US Decline Series: Financial sector health makes US a sound investment

US Decline Series: Financial sector health makes US a sound investment
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The US regulatory response to the crisis has resulted in a stronger market and equipped the US to deal with future crises. This GRI series challenges the myth of the American decline.

Despite being half a decade removed from the global financial crisis, concerns remain about the health of financial systems in advanced countries. Contrary to talk of decline, a closer look at the US, however, reveals a financial sector, which has rebounded strongly with a robust regulatory framework. Banks have deleveraged and are better capitalized than before the crisis. The Dodd-Frank Act has given regulators better tools to measure systemic risk and boosted bank resilience. Taken together, the US looks like a safer investment than other advanced economies.

Clean Bill of Health

The IMF recently published its biannual Global Financial Stability Monitor, and the US financial sector compares very favorably internationally. Financial institutions’ gross debt in the US measures 83% of GDP, while the EU remains high at 153% and Japan even higher at 196%. With regard to the amount of bank capital to assets, the US also checks in with a ratio of 12.0% compared to the UK’s 5.0%.

By other measures, US banks’ position has strengthened as the economy has recovered. For example, the ratio of non-performing loans to total loans has fallen sharply by more than half to 2.68%. This improvement can be tied not only to individual bank actions but to the broader and more stringent regulatory focus.

Regulatory Response

In recent testimony to Congress, Federal Reserve Chair Janet Yellen expressed strong confidence that US regulators had made good progress. “Regulatory and supervisory actions, including those that are leading to substantial increases in capital and liquidity in the banking sector, are making our financial system more resilient,” she said.

In April, the Fed concluded its annual review of bank holding companies’ capital plans, approving 25 of 30 plans. The recent results showed that US firms moved aggressively to increase their capital since the crisis — the aggregate tier one common equity of the 30 firms has increased to 11.6% from 5.5% in 2009.

This improvement in the position of US banks has a lot to do with the statutory increases in capital ratios and leverage ratios mandated by Dodd-Frank. Capital ratios were implemented as part of the international Basel III framework and represent the ratio of high quality capital to risk weighted assets.

However, risk weighting opens the door for underestimating the risk of certain assets. In order to counteract this, the US approved an “enhanced supplementary leverage ratio” two percentage points higher than the Basel II standard of 3% for systemically significant US bank holding companies. The leverage ratio measures capital to total assets and therefore does not inadvertently discount assets that are usually thought of as safe, but could prove risky.

Beyond capital ratios, US regulators have also approved an Orderly Liquidation Authority that will help in future crises to smoothly move a firm into bankruptcy. OLA requires firms to maintain “living wills” that will assist in rapid resolution. Importantly, OLA creates the legal authority for a single point of entry for firms in distress, concentrating losses on the shareholders of the parent company. This removes some of the public backstop for large firms and should pressure investors to more appropriately assess the risk of firms.

A New Dialogue

In the US, the Federal Reserve is legally bound by its so-called ‘dual mandate’ of promoting stable prices and full employment. With the crisis having shown the pernicious effect of systemic instability on both of those goals, the Fed has considered how best to include financial risk considerations in its policy.

A year ago, Governor Jeremy Stein made the now oft cited remark that, when macro prudential regulation fails, traditional monetary policy “can get in all the cracks.” In his view, regulation is by its very nature targeted, creating the chance that regulators could miss developing risks. Rate policy, however, changes the environment for all investors.

Governor Daniel Tarullo, the Fed’s top regulator, has agreed that monetary policy could be used effectively but has more faith that macroprudential policies could give the Fed more time to better assess developing risks. While investors rarely like uncertainty in how monetary policy is administrated, this debate over the role of financial stability concerns in shaping policy is healthy for a more stable system.

Looking Forward

On top of strengthened regulation and improved capital positions, the US financial sector might be boosted even further by a strengthening US economy. Despite a harsh winter delivering a blow to first quarter economic activity, recent economic indicators (like unemployment insurance claims and new housing starts) show signs of a spring pick up.

If predications of strong second half growth hold up, the US financial system will benefit — further improving its position vis a vis other advanced economies.

Categories: Economics, North America

About Author

Ned Pagliarulo

Ned Pagliarulo works for a Japanese press company, reporting on economics and government statistics. Ned received a BA in History with a minor in Japanese from Georgetown University in 2012.