FSOC Releases Third Annual Report on Financial Stability

The 2013 FSOC (Financial Stability Oversight Council) Annual Report was developed collaboratively by the members of the Council and their agencies and staff. Under Dodd-Frank, FSOC must make recommendations to promote market discipline, maintain investor confidence, and enhance the integrity, efficiency, competitiveness, and stability of U.S. financial markets.

In its third annual report, the Council’s findings and recommendations are organized around seven themes:

  • The vulnerability to runs in wholesale funding markets that can lead to destabilizing fire sales;
  • The housing finance system that continues to rely heavily on government and agency guarantees, while private mortgage activity remains muted;
  • Operational risks that can cause major disruptions to the financial system;
  • The reliance on reference interest rates, which recent investigations have demonstrated were manipulated, particularly in the case of the London Interbank Offered Rate (LIBOR);
  • The need for financial institutions and market participants to be resilient to interest rate risk;
  • Long-term fiscal imbalances, as the absence of bipartisan agreement on U.S. fiscal adjustment has raised questions about whether long-term fiscal problems may be resolved smoothly; and
  • The United States’ sensitivity to possible adverse developments in foreign economies.

In the report, the Council’s recommendations address the following topics:

  • Reforms to address structural vulnerabilities;
  • Reforms of wholesale funding markets (money market funds, tri-party repo);
  • Housing finance reform;
  • Reforms relating to reference rates;
  • Heightened risk management and supervisory attention;
  • Operational risk (cybersecurity, infrastructure);
  • Risk of prolonged period of low interest rates;
  • Capital, liquidity, resolution; and
  • Progress on financial reform.

Lofchie Comment:  As a lawyer, the parts of the report that I thought most interesting were the non-lawyerly sections of the report (sections 4 and 5) that talk primarily about the big-picture state of the financial markets.  It’s pretty depressing stuff.

In terms of its analysis of risk, most interesting was the discussion of interest rate risk.  The report seemed to say that the government was holding rates down but at some point the rates were going to pop up, and that could be a shock to the system.  It was not so clear how market participants should deal with a risk that was more political than market-driven.  The report also takes a very ambivalent view of the trade-off between risk and stimulating the economy.  On the one hand, the report seemed to praise banks for cutting back on risk and on the other, to criticize them for not making high-risk subprime loans. 

The discussion of regulatory issues is primarily in part 6 and to a lesser extent in part 7.  (The main points of these parts are listed in the descriptive part of this story.) Reading these parts may be useful in terms of understanding the direction that the regulators will go.  That said, these sections feel more like (moderately low-key) political statements, than they do the disinterested studies such as a GAO report.  For example, these sections talk about all the Dodd-Frank “milestones” that have been achieved, without mentioning the raft of no-action letters to deal with unworkable rules and likewise without mentioning that earlier sections of the report discuss the risks imposed on the system by central clearing corporations; and the report boasts of the government’s improvements in requiring information, without mentioning that the government has no way to store and use much of it.  (Somewhat coincidentally, today’s news also includes a speech by CFTC Commissioner O’Malia that is primarily focused on all of the problems with the CFTC’s reporting regime:  see  Commissioner O’Malia Speech Criticizing the CFTC’s Implementation of Dodd-Frank )

The report does not say much about the designation of systemically important financial institutions, other than that it is coming.  Presumably, litigation will follow, particularly in light of the GAO’s fairly critical study on FSOC (cited below).

See: 2013 FSOC Annual Report; FSOC Charts in PDF or Excel.
See also: Remarks by Treasury Secretary Jacob J. Lew.
See also:  GAO Finds FSOC and OFR to Be Well-Intentioned.
See also:  2011 FSOC Annual Report; 2012 FSOC Annual Report.

Commissioner O’Malia Speech Criticizes the CFTC’s Implementation of Dodd-Frank

CFTC Commissioner Scott D. O’Malia delivered a speech highlighting what he viewed as some of the principal failures of the CFTC’s rulemaking.  The problems he claimed in the speech were: (i) the recordkeeping rules do not work and the CFTC is not able to use the information it receives; (ii) there is not even draft guidance on how substituted compliance should be implemented and the expiration date of the CFTC’s guidance is nearing; (iii) the CFTC’s rules on business conduct fail to take into account how market participants actually trade; and (iv) the CFTC does not perform any meaningful cost-benefit analysis of its rules. 

See: Foreign Exchange Committee, Forum on the Dodd-Frank Act and the Foreign Exchange Market.

Statement of Chairman Gary Gensler before the Financial Stability Oversight Council

CFTC Chairman Gary Gensler provided the statement linked below in support of the Financial Stability Oversight Council’s (“FSOC”) annual report and recommendations. In his statement, he asserted the following:

“There are two critical areas . . . in which the CFTC must complete reforms.

First, it is a priority to finish rules to promote pre-trade transparency, including those for swap execution facilities and the block rule for swaps.

Second, it’s a priority that the Commission, working with domestic and international regulators, complete guidance on the cross-border application of swaps market reform.”

Click here to view statement in full (links externally to CFTC website).

Levin Urges CFTC to Apply U.S. Derivatives Rules to Non-U.S. Affiliates of U.S. Firms

Sen. Carl Levin, Chairman of the Permanent Subcommittee on Investigations, filed a letter yesterday urging the CFTC to apply U.S. derivatives safeguards to London and other non-U.S. offices of U.S. financial firms. The key paragraph of Senator Levin’s letter is as follows:

In particular, this letter recommends: (1) applying derivative safeguards to U.S. financial institutions and their foreign branches and agencies on an entity-wide basis; (2) applying the same derivative safeguards to foreign affiliates and subsidiaries that are under common control with a U.S. financial institution; (3) rejecting suggestions to exempt derivatives trading conducted between the non-U.S. offices of U.S.-based financial institutions; (4) expanding the description of guarantee arrangements considered relevant to determining whether a foreign affiliate or subsidiary should be treated as a U.S. person to include, at a minimum, arrangements involving total return swaps, credit default swaps, and customized options; and (5) ensuring that the foreign offices of U.S.-based financial institutions, when conducting derivatives trades that have a direct connection to the United States, comply with the same capital, clearing, margin, recordkeeping, and reporting safeguards and business standards that apply to their U.S.-located counterparts.

Lofchie Comment:  If the U.S. rules relating to swaps were economically rational and would produce a more creditworthy system, there would be considerable logic in transporting them offshore.  However, if one believes that the U.S. swaps rules are not well considered (as evidenced by the mass migration of customers from swaps to futures (“futurization”) to avoid the burdens of Dodd-Frank), it logically follows that following Senator Levin’s suggestion should produce a collapse of the swaps business done by U.S. financial institutions outside the United States.

I use the word collapse rather than the word damage, because the reaction to non-economic rules in a competitive market should be swift. If the U.S. swaps rules are not attractive to non-U.S. customers, they won’t buy U.S. swaps.   Financial markets move quickly on bad news and bad prices; that is why we have bank runs and flash crashes.

The counter to my belief that this proposal would severely damage U.S. financial institutions is the argument that the new swap rules make the U.S. markets better.  If this were perceived to be the case by market participants, then non-U.S. market participants should be moving into the U.S. markets.  My perception is that they are moving away.  This perception can be empirically tested, in light of the information that the government has readily available, and by conducting a survey of the views of non-U.S. market participants.  I hope that the regulators will carefully consider empirical data before pursuing actions that could put the offshore businesses of U.S. financial institutions at material risk. 

See link to Senator Levin’s letter here.

Senate Democrats’ Amicus Brief Sides with CFTC in ISDA v. CFTC

Nineteen Senate Democrats led by Senator Carl Levin have filed an amicus brief asking the U.S. Circuit Court of Appeals for the District of Columbia to overturn a federal district court decision that vacated the CFTC’s position limit rules issued under Dodd-Frank, ISDA v. CFTC, 887 F. Supp. 2d 259 (D.D.C. Sep. 28, 2012). The Senate Democrats’ brief argues that Congress did not intend to require the CFTC to make a necessity finding before implementing position limits, but rather to promulgate such limits within the tight deadlines specified in the statute. Their argument supports the notion that, in issuing its rules, the CFTC did not have the discretion to alter an express mandate from Congress: “Congress chose to direct the agency to establish position limits within a set period, chose to do so unconditionally, and chose to describe those limits as ‘required.'” Under this mandatory regime, according to the brief, the only discretion that the CFTC could exercise was with respect to the level of position limits.

Lofchie Comment: Why would Congress and the CFTC not want to consider all of the economic research on this subject that has already been done?  If we don’t want the regulators to consider economic analyses before adopting rules, what is the point of FSOC and of Form PF and of all the information that the regulators now require?  When Congress mandates that hundreds of millions of dollars be spent collecting financial information, and then regulators argue that rules should be adopted without even considering the information that we already have available, something in the regulatory or legal structure needs fixing.

See: Brief for Senators Levin, Begich, Blumenthal, Boxer, Sherrod Brown, Cantwell, Cardin, Feinstein, Harkin, Manchin, Mccaskill, Menendez, Mikulski, Bill Nelson, Sanders, Shaheen, Warren, Whitehouse, and Wyden as Amici Curiae in Support of Appellant CFTC.

UK, Russia and Others Urge U.S. to Limit Cross-Border Reach of Dodd-Frank Swaps Rules

In a letter dated April 18 to Treasury Secretary Lew, representatives of the UK, Brazil, France, Germany, Italy, Japan, Russia, South Africa and Switzerland, along with European Commissioner for Internal Market and Services Michel Barnier, urged the United States to limit the cross-border reach of swaps rules related to the Dodd-Frank Act.

The letter began with the following sentence:  “We, the undersigned, are writing to express our concern at the lack of progress in developing workable cross-border rules as part of reforms of the OTC derivatives market.”  The letter went on to say that the global financial markets were fragmenting because of the proposed U.S. regulations.

Lofchie Comment:  How often do the U.K. and Russia get together to write an angry letter to the United States?

That non-U.S. customers will simply refuse to trade with U.S. firms because of the burdens imposed on customers, directly or indirectly, by Dodd-Frank, should be a serious concern for U.S. regulators.  The CFTC should do a market study (it can be a small one) and hire an independent research firm to ask non-U.S. customers about their views on the U.S. swaps markets.  If the non-U.S. customers do not believe that Dodd-Frank improves the U.S. markets and makes them more attractive to trade, that should be worrisome.  The United States is not helped if we destroy our position as the global center of finance.

Click here to view the letter to Treasury Secretary Lew in full (links externally to FSA website).
See also: Bloomberg’s reporting on the matter.

Commodity Markets Oversight Coalition Amicus Brief Sides with CFTC in ISDA v. CFTC

The Commodity Markets Oversight Coalition (“CMOC”) submitted an amicus brief in support of the CFTC in its appeal of a federal district court’s ruling vacating its promulgation of position limit rules for physical commodities, ISDA v. CFTC, 887 F. Supp. 2d 259 (D.D.C. Sep. 28, 2012). CMOC’s brief argues that the CFTC’s rules are supported by the rise of speculative traders in the early 2000s, which “fundamentally altered the commodity derivatives markets to the detriment of commodities users” and by a congressional mandate that the CFTC take “swift decisive action” to end the “serious problem” of excessive speculation. Invoking the 2008 financial crisis, CMOC argues that the position limits were necessary “when properly viewed through the lens of the 2008 financial crisis and the long history of Congressional interest in excessive speculation.” It faults the District Court’s outcome for being “improperly divorced from the circumstances existing at the time [Dodd-Frank] was passed, and from the evil which Congress sought to correct and prevent.”

Lofchie Comment:  The “Interagency Task Force on Commodity Markets, Interim Report on Crude Oil” report from July 2008, was led by CFTC staff (and included staff of the Departments of Agriculture, Energy, Treasury, the Federal Reserve, the Federal Trade Commission, and the SEC) found that oil prices rose inversely to institutional activity in the energy derivatives markets, suggesting that the positions of hedge funds “provided a buffer against volatility-inducing shocks.”    Here are some further key lines from the report, which questioned whether speculators had driven up the price of oil:

• “The key driver of oil demand has been rapid economic growth”;
• “[t]he distinction between hedging and speculation in futures markets is less clear than it may appear”;
• “speculators serve important market functions – immediacy of execution, liquidity and information aggregation”;
• “statistical correlations and tests are consistent with the view that current oil prices are being driven by fundamental supply and demand factors”; and
• “there is no statistically significant evidence that the position changes of any category of or sub-category of traders systematically affect prices”; “this is to be expected in well-functioning markets.

In short, the CFTC’s own study seems to indicate that (i) speculators don’t drive up oil prices, (ii) speculators are generally good for the markets and (iii) there is so much going on in the world oil markets (wars, economic booms and busts, government-sponsored oil subsidies) that it is impossible to be confident that position limits would lower prices or make markets better; further, it seems more likely that position limits would be expensive to implement and would make markets worse.  Against the background of the report of the interagency task force, the CFTC’s enthusiasm for position limits is puzzling.  After all, the CFTC has a plate of responsibilities that is overflowing, and a budget that is unlikely to meet its requests (see our recent news stories on the CFTC’s budget).  Why spend limited agency resources on a dubious project when there is good that could be done elsewhere?

See: Brief of Amicus Curiae Commodity Markets Oversight Coalition in Support of Appellant CFTC in Favor of Reversal.

Bretton Woods: The Next Chapter at the IMF/WB Spring Meetings

Kurt Schuler, co-editor of The Bretton Woods Transcripts, spoke on Friday at the IMF/World Bank spring meetings. Kurt is one of three authors who recently came out with a book on the Bretton Woods monetary conference that spoke on this panel.

To see the video, click here.

Jim Boughton, former IMF historian, makes opening remarks. Professor Bessma Momani of the University of Waterloo moderates the panel. Kurt Schuler’s remarks begin at 14 minutes and 15 seconds.

Financial Services Committee Hearing: Who Is Too Big to Fail?

The Financial Services Committee held a hearing to examine whether the Dodd-Frank Act authorizes the break up of financial institutions. The Committee stated that the Federal Reserve has not developed any metrics for determining whether a financial institution poses a “grave threat to the financial stability of the United States.” Congressman Patrick McHenry, Chair for the Oversight and Investigation Subcommittee on Financial Services, stated that the indecisiveness on these issues is “a very frightening thing.”

See:  Who Is Too Big to Fail?: Hearing Examines if Dodd-Frank Authorizes the Break up of Financial Institutions.