Two years after Lehman, risk of financial collapse is still high
By Mark Williams
The opinions expressed are his own.
Events unfolding in Europe — including Greece, Portugal, Spain, Italy, and most recently Ireland — are alarming reminders that systemic risk is the most pressing of this decade.
While itâ€™s been two years to this day since the death of Lehman Brothers almost brought down the entire financial system, global systemic risk — the chance that a single event or series of events can collapse the world financial system â€“ remains quite high.
In response to this threat, international banking regulators just approved higher Basel III capital requirements as a step in reducing global systemic risk. Banks with more capital are being forced to make more room to absorb losses, helping to increase economic stability. Under this tougher standard, banks need to maintain a minimum tier one (core) capital ratio of 4.5 percent, more than double the previous requirement.
As further risk mitigation, dividend and discretionary bonus payments will be restricted unless core capital ratio is 7 percent or higher. Unfortunately the phase-in period for these stronger capital standards is from 2013 to 2019. So this multi-year time gap allows for plenty of systemic risk to persist and grow.
Domestically, the Dodd-Frank Act passed in July also attempts to address systemic risk by setting up a Financial Stability Oversight Counsel (FSOC) made up of major financial firefighters like the Fed, SEC, FDIC, and the Treasury. For the first time, managing systemic risk and its impact on the economy is an official U.S. regulatory policy.
Under this Act, the Fed has the critical duty of monitoring systemic risk institutions, setting risk-management standards, and adding new firms to the watch list as they grow in size, complexity, and risk. But if we rely on the Fed’s previous track record, it is not up to this task.
Over the last decade the Fed allowed major banking institutions to overdose on risk. And in their newly expanded role, Fed field examiners are charged with an even greater role in risk mitigation. Unfortunately these examiners are inexperienced, undertrained and underpaid. There is a clear sophistication gap between the Fed and the major banks which they are charged with regulating.
At the Fed, examiners continue to be viewed as second-class citizens compared to the economists that help to divine monetary policy. Historically, the best and brightest have been driven away from this watchdog that is now supposed to shield us against growing systemic risk.
Given that the global financial stakes are high in getting this assessment correct, it is critical to fix the weak link at the Fed. To close the sophistication gap, more resources must be allocated to upgrade its examination force, training, and modeling tools.
The Fed also has to take a strong stand on higher capital standards. The new Basel IIIÂ rules for capital standards should be the minimum, not maximum, and the mandated phase-in period should be significantly shortened. In deciding the appropriate compliance date for these new rules, the Fed needs to balance the prospects of reduced bank lending and slower economic growth against economic instability caused by weaker capital standards.
In theory the FSOC model is a good first step in reducing systemic risk. But its oversight only covers a small part of the world. The list of the 30 top financial institutions posing the most systemic risk includes only four U.S.-based banks — Goldman Sachs, JP Morgan, Morgan Stanley, and Bank of America.
To effectively measure, monitor, and control this global threat requires international cooperation from the G20 countries. Adoption of Basel III capital standards helps to reduce cross-border regulatory risk, but cooperation in managing global systemic risk remains far from certain.
To increase the odds that a FSOC model will be adopted globally, the Fed must be a good role model and clean up its act. When a single company like Lehman or a country like Greece can distrupt the global economy, working together with other nations on standardized global banking regulation becomes mandatory.
The FSOC structure and Basel III requirements are a smart start in attacking such risk, but much remains to be done. The Fed should lead this mission and persuade other nations to follow — but it first must earn back the worldâ€™s respect.
Mark Williams, a former Federal Reserve Bank examiner, teaches finance at Boston Universityâ€™s School of Management and is author of â€śUncontrolled Risk: The Lessons of Lehman Brothers and How Systemic Risk Can Still Bring Down the World Financial System.â€ť