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Treasury Secretary Lew--and the current Administration more broadly--recently began to promote the idea that Dodd-Frank and related Basel III capital and liquidity reforms have solved the problem of Too Big to Fail.

What are your thoughts on the metrics economists and analysts use to measure TBTF, specifically the existence of a "subsidy" in the form of cheaper debt financing as a result of implicit government support. Does the subsidy accurately measure TBTF? And if not, how can we know when we have addressed one of the core symptoms of the financial crisis?

And what do you think of the glaring holes in financial regulatory reform that the TBTF debate seems to ignore, i.e., securities financing transactions, money market funds, and other shadow banking entities.

Thanks for the response, Tom.

I'm interested more in your thoughts on GSE reform and what I presume is your reference to the confirmation of Mel Watt as Director of FHFA. While I primarily follow banking, I haven't heard of any efforts to reduce either the risk weighting of MBS or individual residential loans held on balance sheets, or any other efforts on the part of the Administration that would clearly open up the GSEs and mortgage finance system more broadly to greater systemic risk or increase the risk appetite for subprime MBS.

I agree that the stress tests are poorly implemented, but I think the Fed is taking steps in the right direction to increase the transparency of the tests by creating their own view of banks balance sheets (new this year for CCAR) rather than accepting banks' own interpretations of their balance sheets, using models developed in house rather than relying on banks' own risk models to calculate things like loan loss reserves, and providing robust severely adverse scenarios, especially for advanced approaches and market risk capital rule banks. If anything, I think the greatest problem with stress tests is the almost counter-intuitive purpose they serve. If banks test poorly on the downward slope of the credit cycle, the Fed could inadvertently create market conditions that enhance the risk for runs. Thus, the Fed has developed a system in which the primary goal is to "prove" banks are solvent rather than expose financial weaknesses.

As are all things derivatives, the answer is complicated. For starters I'd refer you to a series of amendments the Basel Committee made to the leverage ratio over the weekend. Among the changes are a series of inventive ways that banks can discount the gross notional value of derivatives transactions on their balance sheet. Netting derivatives, or considering only the absolute value of long and short positions you happen to hold, is another method that banks advocate for under the pretense of hedging risk, without regard for the poorly understood risk transmission mechanisms of certain types of derivatives. Largely, banking regulators have avoided this pitfall, though we see efforts to weaken regulations on a consistent basis from banking trades and other interested parties.

http://www.bis.org/press/p140112a.htm