An Interview with Karen Petrou

The co-founder and managing partner of Federal Financial Analytics, Inc., Karen Shaw Petrou was dubbed by American Banker in 2012 the “sharpest mind analyzing banking policy today — maybe ever.” Petrou speaks frequently to government officials and financial industry trade groups about regulations and their impacts.  She has also appeared in various media outlets, including the New York Times and Wall Street Journal. Before co-founding the firm in 1985, Petrou worked as an officer at Bank of America.

The Politic: Could you explain you recommendations from your recent report, “A New Framework for Financial Regulations,” in simple laymen’s terms?

KP: I could try. It is a report aimed more at those of us who labor in these mills, but the real point is to cut through all of the battles over Dodd-Frank and financial reform.  At the very end I say that I think that regulation has to serve two fundamental purposes: to punish the guilty and to protect the innocent.  And social engineering, financial market engineering, and many of the much more complicated goals that the new regulatory framework seeks to meet may well be also worthwhile but they’re so complex and untried.  There is often no academic research or market history for those goals and doing them all at once is not only risky — the complexity risk I talk about — but is also a serious distraction from those two fundamental purposes of protecting the innocent and punishing the guilty.

The Politic: Overall, do you think that Dodd-Frank is a successful piece of legislation?

KP: We have no way to know.  I do think it has some important remedies in it, but it is so complicated. It is sixteen titles, a few thousand pages that sought to do many things all at once, often prompted by little more than panic or a not unreasonable desire to punish financial institutions. I don’t think there is any way to judge the law until it’s fully implemented, has been in place and then does or doesn’t appropriately address the next financial crisis.

The US Treasury Department

The Politic: Do you think we know enough to say what the best part of the legislation was?

KP: I think the best part is the effort to craft a systemic regulatory regime that is aimed at insuring big risky financial companies do not escape regulation by virtue of the charters they choose.  Non-banks as well as banks may be regulated if they pose systemic risk.  I also think that this is so far one of the least well executed parts of the law because we are heading into almost three years since it was enacted and the Treasury Department, which leads this effort, has yet to do more than issue three proposals contemplating various ways to do this.  This is called the problem of shadow banking in which the more you regulate banks, the more activity simply moves into the “shadows” in hedge funds or other companies.  When there is market demand for a service it will get done.  The law requires the Financial Stability Oversight Council to name systemic firms and activities so that they are properly regulated, but two years after enactment it still has not named any.  I think that that is an urgent priority.  It’s complex, as it requires defining what systemic is, but I think two years is enough time.  They should do it.

The Politic: Do you think that if this legislation is well executed it could solve the problem of the “too big to fail” bank?

KP: I do, and that’s one of the focuses in the paper.  I think in Title II of the law is a very robust end to “too big to fail,” and I think we need to spend a lot more time being sure that is fully in place and as tough as the law allows it to be.  I think some of the other pieces in the regulatory framework that are designed to penalize institutions for being “too big to fail” are unnecessary, and their destructive effects need to be worried about.

The Politic: You recommend new attestation rules, forcing directors of these companies to sign-off on their firms’ risk.  Do you think Sarbanes-Oxley, which required directors to attest to their company’s financial statements after the Enron scandal, was effective?

KP: I do. The problem is when these attestations become too complicated.  The people signing them do not understand what they are signing, and the attestation becomes meaningless.  The attestation rules I talk about are different than the Sarbanes-Oxley rules. It would apply to bank and financial boards for risk management related purposes, not for investor protection.  They would also be simpler so that the boards were forced to really account for the risk their institution is taking. 

The Politic: Which country does financial regulation the best?

KP: No country does financial regulation well. Right now, the financial industry in Europe is in a crisis.  Many banks are highly leveraged with huge portfolios of sovereign debt, which is not in the best shape right now.  We risk having an asymmetric result with the U.S. financial industry healthy and robust and the European industry increasingly nationalized.  That cannot really work with our global financial markets, so you could see an increasingly regional system.

The Politic: Did the regulations contribute to the European crisis?

KP: No, I think the rules were fine.  They just were not enforced, and the E.U. is now in the process of cleaning up its act, but it is a little late.  For example, you can look at the so-called stress tests European regulators conducted to gauge the health of major banks.  The U.S. had similar tests that worked much better, because the U.S. stress tests were more stringent than the European ones. I think I probably used the word fictitious, because the stresses were not severe, and the capital criteria against which the stresses were judged were very generous.  Furthermore, the European stress tests were not disclosed, so we really had little idea what they showed, just that all the banks passed.  There was one bank, Dexia, which passed the stress tests and was rated strong, and then soon after failed and had to be bailed out.

The Politic: What about the financial industry in China?

KP: I think it is very risk because they are ill-regulated and often engaged in highly speculative activity.  It has less potential for negative consequences because the Chinese currency is not freely convertible and despite the size of the Chinese economy, it is still a very emerging player in global financial markets in contrast to Europe. But I do not view it as a negligible concern.  The best research I have read is agnostic about the risks.

The Politic: What do you think is the future of the financial industry?

KP: I do not know.  I think the industry is relatively strong now.  The risks are because the industry is rebuilding.  It is far from robust; it is just better. And as long as the economy is fragile and the global financial system is at risk to systemic shocks particularly in the E.U., no one can rest easy.  I do not think that the industry is too big now, but I think the compensation is wrong.  The best college students are going into finance instead of other industries.  But I do not know how to social engineer a fix to that. I do not know if you can say these people are just too rich.

The Politic: Do you have any books or movies you’d recommend about the financial crisis?

KP: Sure, I recommend All the Devils Are Here.  It’s a lively book and a good read, but still with a lot of substance.  It doesn’t give a solution, though; it just tells the story.  As far as a movie, Margin Call was actually really good.


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