Mnuchin’s bank reforms carry a warning for Europe
Huw van Steenis looks at the implications of Treasury Secretary Mnuchin's review of bank regulation.
Works on financial regulation rarely make it onto summer reading lists, but an exception needs to be made this year.
The review of bank regulation published last month by US Treasury Secretary Steve Mnuchin's is essential reading for every European central banker or any policymaker who cares about the competitiveness of Europe.
The report does not look to roll back the process made since the financial crisis. Rather, it lays out a range of small, practical steps to help post-crisis rules work in practice without endangering the safety of the system.
Even the toughest bank critics admit privately they have been impressed with the report's thoughtfulness and measured tone.
It also seeks to "advance American interests” and the “global competitiveness of US financial institutions". That's why Europeans should pay attention.
If even a portion of these proposals were to come to pass, the cost of capital for US companies could fall.
First, Mr Mnuchin’s report recognises how dramatic an impact financial regulation has had on the effectiveness of monetary policy and credit transmission.
The US repurchase market1, for instance, has shrunk by one-fifth, or $1 trillion, since 2012 when higher leverage (borrowing) ratios were put in place.
Hence one of the report's recommendations is to take the safest assets, such as central bank deposits or cash, out of leverage ratio calculations.
The report also suggests including a broader range of assets as liquidity. This reflects the reality that central banks now have a wider role as providers of liquidity and they also want to keep larger balance sheets.
Second, it argues that liquidity of markets matters.
A healthy economy requires diverse sources of funding. Since 2009 all net expansion in corporate borrowing in the eurozone has come via bond markets, as banks were dieting. But thin markets are not effective ones.
The Treasury report makes some suggestions to offer more flexibility to support market making2. At a time when a brake has been put on Capital Markets Union progress due to Brexit, efforts to foster safe and effective markets must be redoubled.
Third, the report demands that regulations are proportionate, support competitiveness and are grounded in a cost benefit analysis. The US Treasury met a range of bodies to provide a strong evidence base for the report.
Policymakers rightly had to make quick judgements during the crisis and afterwards, but from now on we should balance speed with efficacy.
One example is the Markets in Financial Instruments Directive, or MIFID II. Its objectives are incontestable, but there are nonetheless concerns about unintended consequences.
Guillaume Eliet of the French regulator AMF recently raised concerns about the impact of MIFID II on the research of small and mid cap companies. It risks putting smaller European companies at a disadvantage compared to US peers where the cost of capital is concerned.
There is one proposal in Mr Mnuchin’s report, however, that I would urge Europeans not to accept: to make the bank stress tests twice yearly.
The initiative by Timothy Geithner, Barack Obama’s first Treasury Secretary, to create public stress tests has been one of the most consequential decisions in financial regulation in the last 50 years.
Europe was slow to stress test all banks rigorously and follow though by adequately recapitalising its weaker institutions.
Given recent bank failures and the large stock of bad debts Europe still needs health checks need to be regular, transparent, confidence-enhancing and prompt remedial action where needed.
Mr Mnuchin's first review may not be everyone's choice for holiday reading. But given how far reaching its consequences could be, better to start reading sooner rather than later.
Justin Bisseker, European Banks and Alan Strauss, US Banks, also contributed to this article, which was first published on the FT online on 24 July 2017.
1. Repurchase market is where a dealer or other holder of government securities sells the securities to a lender and agrees to repurchase them at an agreed future date at an agreed price.↩
2. A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn.↩