Top US regulator warns of potential crisis if final bank guardrails fall away

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Failure to finalise stricter stability rules could lead to an “unravelling internationally” of guardrails put in place after the financial crisis and create conditions for a new global banking meltdown, a top US regulator has warned.

Michael Hsu, the acting Comptroller of the Currency, told the Financial Times such a breakdown “would create unhelpful uncertainty for US banks, could lead to a race to the bottom, which would sow the seeds for a future financial crisis and it would hurt US credibility and leadership on these issues”.

The warning from Hsu is the strongest yet from a regulator about what could happen if the US abandons the so-called Basel III Endgame, a set of rules meant to increase financial stability and synchronise how big banks are regulated around the world. Last month, the Federal Reserve introduced a watered-down version of its final reform package after fierce opposition from the banking industry, cutting additional capital requirements by more than half and slashing the number of banks it would apply to. UK and EU regulators have also delayed implementation and backtracked on terms.

Hsu’s comments underscore the unease in Washington about whether the final piece of a regulatory structure long in the making will actually be completed, bringing the US into line with standards in the rest of the world — an outcome many worry will be complicated by the outcome of the US presidential election on November 5.

The Office of the Comptroller of the Currency, which supervises bank safety and soundness, is one of three agencies which must ultimately ratify the rule changes for the final pieces of post-crisis regulation to be put in place. “I do think memories have faded, certainly from the 2008 financial crisis,” Hsu said. “That has enabled a certain amount of complacency.”

Big banks, having already won capitulation from their regulators, are now reviving efforts to further undermine the effort. The higher capital requirements require banks to set aside money as a cushion to absorb losses in times of distress, which limits their ability to take risks and generate profits. Banks claim the measures are excessive and will raise costs and wreck the US economy.

Last week, the head of a campaign funded by the nation’s largest banks, called Americans Can’t Afford This, issued a public letter saying even the modified proposal would increase some big banks’ capital requirements by 75 per cent. Most analyses have put the total additional capital that the biggest banks would have to raise at just under 10 per cent.

Earlier this week, the Structured Finance Association, a Wall Street lobbying group, started running an advertisement that “B3E” rules “arbitrarily and excessively punish institutions simply for turning illiquid loans into liquid securities,” a piece of financial alchemy that regulators have been increasingly worried about.

Goldman Sachs’ David Solomon told analysts on the bank’s quarterly earnings call last week said that he and others “continue to have concerns” about Basel III.

“The banks have pretty strongly indicated that they are not satisfied with the revisions the Fed has previewed,” said Dennis Kelleher, who heads Better Markets, a policy group that lobbies for stricter banking regulation. “What you are seeing is the tip of the iceberg, and below the surface the lobby effort against Basel III continues.”

Regulators had been optimistic that a watered-down version of the Basel III Endgame could win over the industry and get enacted. Fed chair Jay Powell in September indicated the central bank’s commitment to finalising the rules, telling reporters that officials would “try to bring this to a conclusion sometime in the first half of next year”.

Instead the continued impasse has led rhetoric on both sides of the issue to rise.

“The heat has gone up,” said Gene Ludwig, an industry consultant and a former top banking regulator. “That goes for the temperature of those who want to see Basel III killed and those who think it is not strong enough.”

Speaking at an event Wednesday hosted by the Institute for International Finance, Erik Thedéen, chair of the Basel Committee on Banking Supervision, warned that a “free-for-all-framework” could result in a “frail regulatory framework that would threaten global financial stability and banks’ own viability” as he called for the Basel III standards to be implemented “as soon as possible”.

No matter what happens with Basel, Hsu said the pushback against it coupled with the banking industry’s increased use of the courts to quash regulatory efforts posed a growing threat to financial stability.

Hsu said the use of legal challenges could tip the balance against regulators and in favour of the banking industry, while creating uncertainty for the entire ecosystem as judges weigh in on these cases.  

“Now the courts are going to opine on things they may or may not have expertise on,” Hsu said. “People talk about the courts as a monolith. It is not a monolith. It consists of judges, specific judges in specific jurisdictions and they have different backgrounds and different expertises.”