Main Content

Treasury Department’s Craig Phillips on the FSOC, CRA and the Burden of Financial Regulation

Greg Baer, President of The Clearing House Association, discusses regulatory reform, the plans for Financial Stability Oversight Council, modernizing the Community Reinvestment Act, and the role foreign banks play in the U.S. economy with Craig Phillips, Counselor to the Secretary at the Treasury Department.

By Greg Baer

The Clearing HouseGreg Baer, TCH:  Craig, you have spent most of your career in the business sector. What has been the biggest surprise about working in Washington?

Craig Phillips, Treasury Department: Honestly, that there are more similarities with the private sector than I would have expected. While we play an important function in developing policy at the Treasury, there’s a very large amount of operating responsibility such as financing the government and making what are effectively operating decisions. I have found a lot of similarity with the private sector in decision, planning, and execution processes.

Baer: Following the financial crisis, the Dodd-Frank Act significantly increased regulation on the banking industry. What has been the impact of new bank rules on the U.S. economy, jobs, and consumers? What do you think a genuine cost-benefit analysis of the rules would show?

Phillips: The president issued an executive order that established core principles for the financial system. This executive order directed the Treasury to take a fresh look at the impact of all statutes, regulations, and guidance, much of which had changed quite a bit since the financial crisis.

I think our largest takeaway is that the aggregate burden is significant. Our work concluded that inappropriately tailoring regulation negatively impacts job and economic growth by inhibiting the extension of credit to consumers and businesses.

The reason regulation has had such an impact is the consequence of the complete transformation since the financial crisis. This has involved the roll out of literally hundreds of rules. We want to maintain the gains in safety and soundness that were achieved since the financial crisis, but to also consider the cost-benefit implications. In short, we think the cost exceeds the benefit in many cases, and that recalibrating the regulatory environment can improve the effectiveness and accountability of regulation.

Baer: Much of the regulatory reform focus has been on bank lending, but your background is in the securities business. There are many concerns about how the capital markets will behave when they next come under stress. Has Treasury thought about how a next financial crisis might develop, and how a reduction in dealer inventory against a rising stock of fixed income issuance might play out when a lot of people want to sell and not a lot of people want to buy?

Phillips: First of all, the U.S. economy derives a higher percentage of credit from the capital markets than all of the other developed economies, so capital markets are inordinately important to the United States. We think that’s a strength, and we also think it is one factor that has shaped the recovery from the financial crisis.

Many of the regulations that we studied impact how market-making works and how banks use their balance sheets to support capital market activities. We do worry a bit that there are unintended consequences that may arise from the current regulatory requirements that might impair liquidity during periods of stress. Treasury recommended better tailoring of certain liquidity standards as well as of the Volcker Rule. We also recommended improving the calibration of rules impacting regional and community banks with limited capital markets activities.

Right now, the markets are in very good shape. The flow of credit is strong. Credit spreads are at historically narrow levels. We have experienced an extremely robust stock market over the last year. We have made recommendations to improve access to capital for smaller businesses and startups. At present the capital markets can support the U.S. economy and we do not see immediate threats on the horizon.

Baer: I think some have been surprised at Treasury’s focus on empowering and focusing the Financial Stability Oversight Council (FSOC), especially when it comes to reducing regulatory overlap. What do you see as the advantages of using the FSOC as a coordinating body and for improving information-sharing between agencies.

Phillips: Secretary Mnuchin has, from day one, identified FSOC as a very important convening authority. He believes that gathering the regulators to talk about matters across the markets that may impact financial stability and critically looking at cross-cutting issues across the different regulatory environments is extremely important. So, he values the body.

Having said that, we have issued a report recommending changes in the guidance that FSOC should follow in the designation of systemically important non-bank financial institutions. In short, we advocate for an activities-based approach regarding designation, with a greater reliance on identifying changes that can be implemented by primary regulators. The secretary looks forward to working with the council members in developing changes in guidance for designation that promotes greater transparency and accountability. 

Baer: Clearly one of the goals for the FSOC was to look across agency jurisdictions and identify sources of potential systemic risk. Now as you discuss those at FSOC, where do you see the potential for systemic risk arising these days?

Phillips: First of all, FSOC is a council, not an organization. The staff-level work of the council is done by a series of committees that are populated by the members. These committees focus on topics such as risk, data, designation, and other important topics. 

To address your question more specifically, it is probably important to monitor lending standards in consumer lending, residential mortgage lending, and commercial real estate lending at this juncture in the economic and credit cycle. Maintaining a sensible approach to credit extension and avoiding credit conditions that become overheated should be a priority. It is exactly the type of dialogue that cuts across the various regulators that FSOC serves to convene.

Baer: One of Treasury’s early priorities has been a hard look at the Community Reinvestment Act (CRA) and ways to strengthen and focus that framework to better serve its underlying goal – providing communities with access to credit. What opportunities for improvement do you see there, and how can banks’ CRA investments better align with the needs of the communities they serve?

Phillips: We indicated that Treasury would perform a review of the Community Reinvestment Act in our first executive order report. The secretary made it a priority to engage with banks, regulators, and community advocates in developing our perspectives, which we have been doing over the last four months. As we started this review, the CRA celebrated its 40th birthday, so it’s a very old statute. We believe that regulatory practices for the CRA are in need of modernization. It was created at a time when banks had very limited geographic footprints and for the most part operated within single states.

Banks now have multi-state activities and increasingly interact with customers through the internet and mobile devices rather than at branch facilities. As a result, there is a need to modernize the interpretation of assessment areas, so there could be a more accurate definition of what markets are being served by financial institutions for the purpose of CRA. Many of our other recommendations will relate to the options banks have to invest and support the communities that they serve.

We’ve found a very consistent view among banks, regardless of size, that there can be more accountability in the regulatory environment by having more specific guidance, more clarity on what actually counts and qualifies as either CRA investment or service, and more flexibility in defining those qualified investments based on the nature of the communities being served.

Treasury plans to make recommendations to the primary regulators that oversee the CRA, which include the OCC, the FDIC, and the Federal Reserve, that can enhance the value of the statute for communities. We look forward to sharing our recommendations.

Baer: Let me shift the focus more internationally. The Treasury report on bank regulation also highlighted the role that foreign banks play in lending and capital markets in the U.S. and noted that targeted changes to our regulatory framework might better position them to strengthen that role. What are your views on the importance of foreign banks to U.S. markets? What regulatory changes might make sense?

Phillips: First of all, it warrants saying that foreign banking organizations operating in the U.S. play an extremely important role. We highlighted that in our recent report on banking. Treasury wants to encourage additional investment of foreign banks in the U.S. and in support of our domestic economy. Foreign banking presence also helps facilitate international trade and investment of non-U.S. corporations in the U.S. economy.

Regulations have been implemented for foreign banking organizations that to a large extent are driven by the size of the parent organization rather than the size of the U.S. footprint. It is our belief that reconsidering this regulatory approach, and the threshold for enhanced prudential standards, would encourage further investment in the U.S.

The foreign banking community has shrunk their U.S. balance sheets over the last several years. Much of that reduction has been in broker-dealer activities, reducing the role of foreign banks in U.S. capital markets. Success for us would be to have a level playing field between U.S. and foreign banks, encourage further investment of foreign banks in the United States, and base a bank’s regulatory environment primarily on the size and complexity of the U.S. domestic footprint.

Baer: There is a global trend toward ring-fencing, which makes economies less efficient in good times and may make the system more fragile under stress. The Fed’s ring-fencing of foreign banks in the U.S. may have started this trend, and now the tax bill eliminates deductibility for the debt that the Fed is requiring foreign banks to issue to their banks. Are you concerned that that’s going to further exacerbate these problems?

Phillips: The administration believes that tax reform will have an extremely positive impact on the U.S. economy and promote wage and job growth and greater prosperity for all citizens. A lower tax rate for all corporations, including banks, will help drive more investment in their business. It will also make U.S. banks more competitive internationally.

You correctly note that the implementation of the base erosion and anti-abuse tax (BEAT) in the recent tax law may impact some foreign banking organizations. Specifically, for banks with over $500 million of annual revenue in the U.S., certain deductions for payments to overseas parents may be added back in calculating tax liability. This could, in some cases, include interest payments on internal TLAC.

Treasury is working with the Federal Reserve, Treasury’s office of tax policy and the Hill to review this issue carefully. We believe that many foreign banking organizations will achieve a net reduction in U.S. taxes under most scenarios as a consequence of tax reform. The intent of tax reform is not to promote additional ring-fencing of foreign banking organizations.

Baer: Post-crisis I think we’ve certainly seen the growth in the importance and the expansion of the agenda of super-national bodies like the Basel Committee and the Financial Stability Board (FSB), among others. What do you see as the future of these international standard-setting bodies?

Phillips: U.S. participation in international standard-setting bodies is important, and is not inconsistent with the America First agenda set by President Trump. However, we believe that the participation at these bodies has to be properly calibrated and better and more consistently represent U.S. interests. The U.S. has a fragmented regulatory system. So, it’s extremely important that the U.S. regulators coordinate their views expressed at standard-setting bodies. This has not always happened in the past.

We think that the basic structure of the decision-making process in these organizations warrants a fresh look. Both governance and decision-making processes should be properly calibrated to set better, clearer policy direction. We’re happy to see the finalization of the Basel framework, but it’s probably taken too long and been too complicated. We also recognize that implementing the agreement in the U.S. will need to be done in a thoughtful manner.

The final point is that most of these organizations have been primarily focused on bank regulation and are primarily staffed by banking regulators and central bankers. As a result, the standard-setting bodies have not always been effective in their approach outside the banking sector, in asset management and insurance, for instance.

Baer: Lastly, FinTech continues to be the topic du jour, as it offers the potential to be a driver of significant change in the financial industry. However, there are also certainly risks and challenges with respect to how to change the regulatory framework to incorporate new participants. Should the public be concerned about the ability of cryptocurrencies to avoid anti-money laundering rules and other potential consequences of a move to a less-regulated financial system?

Phillips: We believe innovation is incredibly important in financial services, and we’re undertaking a fourth and final report on the executive order covering non-bank financials and innovation, to include many aspects of FinTech. One consequence of the regulatory environment has been less innovation within the established, regulated banking sector. While we applaud innovation in FinTech, it raises the question, how do we keep encouraging innovation within traditional organizations? We’re going to study that very closely.

If an entity providing financial services is not regulated or is lightly regulated, the line as to where regulation starts and ends is something that needs to be addressed, to promote appropriately tailored regulations across markets. Exploring the right regulatory approach at the federal and state levels is an important priority.

Cryptocurrencies are such a case in point. Tokens are linked to blockchain technology, an important innovation. In the last year, however, they have also been associated with speculative valuation activities, possible market manipulation activities, and potentially a significant amount of illicit activities that escape traditional anti-money laundering and anti-terrorist controls globally. So, cryptocurrency is an example of innovation at its heart, but also an example of the need to carefully look at how regulations are applied outside the traditional sector to protect investors and global security at the same time.