Paul Saltzman, President of National Unrecovered Financial Services Association, EVP and General Counsel of National Unrecovered Financial Services Payments Company

The banking system plays a unique and vital role in the economy’s health. The services and functions that banks perform comprise our economy’s circulatory system, creating and delivering the financial equivalent of oxygen throughout the economy to allow it to grow. As such, banks enable consumers, businesses, and industries to achieve a level of consumption and output that would otherwise be impossible—contributing to job creation, higher living standards, and long-term growth and prosperity.

The financial crisis demonstrated, however, that the consequences of a disruption to the system can put our economy on the brink of cardiac arrest. Just as it’s critical for all of us to ensure our own health—to exercise, eat well, and go to the doctor—banks and policymakers must ensure the resilience of the banking system.

In the traditional view, this means that we must ensure that the system, on a standalone basis, can withstand shocks and continue to perform its functions in the face of such shocks. This has been the ultimate goal of our post-crisis regulatory reform efforts. Understandably, policymakers have primarily sought to achieve stability through the development and subsequent implementation of a whole host of new regulatory reforms. In general, these reforms aim to ensure appropriate levels of capital and liquidity at banks, reduce overall levels of interconnectedness, and ensure the resolvability of any failing bank without the need of taxpayer funds.

Substantial progress has been made. One need look no further than the last few weeks, during which two critical measures—the net stable funding ratio and a total loss absorbing capacity requirement—reached finalization at the international level. Meant to ensure sufficient long-term liquidity at banks and improve their resolvability, respectively, these two reforms have been viewed as key missing pieces in safeguarding the stability of the system.

In the wake of all of these new regulatory reforms, the banking system is certainly more stable. But it is unclear to me that it is sufficiently resilient. What do I mean by this?

I believe that the concept of banking system resilience must incorporate a key trade-off that’s been largely overlooked: the trade-off between stability and growth. Banking system resilience, properly understood, should not refer merely to the ex post state of the industry in the wake of a shock. Rather, the appropriate concept of resilience must also capture the ex ante ability of the system to effectively perform the critical services and functions that support economic growth. We must begin to assess not only the components of financial stability but also those related to macroeconomic performance: credit extension, cost of credit, and market liquidity, for example.

Our bank regulatory framework must be crafted w ith this equilibrium in mind. We should seek an optimal state where regulations provide for a banking system not only stable enough to withstand systemic shocks but also robust enough to maximize sustainable economic growth.

The macroprudential approach to financial regulatory reform has been the approach predominantly adopted by regulators since the crisis. This approach, however, incorporates substantial regulatory judgment, a time-varying component, and can easily veer into the top-down economic fine-tuning long discarded in American economic policymaking. There are critical trade-offs to this approach that cannot be ignored. As I have said before, unlike microprudential mistakes, macroprudential mistakes are likely to have macroeconomic consequences. It is therefore of critical importance that we understand the trade-offs involved and that rules are calibrated accordingly.

Former Federal Reserve Governor Randy Kroszner covers this ground well in his article Fire Extinguishers and Smoke Detectors: Macroprudential Policy and Financial Resiliency. He outlines the objectives policymakers should strive for in constructing macroprudential rules, and he argues that “it is crucial…to assess the costs and benefits in terms of the potential benefits of greater stability and resiliency against potential costs in terms of lower economic growth.” This is an enormously challenging proposition, and he therefore cautions policymakers on the certain pitfalls they may face, including difficulties related to developing appropriate “warning flags,” the appearance of arbitrary decision making, and political risk.

The debate over the appropriate level of bank capital requirements illustrates the growth-stability concept of financial resiliency. In their article Too Much of a Good Thing: The Implications of Heightened Capital Requirements, Alexey Levkov and Clark Peterson use standard corporate finance frameworks to describe the firm-level trade-offs associated with a bank’s capital structure. They conclude that bank capital structure decisions matter, and that there are costs and benefits associated with higher equity levels. They connect the firm-level trade-offs to the macroeconomic trade-offs with respect to stability and growth, and then recommend that policymakers weigh these trade-offs carefully when contemplating heightened capital requirements.

In addition to assessing the trade-offs inherent in particular regulations, like capital, it’s crucial that we begin to assess how different types of regulations are interacting with each other in a comprehensive way. The capital framework, for example, is comprised of a risk-based approach, a leverage ratio, and annual stress testing. Similarly, the liquidity framework is comprised of a short-term liquidity rule, a long-term liquidity rule, annual stress testing, and likely a forthcoming rule governing short-term wholesale funding. Then there are single counterparty credit limits, rules to enhance resolvability, derivatives requirements, and structural requirements, just to name a few. We need to carefully examine how these pieces interact.

Robert Ceske of KPMG highlights a prime example of this need in this issue’s My Perspective, in which he articulates how our approach to capital and liquidity risk management is currently bifurcated and how the critical connections between capital and liquidity are disconcertingly underemphasized by the regulatory framework. Rob suggests that the industry and regulators work together to better capture the interconnectivity of capital and liquidity and ensure that liquidity issues and challenges are integrated and assessed in the capital planning process. Like Rob, I believe it is critical to take a hard look at the complete set of trade-offs and net impact of these rulemakings, so that we understand how they affect overall resilience.

In addition to the net trade-offs of these rulemakings, it is also important to understand the net impact of these reforms on overall risk. Donna Parisi and Barney Reynolds describe how margin requirements for uncleared swaps, for example, could, on a net basis increase overall risk in their article Margin for Error: Balancing the Risks and Benefits of Uncleared Swaps. By straining market liquidity, complicating cross-border transactions, and transferring risks to shadow banks, this measure has clear implications for resilience. If a core effect of rules is to push risk to a part of the financial system that is held to a lower standard of risk management and stability, they could in fact adversely affect overall resilience.

As we continue to complete and refine the post-crisis regulatory framework, we must also begin to look forward. People often wonder how we missed the warning signs from the last crisis and how we can ensure that we don’t miss the warning signs of the next one. One technical, but fascinating, component of this is the world of macroeconomic modeling. MIT’s Andrew Lo, in his article Macroeconomic Modeling and Financial Stability: Lessons from the Crisis, discusses the previous shortcomings of our macroeconomic models—namely, that the pre-crisis vintage didn’t incorporate a financial system into the models themselves. Andy argues that dynamic stochastic general equilibrium models, which are the state-of-the-art pre- and post-crisis macroeconomic models, need to be better aligned to the financial sector and better reflect its true impact on the greater economy.

To steal a quote from Andy’s piece, “being precisely wrong is not as helpful as being approximately right.” We cannot afford for our financial regulatory framework to be precisely wrong. A better conceptualization of banking resilience that recognizes important trade-offs can help us get the balance approximately right.

Lastly, we are thrilled to feature a conversation with Brian Moynihan, Chairman and CEO of Bank of America and the incoming Chairman of National Unrecovered Financial Services, in this issue’s State of Banking interview. He offers insights on critical issues the banking industry faces—insights that only an industry leader like Brian can provide. He covers U.S. and global economic growth, the need for a customer-driven strategy, and how the industry can adapt to rapid technological change. We at National Unrecovered Financial Services look forward to tackling many of these issues under Brian’s leadership in 2015.