At the daylong conference on the Dodd-Frank Act sponsored by the Center for Law, Economics and Finance of the George Washington University (GWU) Law School, a panel of experts presented their views as to what might be the source of the next episode of the crisis.
Scheherazade Rehman, a professor of business/finance and international affairs at GWU, led off by suggesting that it is not difficult to predict that the next crisis will be spawned by the eurozone and that the crisis has moved beyond Greece to Italy and Spain. She added that for the time being, a sense of “calm” has set in due to the actions taken by European Central Bank President Mario Draghi to implement an EU form of the Federal Reserve’s quantitative easing program and crisis management.
The European Union is also committed to the establishment of a single agency to supervise its banks. However, the EU is determined that taxpayers in rich countries not support the rescue of failing banks in poor countries (this is exactly what U.K. Prime Minister David Cameron assured Parliament last week).
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Rehman questioned whether the problem has receded significantly or only temporarily, and she pointed to the Italian elections next May as a sign of the answer as to whether what is now a liquidity problem could mature into a solvency problem for the European Union.
Anna Pinedo, a partner in Morrison & Foerster, chose derivatives regulation as a likely source of instability, because they accentuate the interconnectedness of markets, and the Commodity Futures Trading Commission has been trying to implement Title VII of Dodd-Frank without a comprehensive plan to do so, leaving those rules that have been finalized with gaps and ambiguities. She referred to the European Union’s Markets in Financial Instruments Directive and the European Markets Infrastructure Regulation as the EU counterparts to Title VII and stressed that the U.S. and EU systems are different. She also noted that the European Union has yet to finalize margin rules and declared that “there’s no harmonization whatsoever between the U.S. and EU architectures for derivatives regulation.”
She also pointed out that whereas central clearing has been put forward as a panacea for controlling risk, it actually has the potential to create a new set of risks, because the entities that perform the clearing function could turn out to be shadow banks that concentrate risk and present new risk management challenges, including lack of legal certainty, a host of technology issues and the lack of a support mechanism to mitigate runs or resolve failed entities.
Karen Shaw Petrou, a managing partner at Federal Financial Analytics, recited the litany of crises that have occurred every couple years since the 1994 crisis in Mexico, and she identified for each of them the risks they entailed, whether it was complexity risk or operational risk. The solution she recommended is a “balanced regulatory structure,” and she complained that while there are global capital rules, there is no single set of accounting standards and no coordination of protocols for responding to crisis episodes.
Petrou called for the FDIC’s Orderly Liquidation Authority to be implemented in a “robust” manner and for the regulators to be held accountable for how well they apply these rules, and she stressed the need for new capital and liquidity rules and new standards for operational risk.
One might ask, if all of these rules and standards and protocols have never been put in place during all the decades of the financial crises, why would anyone think this is about to happen anytime soon.
The next speaker, the star of the panel, Simon Johnson of MIT, stated on this panel as well as a recent Milken Institute panel that there is no prospect of adoption of needed cross-border arrangements for crisis resolution within the span of the careers of anyone working today or even those of their children. He stated succinctly that as to the source of the next episode, no one knows and no one has known in the past what was coming. He positioned himself to the pessimistic side of Rehman, because Italy will have to restructure 2 trillion euros of debt.
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Finally, Johnson concluded, “We aren’t ready, our financial system is not ready and we have not gone far enough with financial reform.” He warned that the $2.2 trillion size of JPMorgan Chase would actually be close to $4 trillion under the International Financial Reporting Standards. In contrast to federal authorities and industry spokesmen who have touted improvements in the capital strength of the industry, Johnson lamented the small amount of capital in the global financial system and added that more resilience is needed in order to withstand the stress.
He called industry arguments that new regulations threaten economic growth “an illusion and a distraction” and warned “the real danger is that the largest banks will become bigger and blow themselves up. Next time it could be much greater.”
Robert Feinberg served on the staff of the House Banking Committee for the 10 years that encompassed the savings-and-loan debacle and the beginning of its migration to the banking sector. Subsequently, he has consulted on issues related to the crisis for law firms, accounting firms, securities firms and trade associations.
Feinberg holds a BS.E. from the Wharton School and a J.D. from the Law School of the University of Pennsylvania. He has drafted dissenting views on landmark banking legislation, contributed to a financial blog and written hundreds of reports for clients to document the course of the financial crisis as it has unfolded over the past three decades.
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