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In our recent paper on trade in financial services, FedFin laid out ways that protectionist U.S. actions affecting trade in goods could metastasize into financial services.  We missed a critical issue laid out Thursday in a Wall Street Journal op-ed by former Senate Banking Committee Chairman Phil Gramm.  In it, Mr. Gramm works through how the GOP border-tax adjustment would affect the value of the dollar, concluding that the forecasted 25% increase would have profoundly adverse consequences across the spectrum of U.S. trade and tourism.  I add finance to the border tax’s hit list.  Any rise in the dollar of this magnitude – especially when it’s the result as it is here of artificial political, not market forces – would lead to boom-bust cycles in global finance just as surely as it would create cyclical firestorms in manufactured-goods trades.  The last burst of financial-market procyclicality didn’t work out so well; this one would make that look like a warm-up.

Mr. Gramm’s op-ed lays out well how a border tax creates boom-bust cycles for imports and exports in goods.  This would also be the case in finance, although the dynamics would be directionally different because, with the exception of insurance, the U.S. runs a sizeable trade surplus in cross-border financial services.  Finance is, though, even more affected by changes in the value of the dollar because the dollar isn’t just a currency in financial transactions on which pricing is based; in finance, moving the money is what the business is all about. U.S. monetary policy also sweeps across the globe in relentless fashion in ways no other U.S. trade policy can match.

Think about what has already happened with a strong dollar.  Once a small, if profitable bailiwick for sophisticated financiers, the “carry trade” is now the way everyone tries to make money.  Capital moves not for fundamental economic reasons, but rather because a strong currency provides disproportionately high return, a strategy with particular potency – not to mention risk – when home-country interest rates are deep in negative territory.  U.S. financial companies pack a punch in the opposite direction – one reason for the trade-in-financial services surplus. 

So far, this is roughly similar to what happens to trade in goods when the dollar appreciates – business moves in response to currency valuations, waxing and waning  or – when valuations are distorted – ebbing and flowing with tsunami-like force.  These foreign-exchange flows in finance pose their own procyclical risk, but the chances of a dangerous negative feedback loop rise when the financial-stability impact of financial procyclicality amplifies macroeconomic booms and busts.

Think for example about bank capitalization. Every loan made by a foreign bank in the U.S. costs it capital.  If this capital is housed in a parent-bank branch, cool – the dollar loan is backed by weak-currency capital, essentially a double-leverage play.  Conversely, if the loan is booked in an intermediate holding company, then a dollar of capital backs the risk-weighted asset, disproportionately draining parent-bank resources because dollar-denominated capital costs it so much.  Given the role of capital and credit, exchange-rate driven differences have clear macroeconomic impact, impact that could easily turn damaging if the border-tax adjustment is far from smooth (as seems likely). 

A still more profound challenge arises when one considers how an artificially-strong dollar affects foreign-bank holdings of excess reserves and asset-management company trade through the reverse repo program.  As the Fed itself has acknowledged, a high dollar value is a de facto interest rate increase, and it’s thus one reason foreign banks now hold such huge balances in excess reserves.  A rise in the dollar’s value in concert with continuing slow growth and negative rates back home will turn foreign-bank floods into the Fed into torrents. 

At the least, this will cost the Fed billions more in interest on excess reserves – payments that make IOER still more of a risky political liability.  At worst, though, huge funds in Fed excess reserves will alter the way they now serve as the boundaries for FRB interest-rate signals, widening the divide between the interest rates the Fed wants and those set by the market at greater risk to inflation and, yes, procyclicality.

The Federal Reserve Bank of New York’s blog today might seem to offer a comforting thought.  It suggests that the border-tax adjustment won’t spike the value of the dollar because it simply won’t work – so many trades are now dollar-denominated that all the tax would do is – I paraphrase here – screw things up some more.  This could well be true for trade in goods, but I’m far from certain the same holds for trade in financial services because far less of it is dollar denominated.  Thus, we could well get the worst of all possible worlds – a border-tax adjustment that still creates procyclicality by undermining U.S. exports in concert with acute distortions in the flow of capital that undermines financial stability and muzzles U.S. monetary policy.

As we review the GSEs’ 4Q earnings, we reiterate our prior conclusion:  for all of the efforts of the firms’ boards and management, they cannot control their destiny but only do the best they can with the magical construct demanded for U.S. mortgage securitization following eight years of inaction on substantive reform.  Some quarters, things will go well when all is right with the GSEs’ derivatives books; some quarters it won’t.  At no time will the GSEs have a sustainable business model since there are neither sufficient operating earnings nor a robust capital base.  Without these, the GSEs can do nothing but generate still more risk given the continuing dependence of the entire economy on agency securitization.

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It’s hard to find anyone who isn’t for regulatory cost-benefit analysis (CBA). Indeed, Chair Yellen appeared to endorse it at least in principle when she agreed earlier this week with the Trump Executive Order. However, the Trump plan is striking in espousing what may well be a substantive approach to CBA instead of the formulaic analyses the FRB to date has deployed to defend its rules from CBA advocates. The President’s Executive Order eschews the platitudes of cost-benefit analysis instead to call for “efficient, effective, and appropriately tailored” rules. This is the right way to go about CBA, but it’s also a lot harder to do than simply toting up the easiest costs one can find against the most unqualified benefits that could be attributed to a rule and allowing a regulatory edict to fly through a cost-benefit analysis without a scratch. Specifics from the Trump regulatory review about meaningful CBA would make a major difference in the post-crisis framework without materially undermining it. Here’s how to make it happen.

In 2012, FedFin issued a report laying out the challenges we saw then to simple CBA. Then as now, many in the industry were pushing for CBA not only because they hoped it would make the burden of new rules less crushing, but also because it gives opponents a large hook from which to suspend rules they want dead -- ask the SEC about its proxy-access rule. However, what one means by CBA determines how much it makes a difference.

Much to the annoyance of CBA advocates, the FRB is not under the SEC’s express CBA requirements. It thus has a lot more latitude to count costs and benefits as it likes. Numerous rules – check out for example the GSIB surcharge and TLAC – bear evidence to the fact that the FRB’s approach to CBA makes everything it does seem all the better. Other bank regulators approach CBA in a still less sophisticated way. For example, when the OCC comes before OMB to argue that its rules do not have significant economic cost, it often counts as costs only all the new forms a rule requires or systems it mandates, not looking past policies and procedures to assess whether any bystanders such as borrowers might get hurt by the strategic adjustments a bank makes to handle the real costs of a new capital or prudential requirement. There aren’t any costs, so goes this type of CBA, because banks adjust to them and thus the bank bears no cost to speak of.

To counter these never-lose CBAs, the Hensarling CHOICE Act includes a very different approach to CBA. It requires a massive, double-diligent calculation of every possible cost at every stage of implementation for every affected institution, market, and economy. This as intended would stifle any and all new financial regulations.

Is this what every banker burdened by all the post-crisis rules should fervently desire? I don’t think so. All rules are not the devil’s handiwork. It’s of course tempting to put a pitchfork on the post-crisis rules, but over-burdensome CBA without meaningful results will not lead to the efficient, effective, and tailored framework rightly sought by the Executive Order. New rules that could be caught in the CBA quagmire could otherwise replace older ones with clearer standards that retain prudential rigor but add more certainty and clarity. Others are needed to replace anachronistic standards with innovative rules that reflect technological and market change. Sure, one could simply eviscerate the entire rulebook and let the market rip, but I’m not sure bankers would love so wild a market nor, for that matter, might the rest of us.

So, how to do meaningful CBA? First, it has to be marginal – that is, one has to look not at each new rule as a thing in and of itself, but rather as a thing intimately intertwined with many other like-kind things. How many capital rules do banks really have to have? How well do all the new resolution plans ensure meaningful market discipline that then warrants regulatory relief? Does stress testing counterparty exposures mean there is little marginal value to single-counterparty credit limits? And, how many other rules could be made more efficient and effective as President Trump demands if they are better tailored not just to the size of the company subjected to them, but also to the purpose for which they are intended?

Marginal CBA would make a big different within the body of rules, but meaningful CBA must also recognize that costs can’t be borne by one part of a market without undue benefit to competitors unless these costs are evenly distributed among like-kind companies. Many new rules nominally subjected to CBA conclude that all of their costs are worth it because the rule means less chance of a systemic crisis. And, if I stay in bed, I’ve less chance of getting hit by a bus. However, I’ve also a lot more of a chance of getting bedsores, fat, and very bored by watching too much TV. Making banks very, very safe keeps them from running amok, but it clears a path for competitors who, absent like-kind rules, almost surely will. So much for less systemic risk.

Finally, meaningful CBA must assure that any rule that passes the first CBA rounds described above can also be effectively enforced first by internal management and, should that fail, by regulators or the courts. All too many of the rules I read focus far more on mandating one after another policy and procedure each and every level of a company has to put in the great big loose-leaf binder plopped every quarter before an increasingly exhausted board of directors. Even worse, many new rules focus to an astonishing extent only on policies and procedures and/or complex, often-untested models. Do banks and their boards know what’s expected of them in substance, not just form? How about examiners? If compliance means filling out a lot of forms or back-testing a bunch of models, not achieving defined prudential goals that can be validated over time through objective criteria, do we know how safe a bank really is even if it’s in full compliance with everything each of its regulators throws at it?

In short, CBA is no guide to quality regulation unless it tells us whether one more rules make a meaningful prudential difference, if a new rule on one part of the market has consequences elsewhere that frustrate the rule’s objectives, and if the rule has measurable mandates that mean more than yet another big file of still more filled-out forms. If that’s what Mr. Trump has in mind, bring it on.



As anticipated, today’s hearing with House Financial Services was considerably more contentious than the Senate Banking session (see Client Report FEDERALRESERVE34), with Chair Yellen taking a still more assertive stand in the face of stronger and often more partisan criticism.  Although House Republicans share concerns about the FRB’s portfolio with their Senate colleagues, Chairman Hensarling (R-TX) reiterated also that he believes that payments by the Fed of interest on excess reserves (IOER) are illegal.  A recent FedFin paper addresses this question and broader IOER issues clearly now on the FinServ agenda.

The full report is available to retainer clients. To find out how you can sign up for the service, click here.