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Jakob Wilhelmus
Senior Research Analyst, International Finance and Macroeconomics Research
Capital Flows and Finance and Regulation and Systemic Risk
Jakob Wilhelmus is a senior research analyst in international finance and macroeconomics at the Milken Institute. He studies topics relating to systemic risk, capital flows, and investment. Concentrating on market-level information, his work focuses on identifying and analyzing financial data to produce a better understanding of the behavior and underlying...
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Reality Check: Financial Regulation Faces a Stress Test

By: Jakob Wilhelmus
January 23, 2017
   
   

Since the advent of the Great Recession—the most severe financial crisis since World War II—there has been much discussion of financial regulation, from the extent of its reach to the intricacies of its implementation. Almost a decade after the crisis, it seems that the new policy framework will soon encounter its first real test. Up until now, markets have operated on the foundation of a stable and predictable zero-interest-rate regime. But the rising rates that are anticipated will beget a much more complex post-crisis financial system whose nature is not entirely understood. The new Trump administration’s plan to repeal large parts of the Dodd-Frank Act, which was intended to boost capital market resilience, promises to heighten the uncertainty.

The End of Easing

After the collapse witnessed in 2008, amid the debates about optimal monetary and regulatory policy, there was one principle almost everyone agreed on: Markets needed support and central banks had to do whatever it took to stabilize the economy.1 As time passed, however, with the persistence of the zero-rate environment and investors’ search for yield, views began to change, and in December 2015, the Federal Reserve timidly moved away from the lower bound.That was initially thought of as the start of a series of moves, but the Fed—constrained by an unhappy new year for markets and mixed economic fundamentals—delayed a second hike until December 2016.

Figure 1: The Federal Funds Rate Since 1975

Screenshot 2017 01 23 15.04.24

Source: Federal Reserve.

For financial institutions and regulators alike, this will be the first robust test of the many regulations that originated in the crisis. It is certain to produce insights into the new framework’s effects on both the functioning of the markets and their resilience. Until now, due to the markets’ reliance on the actions of central banks, including quantitative easing and the prolonged maintenance of rock-bottom short-term rates, there was little danger of major disruption. In 2017, it is uncertain how the changing market structure—for example, money market fund regulation has caused a pivot from prime retail funds to government funds (see Figure 2)—will evolve in an environment that is no longer dominated by monetary policy. The U.S. economy is still in the midst of a slow recovery, and unexpected adverse developments (high corporate debt and potential market liquidity issues are among the risk factors) could spiral it back into recession. Adding to this, regulators will have to simultaneously look out for possible systemic risk surges stemming from asset managers and clearinghouses—beyond the more stringently monitored banking sector.

Figure 2: U.S. Money Market Funds by Category

graph1

Note: All prime and institutional tax-exempt funds are shown as Prime Retail. Government funds (with and without fees and gates) are shown as Government.
Source: Treasury Department. 

Dodd-Frank: As Strong as the Weakest Link

The second issue is that while a lot has changed in financial regulation, there are still many rules—as of July 2016, only 70 percent of proposed Dodd-Frank rules had been finalized3—to be implemented and agreements to be made.Furthermore, the leaders of the regulatory establishment exert significant impact in how they interpret existing rules. In the coming weeks, most U.S. regulatory bodies will see rotation at the helm, as occurs in any transition of power. In fact, President Trump will appoint three of the five commissioners at the top of the Commodity Futures Trading Commission and the Securities and Exchange Commission. At the same time, seven of the 10 Financial Stability Oversight Council members are set to change.5

Figure 3: Positions at Key Regulatory Agencies

CFTC – 3 out of 5
SEC – 3 out of 5
FSOC – 7 out of 10

 J. Christopher Giancarlo
(Acting Chairman)

Kara M. Stein
(Term until 2017)

Janet L. Yellen
(Fed)

Sharon Y. Bowen

Michael S. Piwowar

Richard Cordray
(CFPB)

**Open**

**Open**

S. Roy Woodall, Jr.
(Independent)

**Open**

** Open**

Rick Metsger
(Open Aug. 2017)

**Open**

**Open**

Thomas J. Curry
(Open Apr. 2017)

 

 

Martin J. Gruenberg
(Open Nov. 2017)

 

 

**Open**
Chair of the SEC

 

 

**Open**
Chair of the CFTC

 

 

**Open**
Director of FHFA

 

 

**Open**
Secretary of the Treasury 

 

While there has been talk about repealing Dodd-Frank altogether,recent developments appear to suggest a less disruptive approach that will concentrate on regulatory relief that would reduce compliance costs for many smaller banks.7

The resilience of the current oversight framework is yet unknown, but in a year likely to be filled with wild cards—new political leadership, a changing monetary policy stance, and a potential regulatory makeover—it will have its first real stress test. Caution is warranted. Adding a big dose of uncertainty will not help us achieve economic growth and financial resilience, but rather could stir a toxic cocktail for the global economy and financial system.


4 Lopez and Saedinezhad, “Washington, We Have a Problem.”

5 Depending on court rulings, the number could increase to eight.

7 See Lopez and Saedinezhad, “Financial Deregulation: repeal or Adjust?


Comments

  • It is unbelievable that the financial regulations will be overthrown with little consideration and analysis of the long-term impact of eliminating the provisions that have created a safety net for future risk management

    Posted by Alan, 02/06/2017 (10 months ago)


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