The need for nonbank regulation is a consensus issue for the Fed

WASHINGTON — A consensus is emerging within the Federal Reserve about the need to address the risks nonbanks pose to the financial sector, with champions on opposite ends of the Board of Governors' ideological spectrum.

Vice Chair for Supervision Michael Barr and Fed Gov. Michelle Bowman both voiced concerns last week about the growing volume of financial activity taking place outside the traditional banking system.

The two governors also shared a common solution: bringing more financial market activity within the Fed's regulatory authority.

Bloomberg News

"You can't ignore the risks in the nonbank sector; you've got to do what you can to regulate those risks," Barr said during an event hosted by the American Enterprise Institute last Thursday. "That's one of the reasons, for example, in the Dodd-Frank Act, there was this process for designating things like financial market utilities, designating nonbank systemically important financial institutions to expand that perimeter, where needed, to be able to apply stricter rules so that you didn't have that migration of risk out of the banking system into a sector that was not fully regulated."

Bowman struck a similar chord during a question-and-answer session at an event hosted by the New York-based investment bank KBW on Thursday morning, saying that when nonbanks engage in banklike activities, they should be overseen by the Fed or other relevant regulators.

"It's important to reiterate that where traditional banking functions are being presented outside of a regulated entity, if it's the same product, the same risk, we have to have the same regulation," Bowman said. "It really shouldn't matter where that activity is taking place; if it's the same activity that a bank is participating in or providing, it has to have the same oversight."

The comments from Barr and Bowman, who both sit on the Fed's supervision and regulation committee, reflect their respective approaches to regulation. Barr played a key role in implementing Dodd-Frank as part of the Obama Treasury Department and has argued in favor of a more robust regulatory framework since taking over as the Fed top regulator this summer. Meanwhile, Bowman is a Trump appointee who shares the prior administration's concern about overregulation but also supports ensuring banks — especially community banks — can compete with their less-regulated counterparts. 

Despite their different perspectives on regulation, former Fed Gov. Dan Tarullo said he is not surprised the two governors arrived at the same conclusion.

Tarullo, who oversaw the Fed's regulatory and supervision policy in the wake of Dodd-Frank, said there has long been a shared belief that certain activities by nonbank actors should be subject to some form of regulation. 

"In an odd way, there's kind of a consensus among the regulators who've been appointed by all three presidents since the financial crisis that activities need to be the focus," he said. "But, the question is, what are you going to do about it?"

As Barr noted, nonbanks — including hedge funds, money market funds, private equity firms, insurance companies, government-sponsored entities and other asset managers — now account for 60% of credit extended to the U.S. economy through mortgages, business lending and other activity, up from 30% in 1980. 

Much of this activity is financed by banks, which have extended nearly $2 trillion of credit to nonbank financial institutions, according to the Fed's latest financial stability report. This a conservative calculation that likely understates the interconnectedness of regulated banks and so-called shadow banks, experts familiar with the statistics say. 

Barr said this exposure is cause for concern. "We need to worry, a lot, about nonbank risks to financial stability," he said.

Bowman said it was "critically important" that the Fed get a better understanding of the types of activities taking place in the "shadow" sector and adjust regulatory policy to minimize their risks.

"Some of those activities used to be traditional banking activities and they've been pushed outside that regulated perimeter from, whether unintended or intended, consequences of regulation," Bowman said. "In my mind, it's important that we work to specifically further the ability for banks to participate in those traditional activities that they have been very successful in providing services in and not unintentionally or intentionally push those services outside the regulated banking sector."

Fed's Bowman: Regulations shouldn't push banks out of traditional activities

Where Barr and Bowman seemed to diverge on the subject of addressing nonbank risk is on if or how bank capital requirements should be adjusted accordingly. Both said the current regulatory framework makes it harder for banks to engage in certain activities, like mortgage lending, which has created openings for shadow banks. But Barr was adamant that lowering bank capital requirements was not an option on the table for addressing this. 

"We should monitor the migration of activities from banks to the nonbank sector carefully, but we shouldn't lower bank capital requirements in a race to the bottom," Barr said. "In times of stress, banks serve as central sources of strength to the economy, and they need capital to do so."

Bowman, on the other hand, made no such declaration. She did not advocate any changes to the Fed's capital framework, but she has in the past questioned whether current regulations have become overly restrictive. 

Fed's Barr builds case for tougher capital requirements

Karen Petrou, managing partner at Federal Financial Analytics, said there are elements of truth to both perspectives and they must be squared with one another to properly address the issue of nonbank systemic risk.

"Both Barr and Bowman are right," Petrou said. "Banks need to be regulated because they are systemically special, but to the extent you do that, it's not just the activities that migrate but also the systemic risk. And it is the signal failure of financial policy since 2008, not to have done much but talk about that."

Dodd-Frank created some mechanisms for expanding the reach of regulators through the creation of the Financial Stability Oversight Council, or FSOC. This includes the ability to designate systemically important financial market utilities, or SIFMUs, and systemically important financial institutions, or SIFIs. But these have proven less effective than many initially predicted, Jeremy Kress, a former Fed lawyer and current law professor at the University of Michigan, said.

"We've learned that there's some limitations under the law as to the extent of what FSOC can do," Kress said. "If we really want to get serious about nonbank oversight, it probably requires some legislative changes either to give FSOC more authority or to reduce the fragmentation in U.S. regulators that lets some nonbank risk fall through the cracks."

Only four — the insurers AIG, MetLife and Prudential and the nonbank lender GE Capital — were classified as SIFIs. but all have since had the designation removed. Similarly, only eight entities have been named SIFMUs, and none since 2015.

Tarullo said the stasis in the FSOC designation program is due in part to the stark difference between being a wholly unregulated nonbank institution and a highly regulated SIFI nonbank. 

"It puts them at a competitive disadvantage, they feel, because it's not just an incremental increase in regulation," he said. "It's a big one."

While at the Fed, Tarullo supported a minimum margin requirement for all securities financing transactions to give the central bank insight into a wide variety of market activity and participants. He said the initiative was well received by both the bank industry and regulators, but ultimately fell apart at the onset of the Trump administration amid its push for deregulation.

Tarullo said such a market-based, transaction-focused approach could help the Fed in its effort to rein in nonbank risk, but he acknowledged that until all the gaps in the financial regulatory ecosystem are filled in, there will always be pockets of unknown risk within them. 

"People in the U.S. government need to sit down and say, OK, where are these gaps?" Tarullo said. "To what degree could we do things, so long as we get agency coordination and cooperation? To what degree do we need to augment authority? Might we have some authority that has been unexercised?"