Congrats Randal Quarles on Fed Appointment…

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Congratulations to Randy Quarles for his appointment and confirmation to serve as the Vice Chairman of the Federal Reserve Board.

CFS is thankful for Randy’s early and constant support of our organization. As an Advisory Board Member and Trustee, he has been a source of wisdom on a wide range of topics. In particular, his involvement in “Bretton Woods: The Founders and Future” was especially productive and meaningful. The inspiration and encouragement from Randy will continue to guide CFS especially as we plan to honor the 75th anniversary of the birth of the international financial system and think strategically about the future.

See “Summary and Next Steps  – Bretton Woods: The Founders and Future.”

Randy is uniquely experienced, remarkably learned, and thoughtful on virtually any monetary, regulatory, or related legal topic. Likewise, few to none are more honorable in character.

We wish him the best at the Fed.

House Subcommittee Considers Potential for Central Bank Digital Currencies

The House Financial Services Subcommittee on Monetary Policy and Trade considered testimony on the future of cryptocurrencies, including the potential development of central bank digital currencies (“CBDCs”).

The following witnesses testified at the hearing: Dr. Rodney J. Garratt, Professor of Economics at the University of California in Santa Barbara, Dr. Norbert J. Michel, Director of the Heritage Foundation Center for Data Analysis, Dr. Eswar S. Prasad, the Nandlal P. Tolani Senior Professor of Trade Policy at Cornell University, and Mr. Alex J. Pollock, Distinguished Senior Fellow at the R Street Institute.

Dr. Garratt noted the increased prevalence of electronic payment systems and resulting decline in the use of cash for payments. He suggested the possibility of developing a “widely accessible, retail-oriented [CBDC] that could be used by the public for person-to-person and retail transactions.” Dr. Garratt acknowledged the various risks associated with such an undertaking, and asserted that further research will be necessary to better understand the monety policy and financial stability issues.

Dr. Michel explained that paper-based payments have faded in popularity. He encouraged the “neutral” treatment of all forms of currency, including cryptocurrency, and asserted that capital gains taxes should not apply to cryptocurrency transactions. Dr. Michel argued against both the development of CBDCs and restrictive policies that may limit the development and growth of private cryptocurrencies, and applications of distributed ledger technology.

Mr. Pollock warned of the dangers of CBDCs. He cautioned that CBDCs could potentially result in an “increase of the monopoly power of central banks.”

Dr. Prasad also warned of the potential effects of CBDCs on traditional banking structures.

President Trump Issues Executive Order to Establish Task Force on Market Integrity and Consumer Fraud

President Donald J. Trump issued an Executive Order instructing the Attorney General (“AG”) to establish a Task Force on Market Integrity and Consumer Fraud (the “Task Force”). The goal of the Task Force is to provide guidance on financial fraud and other crimes, including cyber fraud, that target members of the public.

Specifically, the Task Force will give recommendations to the AG on fraud enforcement activities across the DOJ regarding (i) actions to improve inter-agency cooperation in investigating and prosecuting financial crimes, (ii) actions to bolster communication among Federal, State, local and tribal authorities with respect to the detection, investigation and prosecution of financial crimes, and (iii) changes in “rules, regulations, or policy, or recommendations to . . . Congress regarding legislative measures, to improve the effective investigation and prosecution” of financial crimes.

The Task Force will terminate and replace the Financial Fraud Enforcement Task Force created by Executive Order 13519 on November 17, 2009, which is now revoked.

In remarks delivered in Washington D.C., SEC Chair Jay Clayton expressed support for the establishment of the Task Force. Mr. Clayton reaffirmed the importance of inter-agency cooperation when it comes to protecting retail investors, and underscored some of the actions that the SEC recently undertook to confront retail securities fraud. In particular, Mr. Clayton highlighted retail enforcement strategies, emergency actions, and cyber and initial coin offering (“ICO”) fraud. With respect to retail enforcement strategy, Mr. Clayton discussed the Retail Strategy Task Force created by the SEC in 2017 to provide additional protection for Main Street investors by developing strategies for dealing with various types of wrongdoing that most impact retail investors. Mr. Clayton also stated that in response to bad actors utilizing new technologies to commit ICO fraud, the Enforcement Division created a Cyber Unit to deal specifically with cyber-related crimes.

Lofchie Comment: There seem to be two major differences between the newly issued order and the Executive Order that it replaced.

First, the former Task Force included membership from a complete A-Z of agencies making it unwieldy at best. The reconstituted Task Force can call upon the agency alphabet as is needed.

Second, the former Task Force was established, in large measure, to address concerns related to the financial crisis. The new Task Force is forward-looking; it now includes fraud on the government, cyberfraud, fraud against senior citizens, health care fraud, and fraud involving cryptocurrencies.

Fed Weekly Balance Sheet since 1914 Now Available

With several current or former undergraduate students of CFS Special Counselor Steve Hanke, I have converted the Fed’s weekly balance sheet from its beginning into spreadsheet form. The data should prove useful for anyone concerned with the quantitative study of monetary policy in the United States over the last 100+ years. Our working paper, “The Federal Reserve System’s Weekly Balance Sheet since 1914,” is available here.

The working paper is based on three earlier papers that I have previously written about; all are available at the link above:

“Insights from the Federal Reserve’s Weekly Balance Sheet, 1914-1941” by Justin Chen and Andrew Gibson,” January 2017 (post)

“Insights from the Federal Reserve’s Weekly Balance Sheet, 1942-1975” by Cecilia Bao and Emma Paine, May 2018 (post)

“Insights from the Federal Reserve’s Weekly Balance Sheet, 1976-2017” by Nicholas Fries, July 2018 (post)

CFS Monetary Measures for June 2018

Today we release CFS monetary and financial measures for June 2018. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.8% in June 2018 on a year-over-year basis versus 4.5% in May.

For Monetary and Financial Data Release Report:
http://www.centerforfinancialstability.org/amfm/Divisia_Jun18.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’

The Fed’s Weekly Balance Sheet since 1976

Students of CFS Special Counselor Steve Hanke have previously written two papers digitizing the weekly balance sheet of the Federal Reserve System from 1914-1941 and 1942-1975 and analyzing developments in the Fed’s balance sheet. I wrote about them in previous posts. Now a third paper completes the data and the analysis by bringing the story up to the present. The author is Nicholas Fries and the paper is called “Insights from the Federal Reserve’s Weekly Balance Sheet, 1976-2017.”

The most recent paper is no. 114 (currently the latest paper) in this working paper series that Hanke edits. The earlier papers were nos. 70 and 104 in the series. The data files can be viewed from links under the paper.

The Fed has made digitized weekly data of its weekly balance sheet available since 1996, but not earlier, and from 1996-2002 the data were only previously available as individual files on the Fed’s Web site, not in a spreadsheet. From 2002 downloadable spreadsheet data are available. Besides appreciating the service Fries has done making the data available, readers will appreciate his balance sheet analysis, which is simple and to the point.

One more paper is left in the series on the Fed’s balance sheet. I will post about it within the next month.

SEC Office of Investor Advocate Releases FY 2019 Policy Objectives

The SEC Office of the Investor Advocate (“OIA”) set forth its priorities for protecting and promoting the interests of retail investors in a newly released FY2019 annual Report on Objectives. The OIA will focus on the following nine areas:

  • Public Company Disclosure: The OIA will continue to support SEC efforts to update and modernize disclosure requirements for public companies but noted that a “holistic” approach is needed to cultivate a healthy environment for public companies while protecting retail investors.
  • Equity Market Structure: The OIA will continue to work with the SEC and staff on proposed rule changes to Regulation NMS Rule 606 and proposed amendments to Regulation ATS. For example, in March 2018, the SEC proposed a rule to conduct a transaction fee pilot program for National Market System (NMS) stocks. The OIA explained that it will review elements of the pilot to determine whether it helps the SEC to evaluate potential equity market structure reforms.
  • Fixed Income Market Reform: The OIA will continue to monitor MSRB and SEC efforts to supervise the municipal securities markets while broadening its focus to fixed-income market reform more generally.
  • Accounting and Auditing: The OIA will work to close the gap between what investors expect from financial statements and what the statements actually communicate to investors.
  • Standards of Conduct for Broker-Dealers and Investment Advisers: The OIA will monitor closely the developments of the proposed rules on standards of conduct for broker-dealers and investment advisers. The OIA stated that it has been researching whether investors can distinguish between “different types of investment professionals, and how effectively investors navigate the market for financial advice, and the types of conduct investors expect from an investment professional.”
  • Exchange-Traded Funds (“ETFs”): The OIA will continue to support the SEC’s proposal permitting ETFs to operate without an exemptive order to the extent that the proposal does not sacrifice investor protection.
  • Enhanced Disclosure for Mutual Funds and Variable Annuities: The OIA will continue to conduct research intended to improve fund fee and expense disclosure. The OIA highlighted its support for the development of a summary prospectus for variable annuities that would divulge key information needed by investors to assess the benefits, risks and costs of their investments.
  • Transfer Agents: The OIA will focus on the importance of modernizing transfer agent rules in order to help strengthen investor protection as well as combat fraud in the microcap market. According to the OIA, transfer agent responsibilities have evolved significantly since the advent of transfer agent rules, so the rules need to be updated in order to account for the shifting landscape.
  • Impact of Kokesh v: SEC on Enforcement Actions: The OIA will examine potential solutions to mitigate the impact of the Supreme Court’s ruling in Kokesh (which “bars the [SEC] from obtaining disgorgement in actions brought beyond the five-year statute of limitations”). The OIA asserted that the ruling has had negative effects on retail investors.

Lofchie Comment: The OIA policy report fails to acknowledge the trade-offs of costs and benefits inherent in regulatory policy. For example, the SEC’s Best Interest proposal, which will effectively discourage broker-dealers from making recommendations to retail customers, will inherently disincentive broker-dealers from making public offerings available to retail customers. If the SEC is going to adopt a rule that makes it substantially more risky to recommend new offerings or start-up companies to retail investors, then start-ups are better off staying private because they already have access to institutional money without going public, and going public will subject them to material additional expense. The suggestions as to ETFs also fail any basic cost-benefit basic analysis.

Put another way, is there no reduction in regulation that might be worthwhile if it causes any reduction in investor protection? Who could disagree with the promulgation of even more rules that provide benefits without cost?

FRB Vice Chair Discusses Lessening Regulatory Burden on Community Banks

Federal Reserve Board (“FRB”) Vice Chair for Supervision Randal K. Quarles outlined the agency’s recent efforts to review and improve its regulatory framework now that implementation of major post-crisis reforms is largely complete.

In a speech before the 110th Annual Convention of the Utah Bankers Association, Mr. Quarles emphasized the importance of U.S. participation in the Financial Stability Board (“FSB”). He highlighted two supervisory improvements that the FSB and other agencies applied to reduce the regulatory burden on community and regional banks: (i) the FRB “Bank Exams Tailored to Risk” program and (ii) a joint action taken with other agencies to simplify the reporting responsibilities of smaller banks.

Mr. Quarles discussed the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Act”), which was recently signed into law. According to Mr. Quarles, the Act retains the most important post-crisis reforms while directing the FRB to make necessary changes to reduce the regulatory burden on regional banks. Additionally, Mr. Quarles said that raising the asset threshold for bank holding companies that are eligible for the Small Bank Holding Company Policy Statement allows the FRB to “tailor its rules for these firms moving forward while retaining the ability to protect the safety and soundness of the system.”

Mr. Quarles also underscored the importance of international regulatory communications, standard setting and assuming a comprehensive perspective on financial vulnerabilities when addressing global issues. Mr. Quarles argued that more accurate risk assessment in the broader financial system is integral to reducing the regulatory burden on community banks.

SEC Proposes Changes to ETF Approval Process

The SEC proposed a new rule that would modify the approval process for certain exchange-traded funds (“ETFs”).

Under proposed Investment Company Act Rule 6c-11, open-ended ETFs would be able to come to market without applying for an exemptive order. Certain ETFs would not be able to rely on the rule, including ETFs organized as unit investment trusts (“UITs”), leveraged ETFs, inverse ETFs and ETFs organized as a share class of a multi-class fund.

ETFs that qualify for the exemptive rule would be required to meet certain conditions, including:

  • posting daily portfolio transparency information on their websites;
  • using custom baskets only after adopting adequate written policies and procedures;
  • adhering to certain recordkeeping requirements; and
  • complying with certain website disclosure requirements.

The proposal would rescind previous exemptive relief for ETFs that are able to rely on the rule. The SEC recommended preventing the creation of new ETFs organized using a “master-feeder” structure.

The SEC also proposed amending disclosure obligations for funds organized as UITs.

The SEC will accept comments on the proposal for a period of 60 days after it is published in the Federal Register.

Lofchie Comment: The SEC’s proposed ETF exemptive rule is a recognition that ETFs have become a “plain-vanilla” form of transaction, even if any individual ETF may be based on a unique investment thesis.

Notably, leveraged ETFs cannot benefit from the exemptive rule (they still will be required to obtain individual exemptive orders). Commissioners Stein and Jackson issued statements expressing skepticism as to the benefits of such ETFs.

House Subcommittee Considers AML De-Risking

The U.S. House Subcommittee on Financial Institutions and Consumer Credit considered testimony regarding the implications of “de-risking,” wherein financial institutions end relationships and close the accounts of “high-risk” clients to avoid legal liability and regulatory scrutiny. The subcommittee noted that de-risking (i) may affect “many legitimate businesses,” (ii) could reduce access by small businesses to financial products domestically, and (iii) could affect the flow of humanitarian aid globally.

Witnesses at the hearing included Michael E. Clements, Director of Financial Markets and Community Investment of the Government Accountability Office (“GAO”); Sue E. Eckert, Adjunct Senior Fellow at the Center for a New American Security; Gabrielle Haddad, Chief Operating Officer of Sigma Ratings Inc.; John Lewis, Senior Vice President of Corporate Affairs and General Counsel at the United Nations Federal Credit Union on behalf of the National Association of Federally-Insured Credit Unions; and Sally Yearwood, Executive Director of Caribbean-Central American Action.

GAO Reports

Mr. Clements based his testimony on GAO reports from February 2018 and March 2018. He stated that Bank Secrecy Act/Anti-Money Laundering (“BSA/AML”) regulations have been a factor for some banks in terminating or limiting accounts and closing branches. The February report found that certain geographic areas were more likely to lose bank branches if they were (i) urban and had higher per capita personal incomes and younger populations, or (ii) designated as High-Intensity Financial Crime Areas or High-Intensity Drug Trafficking Areas, or featured higher rates of banks filing suspicious activity reports. According to the February report, approximately 80% of U.S. Southwest border region banks, due to increased BSA/AML oversight, either limited or did not offer accounts to customers considered to be at high risk for money laundering. According to the March report, money transmitters in Haiti, Liberia, Nepal and Somalia (collectively, “fragile countries”) reported a significant loss of banking access and increased reliance on nonbanking channels as alternatives.

The February report urged the Financial Crimes Enforcement Network, the FDIC, the Federal Reserve and the Office of the Comptroller of the Currency to conduct a retrospective review of BSA/AML regulations and their implications for banks. The March report advised the U.S. Treasury Department (“Treasury”) to analyze how “shifts in remittance flows from banking to non-banking channels for fragile countries may affect the Treasury’s ability to monitor for money laundering and terrorist financing.”

Testimony and Recommendations

Mr. Lewis testified that financial institutions may de-risk themselves in response to examiners who go beyond what is required by guidance, or in response to broad law enforcement requests for information about particular types of customers. He said that additional pressure from examiners and the threat of overbroad investigatory demands are both factors in de-risking decisions. Mr. Lewis recommended (i) implementing a “safe-harbor” policy for financial institutions that provides services to high-risk accounts if the financial institutions conduct sufficient scrutiny of the accounts, (ii) educating financial institutions on risk-based review requirements and (iii) amending regulations so that a financial institution is not “the ‘de facto’ regulator of a business.”

Ms. Yearwood recommended that (i) the Treasury continue providing assistance to Caribbean nations (a high-risk region), (ii) regulations be harmonized to better enable small countries with limited capacities to remain compliant, (iii) investments in new technology be made to “level the playing field” and (iv) regulations be recalibrated when they are weighted against smaller economies.

Ms. Haddad recommended (i) improving the sharing of risk information between the private and public sectors to enhance overall transparency, (ii) using third-party providers to conduct assessments of respondent banks’ compliance with global standards, and (iii) using technology to lower AML and other related compliance costs without threatening financial institutions with regulatory backlash.

Ms. Eckert testified that the “de-risking phenomena” restricted financial access for non-profit organizations with “deleterious humanitarian consequences.” Ms. Eckert called for U.S. leadership to ensure the flow of humanitarian funds.

Lofchie Comment: Well-intended rules may have negative consequences. In this case, the potential fines — and the potential for public embarrassment for accepting an account that appears in any way AML-uncertain — far outweigh any ordinary business gain from accepting the account. It is not so clear how the regulators can be very tough on AML failures and at the same time motivate financial institutions to accept accounts that appear in any way AML-risky.

Federal Judge Determines that the CFPB Is “Unconstitutionally Structured”

The U.S. District Court for the Southern District of New York (“S.D.N.Y.”) dismissed Consumer Financial Protection Bureau (“CFPB”) claims based on the determination that the CFPB “lacks the authority to bring [these] claims” because it is “unconstitutionally structured.”

In the Opinion and Order, the S.D.N.Y. disagreed with the en banc holding of the D.C. Court of Appeals (the “Court of Appeals”) in PHH Corp. v. CFPB, which upheld the CFPB’s constitutionality under Title X of the Dodd-Frank Act. Judges Brett Kavanaugh and Karen LeCraft Henderson issued dissenting opinions in PHH Corp., which the S.D.N.Y. partially adopted in its decision. The S.D.N.Y. affirmed that, as stated in Judge Kavanaugh’s Opinion, the CFPB “is unconstitutionally structured because it is an independent agency that exercises substantial executive power and is headed by a single Director.” Furthermore, the S.D.N.Y. adopted Judge Henderson’s dissenting opinion, which argued that the entirety of Title X of Dodd-Frank should be stricken.

The S.D.N.Y. also rejected the argument within the Notice of Ratification (filed on May 11, 2018) that Acting Director Mick Mulvaney’s ratification dismisses any grounds upon which the CFPB’s constitutionality can be questioned. The Notice of Ratification debated that, because President Trump could remove Mr. Mulvaney at will, there are no longer grounds for an argument that the CFPB violates the Constitution’s separation of powers. The S.D.N.Y. stated that the Notice of Ratification failed to “render[] Defendants’ constitutional arguments moot.”

Lofchie Comment: Given the divide between the courts as to the constitutionality of the CFPB, one might ordinarily expect the government to appeal this decision. However, many members of the administration are likely in agreement with the S.D.N.Y. determination that the CFPB is not constitutionally established. It is not certain how the government will react.

That said, there is no justification for giving a single person – the head of the CFPB – such a tremendous amount of power, without subjecting the individual to any checks, whether that be the Presidential power to dismiss the individual, Congressional power to limit the CFPB’s budget, or the power of other Commissioners to dissent to actions taken by the CFPB. Hopefully, the Court’s decision will motivate Congress to improve the structure of the CFPB and to dampen the remarkable and unseemly authority granted to the agency’s head.