House Financial Services Committee Chairman Calls on FSOC to Cease and Desist

House Financial Services Committee Chairman Jeb Hensarling (R-TX) delivered an opening statement at a committee hearing regarding the Financial Stability Oversight Council (“FSOC”), calling on FSOC to “cease and desist” designating nonbank institutions as systemically important financial institutions (“SIFIs”) until Congress can further review the jurisdiction and effectiveness of FSOC and related organizations. 

See: Video of Chairman Hensarling’s Remarks; Press Release.
Related news:  SIFMA Says Asset Managers Do Not Pose Systemic Risk (May 8, 2014); SIFMA AMG Submits Comments to the FSB on Assessment Methodologies for Identifying Non-Bank Non-Insurer G-SIFIs (April 7, 2014); SIFMA AMG Submits Comments to the FSB and SEC in Response to OFR Study and with Regard to Separate Accounts (April 8, 2014); SEC Commissioner Gallagher Submits Comment Letter in Opposition to FSOC Process (May 16, 2014); House Financial Services Subcommittee Chairmen Send Letter to FSB and FSOC Requesting Information on Methodologies Used to Designate G-SIFIs (May 12, 2014); FSOC Issues 2014 Annual Report (May 9, 2014); House Financial Services Committee Chairman Hensarling Urges Secretary Lew to Cease Using “Too Big to Fail” Designations (May 9, 2014). 


Banca d’Italia’s Financial Stability Report

Bank of Italy’s most recent FSR became available earlier this month. Below is the Bank’s summary:


The global expansion proceeds at moderate and regionally uneven rates – The world economy continues to expand moderately with differing regional performances. In Europe the recovery has also involved the countries hit by the sovereign debt crisis. In some of the emerging economies with structural imbalances, growth has slowed and capital outflows have been recorded.

In Europe financial conditions improve in the countries worst hit by the sovereign debt crisis … Financial conditions in the euro area have improved in the last few months. The reduction in the spread on government securities, which has been more pronounced since last autumn, mainly reflects the subsidence of fears of a break-up of the single currency, thanks to signs of economic recovery, the effects of fiscal consolidation and the introduction of reforms in a number of countries, the Eurosystem’s initiatives and the progress made towards Banking Union.

…but the risks are still considerable – Significant risks remain, especially as regards the evolution of the macro-economic situation. Negative consequences for growth and financial stability in the euro area could come from a worse than expected slowdown in the emerging economies or an unexpectedly protracted period of low inflation. Uncertainties also stem from the geopolitical tensions in various parts of the world, in particular the crisis between Russia and Ukraine. On the other hand, the risk that the less accommodative monetary policy stance in the United States might cause an increase in medium and long-term interest rates in the euro area as well has lessened, although it has not disappeared.

In Italy the slow improvement in the macroeconomic situation continues – In Italy the economic recovery is spreading, but it remains fragile. The real estate market is still weak. House prices are still declining, although the fall in non-residential property prices has come to a halt. Foreign portfolio investment in Italy has increased, both in government securities and private-sector securities. Interest rates have declined on all maturities.

The financial conditions of households are sound … In 2013 households suffered a smaller decline in disposable income than in 2012; there was a reduction in debt and a recovery in investment in financial assets. Low interest rates and measures to support borrowers helped to contain the vulnerability of indebted households. It is estimated that the proportion of financially fragile households would increase by only a modest margin even under adverse macroeconomic scenarios.

… but those of firms are still difficult – Although some positive signs are emerging, the financial conditions of firms remain weak. Several large companies have substituted bonds for part of their bank debt; for smaller firms, difficulties in accessing credit, low liquidity and the uncertainties still surrounding the cyclical upswing will remain the main sources of risk in the coming months.

The Comprehensive Assessment is under way – The Comprehensive Assessment of the largest euro area banks is now in progress. The exercise, in which 15 Italian banks are taking part, will permit uniform comparison of bank balance sheets in different countries, helping to reduce the segmentation of European financial markets still further.

Market assessments of Italian banks improve – In the first few months of the year the markets’ evaluations of Italian banks improved considerably, bringing them nearer to those of banks in the other main euro-area countries.

The contraction in credit eases – The contraction in bank lending abated somewhat at the start of 2014. Qualitative surveys of banks found more favourable conditions for credit to households; the conditions of credit access for firms, though slightly better, remain restrictive.

The deterioration in loan quality slows – The deterioration in banks’ loan asset quality has eased. The flow of new bad debts as a ratio to outstanding loans stabilized in the fourth quarter of 2013, and preliminary data indicate that in the first quarter of 2014 it declined. However, the volume of non-performing loans is still growing.

Loan loss provisions hit profitability but significantly raise coverage ratios – The massive loan loss provisions entered in the banks’ accounts at the end of 2013 completely absorbed operating profits, but at the same time they resulted in a significant rise in coverage ratios. This development was welcomed by the markets and may help to revive the market for non-performing loans. Some large banks have announced initiatives to optimize the management of these exposures. The lowering of banks’ operating costs continued, thanks in part to the rationalization of branch networks.

Banks reduce their sovereign exposure – Beginning in the second half of last year, Italian banks have reduced the volume of their government securities portfolio.

The funding gap narrows and repayment of Eurosystem financing proceeds – The funding gap has been brought back down to the levels registered in the middle of the last decade, and the repayment of Eurosystem financing has continued, albeit unevenly across banks. The largest have stepped up their bond issuance on the international markets, returning to positive net issues.

A number of banks announce capital increases – Italian banks’ capital position deteriorated as a result of the massive loan loss provisions made at the end of 2013. A number of banks have undertaken capital increases for a total of €10 billion. Italian banks’ leverage remains lower than that of other European banks.

Risks in the insurance sector are modest – For insurance companies the risks deriving from the protracted phase of low interest rates are modest, thanks in part to insurers’ prudent policies on guaranteed-yield policies. The main risks for the sector stem from the tenuous economic recovery. The soundness of the leading companies is now being assessed by the European insurance authority.

Liquidity conditions in the financial markets are easier – The liquidity of the Italian financial markets has improved further. The systemic liquidity risk indicator is now at its lowest level ever, reflecting heavier trading on the secondary market in government securities.

Banca d’Italia’s financial stability report can be found on the CFS FSR page.

SEC Commissioner Piwowar Speaks on Cost-Benefit Analysis and Flash Boys

SEC Commissioner Michael Piwowar spoke at the First Annual Conference on the Regulation of Financial Markets regarding the important role that economic analysis and academic research plays in securities regulation.

Commissioner Piwowar stated that, during his tenure at the SEC, he has seen economists become more involved with respect to rulemakings, enforcement and inspections of regulated entities. He explained that the SEC Division of Economic and Risk Analysis (“DERA”) provides the foundation of economic analysis, at the front end of tackling regulatory problems, that serves as an essential component to the SEC’s market knowledge. He noted that DERA was “instrumental” in creating Staff Guidance on Economic Analysis in SEC Rulemakings, which stated that high-quality economic analysis “serves as an essential part of SEC rulemaking” and helps to inform the SEC of the likely economic consequences of regulation.

Furthermore, Commissioner Piwowar stated, he “sees the need for the SEC to conduct a multi-year comprehensive review of equity market structure” to allow the SEC and its staff to understand and explore how the equity market structure has evolved. Specifically, Commissioner Piwowar identified some “threshold questions” that should guide the rulemaking process. The questions involve exploring what drives the supposed “need for speed,” and why traders are directing flow to so-called “dark pools” rather than “lit” markets.  A comprehensive review, Commissioner Piwowar explained, will allow us to “put everything on the table for discussion and approach the review with a completely open mind.”

Lofchie Comment: One of the oddities of the bifurcation of swaps rulemaking is that the SEC and the CFTC have pursued opposing processes for adopting rules. The CFTC rushed to adopt many rules as quickly as possible, often in piecemeal fashion, while the SEC moved more deliberately, adopting all of its swap rules as a unified set. Likewise, the two Commissions have taken opposite views as to their obligations to conduct cost-benefit analyses. The SEC seems to take cost-benefit analysis very seriously to the extent that it has imposed robust requirements on itself. By contrast, the CFTC has not acted as though it is particularly constrained by the requirement of a cost-benefit analysis, either because its statute is differently worded or because of philosophical differences. Generally, the CFTC seems to have started with the conclusion that the financial crisis would have been averted if the swap rules had been in place and, thus, the swap rules (or the position limits rules, for example) provide a great benefit and are worth the cost. 

Leaving aside the question of which Commission is “right” in its approach, the fact that the two Commissions are taking such different approaches will almost certainly result in the SEC’s producing a body of swaps regulation that is quite different from the body of regulation produced by the CFTC. To take one example: even if the SEC attempts to adopt a set of cross-border rules that mirrors the cross-border guidance produced by the CFTC, the SEC will likely find it impossible to produce a cost-benefit analysis that justifies these rules (the CFTC avoided this difficulty by not performing the analysis). As different approaches lead to different results, so the different processes of the SEC and the CFTC will give us different rules governing cross-border swaps.

See: Commissioner Piwowar’s Remarks.


FINRA CEO and Chairman Ketchum Speaks on Restoring Investor Trust in Markets

FINRA CEO and Chairman Rick Ketchum delivered opening remarks at the FINRA Annual Conference, focusing on how to regain investor trust and confidence in the markets. 

According to Chairman Ketchum, much of FINRA’s recent work has contributed to improving the protection of investors and market integrity.  One of the changes, Chairman Ketchum noted, was the transformation of FINRA’s risk-based exam program to be more data-driven.  FINRA fully implemented the Request Manager system in 2013, which streamlined the exchange of information between FINRA and its firms.  Additionally, the Risk Control Assessment and the data FINRA gathers through TRACE both have helped inform FINRA exams and knowledge of the business activities of its firms. 

To restore investor trust further, Chairman Ketchum stated, FINRA’s role should be focused on a set of organizing principles, including:

  • to be data informed;
  • to be technology empowered;
  • to be responsive to change; and
  • to be capable of more quickly and effectively identifying and disciplining bad actors. 

According to Chairman Ketchum, an important step in fulfilling these principles is the Comprehensive Automated Risk Data System (“CARDS”), which will allow the collection and management of data from firms in a standardized way, and will provide FINRA with ongoing “birds-eye-view surveillance.”  Chairman Ketchum noted there are many concerns with CARDS, including issues with personally identifiable information, with the security of such a large database, and with costs and operations.  Chairman Ketchum said that, in order to address such concerns, FINRA has been meeting with firms and plans to launch CARDS in stages.  Additionally, he stated, FINRA is changing the CARDS proposal so that firms can choose how to send FINRA data: through a clearing firm, a service bureau or to FINRA directly. 

Chairman Ketchum also mentioned briefly that the ongoing debate on both high-frequency trading and equity market structure has not helped to restore investor confidence, “particularly when we have popular authors saying the markets are ‘rigged.'”  Chairman Ketchum added the clarification that the markets are not rigged, and that FINRA and the exchanges have never been focused more on identifying manipulative or disruptive trading activity.  He explained that, later this month, FINRA will be issuing the first reports of Alternative Trading Systems (“ATS”) volume on a stock-by-stock basis in order to increase transparency for ATS trading.  Additionally, he stated, FINRA recently added Direct Edge data to the data surveyed from NYSE and NASDAQ so that FINRA now conducts surveillance of 90 percent of the listed U.S. equity market. 

Chairman Ketchum explained that, of all the initiatives he mentioned, the “biggest game changer” will be the implementation of the Consolidated Audit Trail (“CAT”), which will collect, identify and link orders, trades and quotes in equities and options from all market participants.  He added that CAT will provide the view needed to restore investor trust and transparency of the markets. 

See: Chairman Ketchum’s Speech


OCC Proposes Rule to Increase Amount of Semiannual Assessment on National Banks and FSAs with Assets over $40 Billion

The Office of the Comptroller of the Currency (“OCC”) issued a proposed rule that would raise the semiannual assessment on national banks and federal savings associations (“FSAs”) with more than $40 billion in assets. 

The proposal would increase the marginal assessment rates on asset amounts in excess of $40 billion by 14.5 percent, as well as amend 12 CFR 8 to clarify that the OCC may increase the marginal assessment rates for reasons other than inflationary indexing. The total increase in the assessment amount for an individual national bank or FSA would depend on its total assets, with increases ranging from between 0.32 to 14 percent.  The proposed increase would not change the assessment amounts for national banks and FSAs with $40 billion or less in assets.

According to the OCC, the proposed increase results from the need to fund new or enhanced OCC activities necessary to supervise the implementation of post-crisis financial reforms, primarily by large national banks and FSAs. 

If adopted, the increase in assessments would be effective for the assessment due date of September 30, 2014.  Comments on the proposal are due by June 12, 2014. 

See: OCC Proposal


Comptroller Curry Discusses Cyber Risks Related to Third-Party Service Providers

In a speech before the New England Council, Comptroller of the Currency Thomas J. Curry discussed cybersecurity, recent efforts to combat cyberattacks, and risks stemming from relationships between banks and their third-party service providers.

Echoing remarks made last month before a meeting of CES (Consumer Electronics Show) Government, Comptroller Curry mentioned three specific risks related to third-party cybersecurity: (i) the extent to which service providers are consolidating and leaving financial institutions more dependent upon a single vendor, (ii) the increased reliance by banks on outside vendors – including foreign-based subcontractors – to support critical activities, and (iii) the access that third parties have to large amounts of sensitive bank and customer data. 

Comptroller Curry emphasized that he is most concerned that risk management practices may not be keeping pace with the cyber-related institutional risks being assumed.  He pointed out that even well-established banks have encountered major challenges as a result of underestimating the risk in third-party relationships.  He noted that, without the appropriate controls and oversight, institutions are left open to credit losses, compliance problems, litigation exposure and reputational damage.

Comptroller Curry concluded by stressing the need for collaboration by federal and state banking agencies, private sector firms, and trade associations in the effort to combat cyber threats. 

See: Comptroller Curry’s Speech.
See also:
OCC’s October Guidance on Risk-Management Practices.
Related News:
OCC Comptroller Curry Discusses Cybersecurity (April 17, 2014).


SEC Commissioner Gallagher Submits Comment Letter in Opposition to FSOC Process

SEC Commissioner Gallagher issued a comment letter criticizing the authority of the Financial Stability Oversight Council (“FSOC”) to designate nonbank entities as systemically important financial institutions (“SIFIs”). Commissioner Gallagher stated that although the SEC does not have a formal role in “FSOC’s misguided debate” over whether or not to designate asset managers as SIFIs, he called on regulators and market participants to engage in an “honest debate” regarding FSOC initiatives.

Commissioner Gallagher criticized the recent OFR Asset Management and Financial Stability Report, which found that asset management firms pose substantial risk to financial markets.  The report, he explained, inaccurately defines and describes the activities of participants in the asset management business by analyzing asset managers in a vacuum instead of in the context of broader financial markets.  In addition to the “myriad” inaccuracies and unsupported analyses contained in the report, Commissioner Gallagher stated that problems are compounded by the OFR’s “brazen refusal” to consider the comments and input from the SEC and other agencies tasked with regulating nonbank entities. He noted that litigation will surely follow any decision by FSOC to designate asset managers as SIFIs.

Commissioner Gallagher went on to say that it is “folly” to force bank regulatory principles upon capital markets since the resolution process for asset managers is vastly simpler than that of most other types of financial institutions.  He explained that asset management firms do not require a backstop or bailout because they are designed to manage risk and the potential for failure by providing enough of a cushion to ensure that a failed asset manager can liquidate in an orderly manner, allowing for the transfer of customer assets to another asset manager.

Commissioner Gallagher called the FSOC’s policy to apply a one-size-fits-all regulatory paradigm to all financial institutions “irrational” and “shortsighted” for not considering the different nature of financial entities.  He stated that the FSOC process itself is more dangerous to financial markets “than the purported risk factors it was purportedly created to address.”

Lofchie Comment:  The suggestion that asset managers could be determined to be systemically significant has been subject to broad and harsh criticism given that asset managers do not themselves own a material amount of assets. The stated justification for OFR’s surprising conclusion sheds light on the direction that OFR might take if it were to have the authority to regulate asset managers as SIFIs. The paragraph below is illustrative:

“[E]ngagement by a significant number of asset managers in riskier activities, could pose, amplify, or transmit a threat to the financial system. These threats may be particularly acute when a small number of firms dominate a particular activity or fund offering. . . .  Activities aimed at boosting returns through leverage, such as the use of derivatives, reliance on borrowing, or other means discussed below, could contribute to system-wide leverage and risk transfer.  (at page 7 of the OFR Report)

The direction of the OFR Report is undeniable.  While it does not say so directly, in light of the “risk” identified, the Report suggests that the government could regulate the investment allocation decisions made by investment advisers on behalf of private entities. This would seem an extraordinary power for the federal government to assert.  Query: should the government be allowed to regulate the investment decisions made by private entities, including perhaps allocating to particular advisers/entities the share of a “particular activity” in which they were permitted to engage? Such a possibility should raise concern.

See: Comment Letter; OFR Asset Management and Financial Stability Report.
See also: House Financial Services Subcommittee Chairmen Send Letter to FSB and FSOC Requesting Information on Methodologies Used to Designate G-SIFIs (May 12, 2014); FSOC Issues 2014 Annual Report (May 9, 2014); House Financial Services Committee Chairman Hensarling Urges Secretary Lew to Cease Using “Too Big to Fail” Designations (May 9, 2014).


Senate Appropriations Subcommittee Holds Hearings on SEC and CFTC Budgets

The U.S. Senate Appropriations Subcommittee on Financial Services and General Government held a hearing to discuss the fiscal year (“FY”) 2015 budget requests of the SEC and the CFTC.  SEC Chair Mary Jo White and CFTC Acting Chair Mark Wetjen testified before the Subcommittee, each explaining the reason for the relevant Commission’s request for a substantially expanded budget.

Lofchie Comment: Chair Wetjen was forthright as to why the CFTC’s budget needs have expanded substantially.

       “The notional value of derivatives centrally cleared by clearing houses was $124 trillion in 2010 (according to ISDA data), and is now approximately $223 trillion (according to CFTC data from swap data repositories (‘SDRs’)). That is nearly a 100 percent increase. The expanded use of clearinghouses is significant in this context because, among other things, it means that the Commission must ensure through appropriate oversight that these entities continue to properly manage the various types of risks that are incident to a market structure dependent on central clearing. A clearinghouse’s failure to adhere to rigorous risk management practices established by the Commission’s regulations, now more than ever, could have significant economic consequences.”

In contrast to statements by the prior CFTC chair that the use of central clearing corporations eliminated risk to the financial system, the current CFTC chair asserts that clearinghouses can fail and that any such failure “could have significant economic consequences.”  While it is possible that massive centralization of risk in the clearinghouses will reduce systemic risk, it quite possibly will not.  Whichever side of the debate one may take, Chair Wetjen’s remarks acknowledging the risk that is being concentrated in clearing corporations opens an honest discussion – itself an advancement in developing a sound regulatory structure.

Click here for YouTube link.

See: Senate Appropriations Subcommittee Hearing Information and Webcast.
See also: SEC Chair White’s Written Testimony and CFTC Active Chair Wetjen’s Written Testimony.


FRB Staff Working Paper on High-Frequency Trading

The Board of Governors of the Federal Reserve System (“FRB”) published a Finance and Economics Discussion Series (“FEDS”) working paper titled “Machines vs. Machines: High Frequency Trading and Hard Information,” written by Yesol Huh. 

The paper focuses on whether, and in what circumstances, high-frequency trading (“HFT”) provides liquidity to the market, arguing that HFT liquidity-takers’ use of machine-readable information causes an information asymmetry, which becomes more severe when markets are volatile.  Using a statistical approach to measure HFT activity, the author argues that the greater the information asymmetry, the lesser the liquidity that is provided by HFTs to stocks that suffer the most from this information imbalance. 

Additionally, the author discusses the potential implications for HFT regulations and for market-making activity in times of market stress. 

Lofchie Comment: The statistical analysis in this article is complicated, but the conclusion is relatively straightforward: in some circumstances, high-frequency trading, or at least some types of high-frequency trading, may result in a reduction in the amount of liquidity in the market. This type of “negative” finding seems to raise a reflex reaction in today’s environment: let’s impose regulation.

Since the world is not perfect, high-frequency trading programs do not furnish the mathematically perfect amount of liquidity in every market. The “problem” discussed in the paper, to the extent that it is a problem at all, is not deserving of urgent attention, nor does it rise to a level that calls for an attempt to regulate it away. Regulatory resources are limited and there are quite enough other material issues that demand attention. 

That said, this is a serious paper and several points made in it are worth particular attention. First, the battle between man and machine as to how trading takes place is not over. Second, it is far from clear that adopting regulations that put a speed limit on machines is the answer (and why would that do any good unless all machines acted at exactly the same speed)? Third, while HFT may withdraw liquidity from markets during volatile periods, human market-makers would do exactly the same thing (for those who remember, that was the case with the 1987 market crash).

Regulators should attend to one aspect of the study in particular: its use of simulations. Historically, when the securities regulators have attempted to adopt rules governing market structure, they simply guessed at the effect of those changes (and their guesses don’t appear to have been very accurate). The use of simulations could allow regulators to game-play the effects of different combinations of theoretical rules and perhaps give them a better chance of adopting rules that would produce anticipated and desired results.

See: Machines vs. Machines: High Frequency Trading and Hard Information