Tag Archives: Volcker rule

Banks Should Know Their Investment Risks

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Nathaniel Zumbach

The latest issue of the Federal Deposit Insurance Corporation’s Supervisory Insights (Devoted to Advancing the Practice of Bank Supervision) has an esoteric, but important article on Bank Investment in Securitizations: The New Regulatory Landscape in Brief (starting on page 13). The article opens,

The recent financial crisis provided a reminder of the risks that can be embedded in securitizations and other complex investment instruments. Many investment grade securitizations previously believed by many to be among the lowest risk investment alternatives suffered significant losses during the crisis. Prior to the crisis, the marketplace provided hints about the embedded risks in these securitizations, but many of these hints were ignored. For example, highly rated securitization tranches were yielding significantly greater returns than similarly rated non-securitization investments. Investors found highly rated, high yielding securitization structures to be “too good to pass up,” and many investors, including community banks, invested heavily in these instruments. Unfortunately, when the financial crisis hit, the credit ratings of these investments proved “too good to be true;” credit downgrades and financial losses ensued.

In the aftermath of the financial crisis, interest rates have remained at historic lows, and the allure of highly rated, high-yielding securitization structures remains. Much has been done to mitigate the problems experienced during the financial crisis with respect to securitizations. Congress responded with the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), and regulators developed and issued regulations and other guidance designed to increase investment management standards and capital requirements.

The gist of these new requirements is simple: banks should understand the risks associated with the securities they buy and should have reasonable assurance of receiving scheduled payments of principal and interest. This article summarizes the most pertinent of these requirements and provides practical advice on how the investment decision process can be structured so the bank complies with the requirements.

The guidance and regulations applicable to bank investment activities reviewed in this article are: „

  • Office of the Comptroller of the Currency (OCC): 12 CFR, Parts 1, 5, 16, 28, 60; Alternatives to the Use of External Credit Ratings in the Regulations of the OCC;
  • OCC: Guidance on Due Diligence Requirements to determine eligibility of an investment (OCC Guidance);
  • Federal Deposit Insurance Corporation (FDIC): 12 CFR Part 362, Permissible Investments for Federal and State Savings Associations: Corporate Debt Securities;
  • FDIC: 12 CFR Part 324, Regulatory Capital Rules; Implementation of Basel III (Basel III); and  „
  • FDIC: 12 CFR Part 351, Prohibitions on certain investments (The Volcker Rule).

As financial institutions move into an investment world where relying on credit ratings from third party providers is not longer sufficient, the advice in this article is welcome. One wonders though what the consequences will be, if any, for those who do not follow it.

Romano’s Iron Law of Financial Regulation

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Roberta Romano has posted an essay, Further Assessment of the the Iron Law of Financial Regulation:  A Postscript to Regulating in the Dark, to SSRN. The abstract reads,

In an earlier companion essay, Regulating in the Dark, I contended that there is a systemic pattern in major U.S. financial regulation: (i) enactment is invariably crisis driven, adopted at a time when there is a paucity of information regarding what has transpired, (ii) resulting in off-the-rack solutions often poorly fashioned to the problem at hand, (iii) with inevitable flaws given the dynamic uncertainty of financial markets, (iv) but arduous to revise or repeal because of the stickiness of the status quo in the U.S. political framework of checks and balances. This pattern constitutes an “Iron Law” of U.S. financial regulation. The ensuing one-way regulatory ratchet generated by repeated financial crises has produced not only costly policy mistakes accompanied by unintended consequences but also a regulatory state whose cumulative regulatory impact produces over time an increasingly ineffective regulatory apparatus.

This Postscript analyzes the experience with regulators’ implementation of Dodd-Frank since the publication of the earlier essay. After a discussion of broad issues related to the statute and its implementation, the analysis focuses on two provisions by which Dodd-Frank exemplifies the difficulties that are created by legislative strategies conventionally adopted in crisis-driven legislation, off-the-rack solutions along with open-ended delegation to regulatory agencies as legislators, who perceive a political necessity to act quickly, adopt ready-to-go proposals offered by the policy entrepreneurs to whom they afford access: the Volcker rule, which prohibits banks’ proprietary trading, and the creation of the Consumer Financial Protection Bureau. The analysis bolsters the original essay’s contention regarding the inherent flaws in major financial legislation and the corresponding benefit for improving decision-making that would be obtained from employing, as best practice, the legislative tools of sunsetting and experimentation to financial regulation. The use of those techniques, properly implemented, advances means-ends rationality, by better coupling the two, and improves the quality of decision-making by providing a means for measuring and remedying regulatory errors.

This is a foray into the dark heart of financial regulation. Romano finds much to be unhappy with. I disagree, however, with some of her main points. For instance, I think that her assessment of the role of the CFPB in the broader context of financial regulation misses the mark. She argues that the “absence of a designated consumer-product regulator” did “not contribute to the financial crisis.” (28) In fact, regulating exotic loan terms like Option ARMs and teaser rates would have slowed the expansion of the subprime market. Those exotic terms allowed lenders to keep the party going longer than it would have otherwise. And that would have limited the exposure of financial institutions to subprime mortgage-backed securities.

Notwithstanding my disagreements with this essay, I think that Romano’s “Iron Law” of financial regulation remains, unfortunately, quite strong.