires regulators-before adopting rules-to solicit and consider public input and to think methodically about whether and how rules will work.

The FSB and its member regulators apparently find these administrative processes tiresome. So they have embraced "voluntary" agreement approach pursuant to which industry members embed FSB prescriptions in their private contracts. No need to bother with rules if all the big banks fall into line without a drop of rulemaking ink being spilt.

The relatively small number of key players in important global financial markets make such non-rulemaking rulemaking possible. Trade groups that represent these banks make the task even easier. Banks and their trade groups have little choice but to work to implement regulators' demands and to smile all the while.

The FSB used such an approach last fall when it arranged for the International Swaps and Derivatives Association to change its standard contract to prevent parties to derivatives contracts from terminating their contracts with a financial institution that regulators are trying to resolve. Mark Carney-Governor of the Bank of England and head of the FSB-explained that the 18 bank signatories covered 90 percent of the derivatives market. Convening 18 banks in a trade association backroom and telling them what to do is a lot easier than inviting everyone, including nonbanks, to hash out rules in a public rulemaking process.

There is nothing wrong with regulators and firms thinking creatively, cooperatively, and globally about how to increase financial stability. The changes effected in the contractual agreements may help to keep markets functioning during future financial crises.

But FSB-orchestrated strong-arming of big industry players to modify private contracts is no substitute for legislation or, when appropriate, orderly rulemaking conducted in the public eye. All interested parties deserve an opportunity to raise concerns about major regulatory initiatives, as does Congress-to which financial regulators are supposed to be accountable.