‘Critical mission’: Janet Yellen unwinds Trump’s financial deregulation

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Late last week, the Biden administration tore up a key piece of its predecessor’s financial deregulation, giving itself the authority to investigate non-bank institutions and designate them as systemically important.

The Financial Stability Oversight Council (FSOC), which sits above other US financial regulators with a mandate to identify systemic risks and is chaired by Treasury Secretary Janet Yellen, agreed last Friday to adopt a new framework for identifying potential risks to financial stability and outlined its procedures for designating individual entities identified as systemically important.

US Treasury Secretary Janet Yellen is tightening the rules for non-banks, saying financial stability is a public good.Credit: Reuters

It is a reversal of the decision by the Trump administration in 2019 which, amid a raft of deregulatory decisions, unwound some of the key measures within the highly regulatory Dodd-Frank Act enacted during the Obama administration in response to the 2008 financial crisis.

The Biden administration’s decision sets the scene for a fight with the big end of the non-bank sector, which opposes the council’s changes to its framework because of the increased scrutiny and the potentially increased costs they would face.

The changes would add a new dimension to the existing activities-based, whole-of-system approach to assessing risks within the US financial system by enabling the council to single out individual organisations for scrutiny and, if it were determined that they were “too big to fail,” bring them under the direct supervision of the Federal Reserve Board and impose prudential standards on them.

Yellen said on Friday that financial stability is a public good and there needed to be a robust structure to monitor and address the built-up risks that could threaten the financial system.

“Congress created FSOC after the global financial crisis to identify and respond to risks to financial stability, and our actions today go to the heart of fulfilling that critical mission,” she said.

What is often called the shadow banking sector is populated by giant hedge funds, asset managers, private equity firms and insurance companies, with little transparency as to what they are doing or what risk their activities might pose for the wider system.

US financial regulators have become increasingly concerned that, as banks have become more stringently regulated, more and more financial activity is being conducted outside the regulated sector by increasingly large non-bank institutions.

What is often called the shadow banking sector is populated by giant hedge funds, asset managers, private equity firms and insurance companies, with little transparency as to what they are doing or what risk their activities might pose for the wider system.

Earlier this year, for instance, US and global regulators became concerned about a leveraged trade in the US Treasuries market, where hedge funds were buying Treasury notes with funds borrowed in the short-term funding market and using the notes as security for equivalent short positions in the futures market.

The regulators were fearful that, in a market that has been volatile this year, the hedge funds could be caught out in a fashion similar to what occurred in the UK bond market last year, when the entire UK pension fund sector nearly blew up after bond yields soared in response to a misconceived (and very short-lived) mini budget announced by (the equally short-lived) then-prime minister Liz Truss and her chancellor, Kwasi Kwarteng.

The surge in yields exposed a derivatives trade used by UK insurers to hedge their liabilities, triggering a series of margin calls, the dumping of physical bond holdings to generate cash and a destructive and self-fuelling cycle that could have wiped out the pension funds and destabilised the entire UK financial system.

That episode and the regional banking crisis in the US earlier this year, when a surge in bond yields caused paper losses for smaller banks (who, unlike systemically important US banks – and all Australian banks — don’t mark the value of their bonds to market) and left them exposed to depositor runs, heightened the interest of US regulators in the regional banking and non-bank sectors.

Lack of transparency

It is worth noting that the Trump administration effectively removed the “systemically important” tag from three big US insurers – Prudential Financial, American International Group and MetLife – and GE Capital. While insurance sector lobbyists have argued that life insurers aren’t a source of systemic risk, the experiences of 2008 and in the UK last year would argue otherwise.

Certainly, the lack of transparency, the amounts of leverage, the use of both debt and derivatives to supercharge leverage – some of the “relative value” trades earlier this year were leveraged more than 70 times, according to the Bank for International Settlements – produce a powerful argument for, at the least, regulators having better insights into what hedge funds and other non-banks are doing.

To label a particular organisation as systemically important will involve a lengthy and cumbersome process, particularly if the entity involved is uncooperative. It could take a year or more between identifying the company as a potential risk and designating it as a systemically important financial institution.

Apart from the concerns about systemic stability, there is also the issue of an uneven playing field.

Banks are intrusively regulated, and the eight major US banks are really intrusively regulated and restricted from some activities, while the mega-non-bank hedge funds, asset managers, private equity firms and insurers can do bank-like things without regulatory boundaries, prudential requirements or any real transparency.

Shifting risks from the strongly supervised parts of the system to its shadowy corners might reduce the concentration of risks and distance them from the cores of financial systems, but it doesn’t eliminate them.

Commercial real estate risks

The other significant item on the FSOC’s agenda on Friday was a discussion about the state of US commercial real estate markets, where property values have been falling and, in some instances, plunging.

With prices down materially and financing costs up significantly, there are rising risks for institutions – particularly the regional banks that do most of the bank lending for commercial real estate and the asset managers active at the big end of the commercial property sector – exposed to that market.

The pressures developing in the property market are a reminder that, when financial conditions tighten and rates have risen quite rapidly, risks to organisations and the system also increase and have the potential to produce unintended and unforeseen stresses within the financial system.

In circumstances where after a decade and a half of loose monetary policies the Fed and its peers have tightened financial conditions considerably within a very short period, it makes sense that the regulators should increase the intensity of their supervision and broaden their gaze to include the potentially systemically important non-banks that now dominate such large segments of the global financial system.

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