Federal Reserve Board Governor Powell Advocates Additional Regulatory Reform

At the Salzburg Global Seminar, Federal Reserve Board Governor Jerome H. Powell lauded the progress made by the U.S. financial system since the financial crises, particularly in the increased liquidity and improved loss-absorbing capacity of banks. Mr. Powell identified five “key areas” that would benefit from additional regulatory reform:

  • Small banks: Continue to improve regulations governing call reports and the frequency of examinations by simplifying the general capital framework for community banks.
  • Resolution plans: Extend the living will submission cycle from once a year to once every two years, and focus every other filing on key topics of interest and material changes from the previous year.
  • Volcker Rule: Work together with the other four Volcker Rule agencies to reevaluate the rule and ensure that it delivers policy objectives effectively.
  • Stress testing: Evaluate stress testing and comprehensive capital analysis and review, including through public feedback, in order to improve transparency of process.
  • Leverage ratio: Reexamine enhanced supplementary leverage ratio in order to adhere to the proper calibration of leverage ratio and risk-based capital requirements.

 

SEC Economist Examines Role of Artificial Intelligence

SEC Division of Economic and Risk Analysis Acting Director and Chief Economist Scott Baugess discussed the development and use of artificial intelligence and machine learning within the SEC, challenges presented by artificial intelligence technologies, and the future of these technologies within the SEC.

Mr. Baugess explained that progress in development of artificial intelligence technologies has made it necessary for regulators to examine the potential uses and impacts of this technology on the regulatory environment. He observed that while there is obvious value in potentially being able to more effectively predict investor behavior, “latent variables,” such as fraud which is not seen until it is found, make understanding likely outcomes an especially difficult task. Because of these unobservable outcomes and other difficulties such as translating languages, the application of machine learning to regulating financial markets is less straightforward than it is in other contexts.

Machine learning has been utilized by the SEC in various capacities, including to analyze tips, complaints and referrals and to identify abnormal disclosures. Mr. Baugess noted that machine learning is also useful for detecting potential investment adviser misconduct by identifying outlier reporting behaviors. While acknowledging the value of this form of analysis, he cautioned that reliance on machine learning technologies, such as feeding the results of unsupervised learning algorithms into machine learning, can lead to false positives, or instances where misconduct or SEC rule violation is errantly identified.

Mr. Baugess concluded by emphasizing that although machine learning will improve the SEC’s ability to identify possible fraud or misconduct, he expects that “human expertise and evaluations” will always be necessary in the regulation of capital markets.

Lofchie Comment: This is technology expertise that the SEC should consider outsourcing. Perhaps the SEC should call up the credit card companies and ask them for some lessons in catching fraudulent transactions.

SEC Chair Clayton Expresses Concern over Decline of U.S. IPO Activity

At an SEC Investor Advisory Committee (the “Committee”) meeting focused on capital formation, SEC Chair Jay Clayton described negative market consequences stemming from a decline in the number of initial public offerings (“IPOs”). He stated:

“The substantial decline in the number of U.S. IPOs and publicly listed companies in recent years is of great concern to me. Some companies have shifted capital raising activities to the private markets, where many Main Street Americans have limited access. High-quality companies may choose to go public at a later stage, after much of their early growth has already been achieved. Other companies may choose to stay private. This ultimately results in fewer opportunities for Main Street Americans to share in our economy’s growth, at a time when we are asking them to do more on their own to save and invest for their future and their children’s futures.”

The June 22, 2017 Committee meeting included a panel on “Capital Formation, Smaller Companies, and the Declining Number of Initial Public Offerings.” A presentation prepared by Cowen Inc. President Jeffrey M. Solomon contained recommendations for improving the small cap market, such as relaxing rules associated with running small funds, as well as exploring measures to make the equity market structure more conducive for small caps.

In general, Chair Clayton explained, the SEC is focused on protecting retail investors, particularly older investors, by providing enhanced resources that can help them to make informed decisions. He added that the SEC will continue to prioritize price transparency for retail investors in the fixed-income markets.

Lofchie Comment: The priorities and concerns of the new SEC Chair are consistent with the traditional missions of the SEC; e.g., the promotion of capital formation and investor protection. This is likely to result in less attention to more political issues, such as conflict minerals and executive compensation disclosures.

Sargen: A Tale of Two Countries: UK and France

Highlights

  • Theresa May’s decision to call an early election as Prime Minister has come back to haunt her:  Labor Party leader Jeremy Corbyn mounted a credible campaign that denied the Conservative Party a parliamentary majority.  The outcome has added to uncertainty about how the newly-formed British Government will negotiate leaving the European Union (EU).
  • By comparison, the political picture in France continues to improve, as Prime Minister Macron’s newly-formed political party posted a decisive victory in the parliamentary elections.  This outcome has boosted hopes that Macron will press forward with plans to overhaul France’s antiquated labor laws.
  • The contrast between the fortunes of the UK and France is striking.  Britain’s economy was among the most dynamic in Europe one year ago, but its future is now clouded by political dysfunction, whereas Macron’s election has raised hopes that France can transform its economy and stabilize the EU.
  • Amid these developments, we continue to favor continental European equities, but are wary of the UK due to political and economic uncertainty.

UK Elections: Another Surprise Outcome

For the second time in twelve months, the electorate in the UK has defied the pollsters, this time by denying Prime Minister Theresa May and the Conservatives a clear parliamentary majority in the British elections.  When May called for an early election two months ago, the initial assessment of pollsters was the outcome would cement the Tory Party’s majority in parliament, thereby strengthening her hand in negotiating Britain’s departure from the EU.

Instead, the opposite happened. The opposition Labor Party, led by Jeremy Corbyn, a staunch left-winger, mounted a credible campaign that attracted younger voters who had abstained from voting on the referendum to leave the EU.  As a result, May is now scrambling to see if the Conservatives can form a coalition government with a splinter party that represents North Ireland.

Investors are now focused on what the change in political fortunes means for Britain’s exit from the EU.  If May and the Conservatives had won decisively, investors were expecting a so-called “hard exit”, in which the UK would sacrifice free trade arrangements with the EU for increased national sovereignty.  Now that the Conservative’s hand has been weakened, other political parties are insisting on participating in the negotiations with the EU, and the outcome could be a “soft exit,” meaning Britain would seek trade and financial concessions from the EU while surrendering some sovereignty to obtain them.

Beyond this is another looming issue – namely, how will the UK be governed when it is deeply divided as a nation?  According to The Economist, Britain’s main political parties appear polar opposite in many respects:  “Jeremy Corbyn has taken Labour to the loony left, proposing the heaviest tax burden since the Second World War. The Conservative Prime Minister, Theresa May, promises a hard exit from the EU.  The Liberal Democrats would prefer a soft version, or even reverse it.”[1]  Yet, The Economist goes on to observe that the Tory and Labour leaders, despite differences in style and core beliefs, have one thing in common: “Both Mrs. May and Mr. Corbyn would each in their own way step back from the ideas that made Britain prosper – its free markets, open borders and internationalism.”[2]

Since the Brexit vote one year ago, the UK economy has held up better than many observers expected, as a 13% – 14% depreciation of sterling versus the dollar and euro have helped cushion the blow on exporters.  However, the latest indications are the economy is slowing, as real wages have stagnated and public funding is stretched. As a result, investors are becoming nervous about the country’s future.


France: More Positive Surprises

Meanwhile the political picture in France continues to improve, as President Macron’s newly-formed political party En Marche scored a decisive win in the French parliamentary elections on Sunday.  With Macron’s party gaining a clear majority in parliament, the 39-year old president is in strong position to enact his pro-reform agenda that includes weakening France’s protective labor laws, changing tax laws, and reducing pension benefits for some workers.  Moreover, whereas a year ago France appeared to be swept up in an anti-European, anti-immigrant wave, the nation has now rallied around a centrist and unabashed globalist, who seeks to strengthen the EU.

The key challenge Macron faces is whether he can make headway in reducing France’s high unemployment rate, which stands at 9.6% – the lowest in five years. For decades French politicians have tried to reform France’s antiquated system, which makes it prohibitively expensive to fire employees, only to back away in response to public protests. While only 8% of French workers belong to a union, 98% are covered by national and industry-wide contracts negotiated by unions.[3]  This arrangement is particularly problematic for smaller businesses that cannot negotiate terms on their behalf.

Macron is attempting to rectify the situation by making it easier to fire employees, capping damages in unfair dismissal cases and decentralizing collective bargaining.  At the same time, he plans to expand worker protections by making those who voluntarily quit their jobs eligible for unemployment benefits.  Macron’s goal of transforming France’s labor laws by the end of summer is considered ambiguous, and it remains to be seen how he will stand up to tumultuous strikes and protests.  That said, this appears to be the best chance to reform the system in decades.  Should Macron persevere, France hopefully would see the benefits of declining unemployment, much as Germany did when it enacted its labor reforms during the past decade.  Note: Germany’s unemployment rate currently is 3.9%, well below other EU members.


Investment Implications

Weighing these considerations, we continue to favor European equities, as political risks in EU have diminished while economic performance has improved. (See Time to Consider Europe, May 23, 2017)  That said, we would underweight UK equities on grounds the political situation has deteriorated and there is considerable uncertainty surrounding Britain’s exit from the EU.

Equity Markets:  France (CAC-40) versus UK (FTSE), January 2016 to Present

Source: Bloomberg. Local currency returns.

 


[1] The Economist, June 3rd-9th, 2017, p.13.
[2] Ibid., p.13
[3] See Catherine Rampell, “Macron attempts a feat that Trump wouldn’t dare,” The Washington Post, June 8, 2017.

CFS Monetary Measures for May 2017

Today we release CFS monetary and financial measures for May 2017. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.4% in May 2017 on a year-over-year basis, maintaining the same growth rate as in April.

For Monetary and Financial Data Release Report:
http://www.centerforfinancialstability.org/amfm/Divisia_May17.pdf

For more information about the CFS Divisia indices and the data in Excel:
http://www.centerforfinancialstability.org/amfm_data.php

Bloomberg terminal users can access our monetary and financial statistics by any of the four options:

1) {ALLX DIVM }
2) {ECST T DIVMM4IY}
3) {ECST} –> ‘Monetary Sector’ –> ‘Money Supply’ –> Change Source in top right to ‘Center for Financial Stability’
4) {ECST S US MONEY SUPPLY} –> From source list on left, select ‘Center for Financial Stability’

Bitcoin Exchanges Targeted in Cyberattacks

At least two prominent bitcoin exchanges were targeted by cyberattacks that interrupted normal operations and trading.

BTC-e and Bitfinex were targeted by distributed denial-of-service (“DDoS”) attacks, a form of cyberattack which typically uses multiple compromised systems to flood a target with message traffic that exceeds its processing capacity.  The attacks temporarily disrupted service for both exchanges but reportedly did not cause a loss of funds or protected information. According to a CNBC report, service interruptions like those caused by the DDoS attacks could allow traders to “manipulate the bitcoin market.”

Both exchanges have resumed normal service.

Federal Register: Treasury Asks Public to Help Reduce Regulatory Burdens

The U.S. Treasury Department (“Treasury”) requested recommendations and information from the public to identify Treasury regulations that can be “eliminated, modified, or streamlined in order to reduce burdens.”

The request was issued in response to Executive Order 13777 (“Enforcing the Regulatory Reform Agenda”), which requires regulatory agencies to form task forces that help to implement previous orders focused on regulatory reform. The Treasury asked that submissions (i) identify regulations by titles and citations to the Code of Federal Regulations, and (ii) explain how the regulations could be modified, if appropriate, or why they should be eliminated.

Comments must be submitted by July 31, 2017.

Lofchie Comment: The Treasury’s request for public input follows immediately on the heels of their real-world critique of problems with the current regulatory system (see Treasury Gets Specific, Recommends Significant Regulatory Reform). Market participants should take up the Treasury on this request for comment. The new regulators appear to be concerned with real, practical problems, such as duplicate or ambiguous regulatory requirements, regulatory costs, diminished liquidity and market fragmentation.

Treasury Gets Specific, Recommends Significant Regulatory Reform

The U.S. Treasury Department (“Treasury”) released a report pursuant to President Trump’s February Executive Order establishing core principles for improving the financial system (see previous coverage). Drafted under the direction of Treasury Secretary Steven T. Mnuchin, the report is the first of a four-part series on regulatory reform and covers the financial regulation of depository institutions. Subsequent reports will focus on areas including markets, liquidity, central clearing, financial products, asset management, insurance and innovation.

The report contained the following Treasury recommendations, among others:

  • Capital and Liquidity: (i) raise the threshold for participation in company-run stress tests to $50 billion in total assets (from the current threshold of more than $10 billion), (ii) tailor the application of the liquidity coverage ratio appropriately to include only global systemically important banks and internationally active bank holding companies, and (iii) remove U.S. Treasury securities, cash on deposit with central banks, and initial margin for centrally cleared derivatives, from the calculation of leverage exposure.
  • Volcker Rule: modify the Volcker Rule significantly, by (i) providing a full exemption for banks with $10 billion or less in total assets, and (ii) evaluating banks with greater than $10 billion in total assets based on the volume of their trading assets. Treasury also recommended a number of other measures to reduce regulatory burdens and simplify compliance, such as further clarifying the distinction between proprietary trading and market-making.
  • Stress Testing: increase the asset threshold from $10 billion to $50 billion, and allow regulatory agencies to make discretionary decisions for a bank with more than $50 billion in assets based on “business model, balance sheet, and organizational complexity.”
  • Consumer Financial Protection Bureau (“CFPB”): restructure the CFPB to provide for accountability and checks on the power of its director, or subject the agency’s funding to congressional appropriations. (Treasury criticized the “unaccountable structure and unduly broad regulatory powers” of the CFPB, and concluded that the structure and function of the agency has led to “regulatory abuses and excesses.”)
  • Residential Mortgage Lending: ease regulations on new mortgage originations to increase private-sector lending and decrease government-sponsored lending.

Treasury also outlined its support for the idea of creating an “off-ramp” from many regulatory requirements for highly capitalized banks. This approach would require an institution to elect to maintain a sufficiently high level of capital, such as a 10% non-risk weighted leverage ratio.

Lofchie Comment: At last, a regulatory discussion that says something more than “there was a financial crisis, so there must be more rules, and more rules will make us safer.” This report reads as if it was informed by real work experience. It is a recognition of both the costs and benefits of financial regulation.

The report is not an attack on government. While critical of Dodd-Frank, Treasury acknowledges the better aspects of it, particularly improvements in bank capital ratios. In sum, Treasury is making the point that Dodd-Frank is seven years old; hundreds of rules have been adopted under it, and the time has come to see what aspects of it are working or not. (If there is anyone out there who believes after seven years of Dodd-Frank that it’s all going swimmingly, that person is just not paying attention.)

The biggest question is whether those who have disagreements with the recommendations will argue why the particulars are wrong, or whether the debate will simply be about the evils of Wall Street and the Administration. After seven years of Dodd-Frank (did someone break a mirror?), it really is time to talk specifics.

House of Representatives Passes Financial CHOICE Act

On June 8, 2017, the House of Representatives passed the “Financial CHOICE Act of 2017” (H.R. 10) (the “CHOICE Act”). The vote was 233 to 186, largely along partisan lines. The CHOICE Act had been approved by the House Financial Services Committee on May 4, 2017. The bill is a major overhaul of the current financial services regulatory regime including a partial repeal of Dodd-Frank. (For previous Cabinet coverage of general provisions of the bill, see House Republicans Release Revised CHOICE Act.)

Financial Services Committee Chair Jeb Hensarling (R-TX) stated that the CHOICE Act would have a significant impact on the economic wellbeing of the United States:

“[The CHOICE Act] stands for economic growth for all, but bank bailouts for none. We will end bank bailouts once and for all. We will replace bailouts with bankruptcy. We will replace economic stagnation with a growing, healthy economy.”

FINRA Economists Report Mixed Progress in Securitized Asset Liquidity

FINRA’s Office of the Chief Economist published a research note authored by two staff members that examined the liquidity of securitized assets over the course of the last several years. The authors utilized FINRA Trade Reporting and Compliance Engine (“TRACE”) data to evaluate liquidity in (i) real estate securities (including MBSs, CMBSs, CMOs, and TBAs) and (ii) other categories of asset-backed securities, including credit cards, automobiles, and student loans. They found that bid-ask spreads are almost universally down and the price impact of trades has fallen in every security since 2012. However, the number and volume of new issues of securitized assets have not recovered to pre-crisis levels and trading volume is generally down for most categories of securitized assets.

FINRA also published a similar analysis dealing with corporate bond liquidity.

Lofchie Comment: Regulators tend to emphasize bid/offer spread as the key data point for assessing market liquidity. However, that is only one measure of liquidity, and arguably not a very important one. The metric that the regulators should focus on more is the amount of the available liquidity; i.e., the size of the bids and offers. In any case, the authors of this study concede that trading volume in certain products is materially down, which would obviously suggest that available liquidity is materially down, notwithstanding that the spreads between bids and offers have decreased.