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July 27, 2017

IMF published its staff report on conclusion of the 2017 Article IV consultation with the United States. Directors observed that the financial system is generally healthy. They urged the authorities to closely monitor the rising vulnerabilities in corporate and household credit markets and implement the remaining recommendations of the 2015 Financial Sector Assessment Program (FSAP). Directors noted that important gains have been made since the global financial crisis in strengthening the financial oversight structure. They concurred that some aspects of the system can be fine-tuned further and the regulatory structure simplified, as has been proposed by the authorities. Directors emphasized, however, that the thrust of the current risk-based approach to regulation, supervision, and resolution should be preserved to safeguard financial stability while facilitating economic growth. In this context, they welcomed the authorities’ commitment to maintain a leading role in financial regulatory discussions in international forums.

The staff report highlights that capital position of U.S. banks is strong and bank asset quality continues to be good, as evidenced by the results of the FED’s most recent Comprehensive Capital Analysis and Review or CCAR. Over the past year, money market fund reform—that required institutional funds to have a floating net asset value and allowed them to impose liquidity fees and redemption gates—led investors to smoothly rotate more than USD 1 trillion out of prime funds (holding commercial paper) and into government bond funds. However, a number of the shortcomings in financial stability oversight, which were highlighted in the 2015 FSAP, remain unaddressed. These include data blind spots (especially for nonbanks) that preclude a full understanding of the nature of financial system risks, residual vulnerabilities in repo markets and money market funds, the absence of harmonized national standards or consolidated supervision for insurance companies, the complex institutional structure for financial regulation, a housing finance system that remains in limbo with little progress in reforming the government sponsored enterprises, and an incomplete picture of financial interlinkages and interconnections in the financial system. There is also a continuing need to remove impediments to data sharing among regulatory agencies. Cyber risks to the financial system are on the rise and potentially systemic. Although the U.S. is steadily improving its regulatory framework to strengthen the resilience of the financial system, the lack of a comprehensive picture and the fast-evolving nature of these vulnerabilities make any assessment of the size of systemic risks and their potential economic costs highly uncertain.

Over the past several years, a series of decisive measures was put in place to lessen the potential for financial stability risks, including enhanced capital and liquidity requirements, better underwriting standards in the housing sector, greater transparency to mitigate counterparty risks, and limits on proprietary trading. Important regulatory measures have been, or are being, implemented, including liquidity risk requirements for money market and mutual funds; standardization of derivatives products and markets; measures that reduce banks’ medium-term asset-liability mismatch (through the net stable funding ratio or NSFR); and a framework for bank recovery and resolution (that is, rules on “living wills” and bail-in-able debt). In addition, the U.S. Treasury has proposed a range of reforms to the financial oversight of depository institutions. These include refocusing existing standards in terms of changes to regulatory thresholds (increasing total asset threshold for banks subject to stress testing); a more conservative liquidity coverage ratio (LCR) measure; a less binding calculation of the supplemental leverage ratio (SLR); risk-based capital surcharges (including revisiting the calculation of total loss-absorbing capacity (TLAC) for global systemically important banks, or G-SIBs, and delay in implementation of trading book capital rules and NSFR); exemption, from Volcker Rule, of banks with less than USD 10 billion in assets and narrowed definition of proprietary trading. To lessen the regulatory burden, the Treasury report proposes moving the FED’s stress testing process to a two-year frequency. 

The staff recommends that the current risk-based capital framework should not be replaced with a simple leverage ratio. On a system-wide basis, the incremental capital needed to meet a 10% leverage ratio is estimated to be close to USD 200 billion. While this may be unduly costly for many banks, the existence of such an “off ramp” may give banks counterproductive incentives to increase capital but place more capital into risky activities. It would be particularly problematic to allow banks to self-select into a less demanding regulatory and supervisory regime, regardless of the underlying systemic risk of their operations. The maintenance of a robust financial regulatory regime in the U.S. has positive spillovers to other economies. These have manifested both through reducing financial stability risks in the U.S. and the knock-on effects from encouraging progress to strengthen the global regulatory framework. To this end, delayed implementation of trading book capital rules, NSFR, and TLAC rules runs the risk of eroding efforts to complete this and other areas of the international reform agenda.

Related Link: Staff Report (PDF)

Keywords: Americas, US, Banking, Securities, Dodd-Frank Act, Stress Testing, Article IV, FSAP, IMF

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