Market Analysis

Regulatory Vagary’s Real Life Impact

Regulatory uncertainty has real costs.

Trivia time! What is the primary reason the Fed was created in 1913? Many today will probably say, "to balance employment and inflation!" But this is only the Fed's congressional mandate tied to 1978's Humphrey Hawkins Act.[i] The Federal Reserve was actually created to act as lender of last resort-the backstop to forestall the 19th and early 20th centuries' endemic bank runs. With that in mind, we noted how odd it was that 11 banks failed the Fed and FDIC's "living wills" test last August in part for presuming the Fed would be available as lender of last resort via the discount window. Both sides charged each other with being vague, and a big, mostly academic squabble broke out. However, the lingering regulatory vagary has prompted some banks to treat a hypothetically absent Fed as a potential reality, and they warn it could shrink credit supply. While this isn't a big threat for investors today, given the cyclical factors supporting lending, it shows how regulators' behavior can impact the business world, even if they don't pass rules.

As a refresher, "living wills" originate from a provision in 2010's Dodd-Frank Act requiring banks to submit annually a plan for the "rapid and orderly resolution in the event of material financial distress or failure of the company." Regulators claim living wills will help them unwind a large failing financial institution by mitigating uncertainty, unlike 2008.

In our view, this is a solution in search of a problem. For one, the next financial crisis probably won't look like the last one. A living will based on a crisis borne from regulation requiring banks to mark illiquid assets to a non-existent market price against a backdrop of fear seems a wee bit inadequate if the issue is totally different. For example, Lehman's "ideal" living will would have forecasted the scenario that blew it up-and known in advance, it would be driven bankrupt simply for lacking liquidity, even though total assets exceeded liabilities. If they had that much detail, wouldn't Lehman just bypass the outcome, rendering the living will obsolete? The catalyst for big failures, big market outcomes and big recessions is pretty much always what folks don't anticipate-not what they do foresee. Plus, announcing a bank's Armageddon plans introduces front-running risks. If a bank comes under some short-term stress, and nervous shareholders and depositors know exactly how and when they'll be wiped out if the bank fails, they flee early. That could make a bank run a self-fulfilling prophecy.

Though living wills' effectiveness is questionable, they are a fact of life, and banks lose regulatory brownie points if they don't have credible plans. So, banks have taken them seriously. After regulators told lenders they shouldn't assume access to the Fed's discount window in their plans, banks went back to the drawing board. Because if you can no longer assume you can get cash from the Fed by pledging good collateral and paying a penalty rate, you need other cash lifelines-but you must assume those lifelines might also vanish in a crisis, which basically forces you to stockpile cash or super liquid assets for a rainy day. In the end, it seems, banks may count only on themselves.

This is where we are today. Banks are scrambling to identify what exactly would appease regulators while also buttressing their capital cushion. Evidently, regulators have not provided much clarity. One of the five biggest US banks is reportedly stockpiling US Treasurys for liquidity. Others believe even Treasurys won't cut it and are selling their holdings and keeping the cash.

Now, this is all sort of a headscratcher when you consider banks must also comply with a liquidity coverage ratio (LCR), which commands them to keep enough cash and other liquid assets on hand to cover costs for 30 days of bank run.[ii] That starts for the biggest banks on January 1, 2015, and per the Fed, they are already darned close. They were darned close when they submitted the last round of living wills. So here's a question: If the LCR isn't a sufficient buffer for living will purposes, then a) what is sufficient, and b) why is the LCR a thing?[iii]

Bully for regulators wanting to make banks "safer," but the simple truth is the only way to make the system truly safe is if banks don't lend ever. Banks are in the business of taking risk for profit for accountholders and themselves. The "safer" regulators try to make them, the less capital is available for lending. Uncertainty over how safe is safe usually makes banks raise even more capital, crimping lending further. This makes life hard for businesses that want to borrow so they can expand. And people who want to borrow so they can buy cars or homes. When businesses and people can't do these things, growth usually slows. (See the eurozone with any questions.)

Now, given we are realistically talking about a dozen or so banks and probably not a huge amount of money, this probably isn't a huge economic headwind. Banks say they'll need billions, which sounds big, but banks lend billions in a single week.[iv] This is just an illustrative example! It also doesn't mean the Fed really closes its lemonade stand when the next crisis hits. For one, it seems odd to deny banks from using the Fed for the explicit reason it was created. For 95 years, the Fed's discount window provided emergency funds to the banking industry. Usually, they'd even encourage use by dropping the discount rate below fed-funds. The Bernanke-led Fed skipped this time-tested rate tool in 2008, instead encouraging banks away from the discount window with a tangled web of acronym-heavy programs-likely extending the panic. Transcripts show Fed members groused about the quality of collateral banks were pledging at the discount window, but none thought closing it was the answer. (Nor did accepting the odd "toxic" asset blow up the system.) Heck, they even encouraged the big investment banks to become normal banks just so they could tap the discount window! Assuming this mentality hasn't changed, the Fed's threat seems more like a political ploy. Regulatory jawboning![v]

So we still believe this is largely an academic debate. If regulators decide to talk banks into action the way they try to talk interest rates up and down,[vi] we guess we could think of worse things-but words have consequences. And the unintended consequences aren't always as small as today's seem to be.

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[i] Which was based on the Phillips Curve, a theory that unemployment and inflation had a direct relationship. This theory was debunked by Milton Friedman (and others) in the 1960s, which is before this became the Fed's dual mandate. That shows you how politicians work, we guess.

[ii]See this for more. The biggest banks must have an 80% LCR by January 1 2015, 90% by 2016 and 100% by 2017. Most of them were already darned close when the Fed finalized this in September.

[iii] The answer, of course, is international regulators and politicians. Logic rarely applies.

[iv] Literally. The average weekly increase in total US bank lending in 2014 (through 9/24) is about $10.6 billion.

[v] Heaven help us.

[vi] Heaven help us.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.