The Fed's Bank Regulation Challenges

In her prepared confirmation hearing remarks, Federal Reserve chairman nominee Janet Yellen mentioned that U.S. banks are in much better shape than they were during the crisis. Indeed, this has been a banner year for new regulations that are already changing U.S. banks forever.

This summer, a significant number of Basel III rules were finalized in the U.S. Numerous banks will be required to not only have more capital, but also hold a higher-quality, more loss-absorbing capital. Also in July, the Federal Deposit Insurance Corp. proposed a leverage rule that has a larger denominator because it covers off-balance-sheet items. This is a much stricter leverage rule than what the Basel Committee recommended this summer.

The market should expect the slew of Basel III guidelines released this summer to be proposed and implemented by member countries once they are finalized, probably by the end of this year and next quarter.

Key developments in Dodd-Frank this year also have significant potential to make large banks safer. The Commodity Futures Trading Commission has worked at record speed to finalize derivatives rules, which are impacting banks' risk management. All major U.S. systemically important banks have been designated as swap dealers. They now have to transition their trillion-dollar portfolios of uncleared, opaque over-the-counter derivatives to cleared derivatives, which are more transparent and have less credit and operational risk.

Additionally, the FDIC took an important step this April by improving requirements for the largest firms' living wills. The new requirements force bank management to understand more about their firm's risk management policies, what their subsidiaries do, and how the bank would be resolved if it failed.

Importantly, the Federal Reserve and FDIC have been having numerous discussions with their foreign counterparts to find ways to cooperate if a globally systemically important bank fails. Given the global interconnectedness of our top banks and the fact that U.S. regulators do not have power over bankruptcies in foreign countries, this international cooperation is key.

Despite these marked improvements, Yellen, should she be confirmed, inherits GSIBs that are larger, more internationally interconnected and more concentrated by counterparties in their derivatives transactions than before the global financial crisis.

Even with its imperfections, the implementation of U.S. Basel III rules only begins in January 2014 with capital improvements implemented incrementally through the end of 2018. Unfortunately, there is much from Basel III that the Basel Committee has not proposed or finalized.

Firstly, rules to require solid capital requirements to sustain unexpected losses due to failing derivatives counterparties have not been finalized. Certainly, the crisis taught everyone that sometimes your counterparty can be downgraded or even fail before your derivatives contract matures.

Secondly, banks are still relying heavily on value-at-risk market risk measurement frameworks. The inputs to these models are highly subjective and not transparent to outsiders. Moreover, even when good, they cannot tell risk managers what the worst possible outcome that could wipe out their banks' capital is. The Basel Committee is in discussions about other frameworks, such as expected shortfall. Yet for the foreseeable future, GSIBs will utilize the less than perfect VaR disproportionately to measure their market risk.

Thirdly, many risk management practitioners continue to ignore operational risk, and the Basel Committee has yet to make any recommendations to its measurement component in Basel III. Much of what led to the global financial crisis – lack of due diligence, personnel errors, internal processes violations, conflicts of interest, weak governance and fraud – are all examples of breaches in operational risk.

Lastly, Basel II and Basel III's Pillar III, which features requirements for transparency, remains neglected. It has not even been implemented in the U.S. In continental Europe, there is little uniformity in banks' disclosures rendering them of little use to market participants who want to know more about how banks identify, measure, control and monitor risks.

Additionally, it remains to be seen whether U.S. regulators will make good use of Dodd-Frank's Title I, which empowers them to curb bonuses and dividend payments if banks cannot comply with new Basel III capital conservation buffers.

Based off the conversations I've had with regulators, I am convinced the living wills still have to be strengthened to be credible. Unfortunately, only the executive summaries of living wills are available to the public. As such, they are of little value to anyone trying to glean anything meaningful about banks' risks. For example, banks need to give more details about the purpose of their subsidiaries. Also, it is imperative that banks explain more about the inputs that go into their risk models and whether those models are really used to minimize risks. Bank management needs to come clean to regulators about where they house both derivatives and the collateral for those transactions. These details are imperative if regulators have any hope of successfully resolving a large, global bank should it fail. As I have argued in these columns, we should focus on improving Title I, so that Title II, an FDIC-led resolution of a GSIB never has to be invoked.

Yellen's confirmation as Fed chair is widely accepted. Assuming she can encourage the Fed to keep up the pace, she can continue to push for a safer, banking system. Under her leadership, it is critical that the Fed work more closely with prudential and relevant global regulators. It is far better for the Fed to lead in preventing a bank resolution rather than to lament what undoubtedly would have dire consequences to the global financial sector and the economy.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm.