Over the past week, some in Washington and the media have seized on headlines to further their philosophical views devoid of the facts and irrespective of the current legal and regulatory framework. Before calling for broad and sweeping prescriptions that could have long-term negative effects on economic growth, we first need to find out exactly what happened.
Things have improved dramatically since 2008. Congress, regulators and banks have materially improved the safety and soundness of our financial system. U.S. financial firms have raised more than $300 billion of common equity. The largest U.S. banks have reduced their average leverage ratio from 16-1 to 11-1 and increased loan loss reserves by about 200 percent. More than 90 percent of the Troubled Asset Relief Program capital infusion funds into banks have been repaid, with interest, dividend and warrant sales for a profit of $19 billion to the taxpayers, to date. The Federal Deposit Insurance Corp. and the Bank of England are making real progress on plans to resolve banks and end “too big to fail” in the two largest markets.
In the latest round of stress tests conducted by the Federal Reserve, the nation’s largest banks were subjected to conditions far worse than what has been reported in the news recently. Nearly all the banks were shown to be able to absorb such losses and remain well capitalized. The system is far safer and more resilient than it was four years ago, a fact that cannot and should not be ignored.
In the midst of Dodd-Frank implementation, it is vital that regulators focus on crafting responsible and workable reforms that will stand the test of time. Using a seemingly isolated event and moving forward, far too quickly, with highly complex regulations in a rushed and political manner might satisfy pundits, but it is almost certain that it won’t serve the long-term strength of the nation’s financial system and its economy.
Risk cannot be entirely legislated or regulated out of the financial system. Risk is part of the system; it has to exist for small businesses and families to get loans and for markets to be made for different assets on behalf of clients. In fact, some of the riskiest activities a bank can undertake is the simple extension of a line of credit or a mortgage.
More than any other set of regulations, it is critical to the financial system that the Volcker rule is done right to ensure the continued efficient functions of financial markets.
The Volcker rule was meant to address proprietary trading solely for a firm’s own profit, while appropriately exempting market-making and hedging activities. The Dodd-Frank Act recognizes that macro or portfolio hedging is permitted and the statute specifically says, “Risk-mitigating hedging activities are designed to reduce the specific risks to the banking entity.” This type of hedging is standard practice for banks trying to manage interest rate, liquidity and credit risks.
It is not a “loophole.” It is a reasonable and important policy choice that does not diminish the core restrictions of the Volcker rule. Regulators understand this and also understand that portfolio hedging is a core part of safety and soundness.
In the coming months, regulators will finalize the Volcker rule, and it will be vital for them to address what are permitted activities — particularly market-making and hedging activities — and those that are not.
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