Congress to Vote on Bill to Repeal Swaps Push-out Requirements

The U.S. Congress is scheduled to consider a proposal to allow banks to keep swaps trading units.

The congressional vote on the proposal, which is included in the government funding bill (H.R. 83), will take place soon.

Regarding the bill, FDIC Vice Chair Hoenig stated that “[i]t is illogical to repeal the 716 push out requirement,” and explained that most derivatives would not even be pushed out of the bank because “interest rate swaps, foreign exchange and cleared credit derivatives can remain within the bank.”

According to Vice Chair Hoenig, the main items that must be pushed out under Dodd-Frank Section 716 are uncleared credit default swaps, equity derivatives and commodities derivatives, which are “much smaller and where the greater risks and capital subsidy is most useful to these banking firms.” Additionally, he stated, the derivatives that are pushed out are “only removed from the taxpayer support and the accompanying subsidy of insured deposit funding – they will continue to exist and to serve end users.”

Lofchie Comment: There are good reasons to repeal Section 716. It is wasteful and expensive for banking organizations to have to build an infrastructure to support swaps-dealing activity in more than one legal entity. This requires a duplication of regulatory expenses, a substantial duplication of technology infrastructure and a significant increase in necessary personnel. Additionally, banking organizations face the same customers in both types of transactions. By forcing banking organizations to split their transactions between two legal entities, the regulations diminish the ability of the banks to reduce credit exposure by netting off transactions with a single customer. Similarly, banking organizations face more operational burdens when moving margin payments back and forth between entities as a customer’s positions change in value at separate entities. Contrary to Vice Chair Hoenig’s view that banks will continue to provide these services to end users, it follows that banks will provide fewer of the services at a higher cost. (These requirements are not cost-free, nor are they internalized by the banking system; they have to be passed on to users, such as the commercial firms that trade in commodities.)

Banks are well suited to engage in these activities. Lending money with respect to debt obligations or commodities, whether the exposure is documented as a loan or as a derivative, is inherently a credit function and, thus, an activity appropriate for banks.

See: H.R. 83; Vice Chair Hoenig’s Statement.


Senate Committee on Banking, Housing and Urban Affairs Holds Hearing on Cybersecurity in the Financial Industry

The Senate Committee on Banking, Housing and Urban Affairs held a hearing, titled “Cybersecurity: Enhancing Coordination to Protect the Financial Sector,” which discussed regulatory efforts to address cyber threats and vulnerabilities and coordinate information-sharing among banking industry, regulatory community and financial industry stakeholders.

The following witnesses testified at the hearing:

  • Mr. Brian Peretti, Director for the Office of Critical Infrastructure Protection and Compliance Policy, U.S. Department of the Treasury (written testimony);
  • Dr. Phyllis Schneck, Deputy Under Secretary for Cyber Security and Communications, National Protection and Programs Directorate, U.S. Department of Homeland Security (written testimony);
  • Ms. Valerie Abend, Senior Critical Infrastructure Officer, Office of the Comptroller of the Currency (written testimony);
  • Mr. William Noonan, Deputy Special Agent in Charge, United States Secret Service (written testimony); and
  • Mr. Joseph M. Demarest, Jr., Assistant Director, Cyber Division, Federal Bureau of Investigation (written testimony).

Regarding the hearing, SIFMA submitted a statement to the Committee in which it encouraged Congress to “engage more productively” in the effort to improve cybersecurity by passing the Cybersecurity Information Sharing Act of 2014 (“CISA” or “S.2588”).

See: Press Release; Webcast of Hearing; SIFMA Statement.

FRB Proposes Rules to Increase Capital Positions of Largest U.S. Bank Holding Companies

The Board of Governors of the Federal Reserve System (“FRB”) proposed a framework to establish risk-based capital surcharges for the largest, most interconnected U.S.-based bank holding companies.

Specifically, the proposed framework would require a U.S. bank holding company with $50 billion or more in total consolidated assets to calculate a measure of its systemic importance to determine whether it is a global systemically important banking organization (“GSIB”). A firm identified as a GSIB would be subject to a risk-based capital surcharge, calibrated based on its systemic risk profile, that would increase its capital conservation buffer under the FRB’s regulatory capital rule. The proposal also would revise the terminology used to identify the firms subject to the enhanced supplementary leverage ratio standards to ensure the consistency of the scopes of application of both rulemakings.

The proposed framework would be phased in beginning on January 1, 2016, and become fully effective on January 1, 2019.

Comments on the proposed rule are due by February 28, 2015.

Lofchie Comment: Yesterday, we posted an opinion piece arguing that the CFTC rules made it uneconomical for “smaller” banks (such as State Street, the 13th largest bank holding company in the United States with over $280 billion in assets) to effectively compete in businesses such as clearing swaps given the high regulatory and other fixed costs. The result is that only the very, very largest banking organizations have the scale to offer derivatives clearing services in products such as rates and currency, which are fairly important to the operation of the U.S. and global economy. Today, the news is that those very, very large banks are going to be hit with materially higher capital charges. In short, under our current regulatory policy, it stinks to be small and it stinks to be big.

While one can argue that there is some overall policy of risk reduction here, it is not obvious that punishing both the big and the small is a consistent policy, given that it does not incentivize any conduct (other than inactivity). Further, the goal of risk reduction in the financial sector (if that is the goal) creates material costs (i) in the “Main Street” sector, by reduced economic activity, (ii) in the United States by chasing credit business out of the United States and (iii) to the regulated sector by driving business out of regulated credit institutions.

At some point, “more regulation” stops being a wise regulatory policy. At a minimum, the regulators should make clear what are their goals. If their goals are a financial system with greater diversity of participation, then it follows that they should reduce the fixed costs of regulation to give small players opportunities. If their goals are to keep small players out of certain business, then it follows that they should not impose surcharges on the big players, which surcharges will be felt by the “Main Street” economy.

See: Text of Proposed Rule; FRB Press Release.

”Streetwise Professor” Craig Pirrong Discusses Developments in Clearing Business

In a blog post titled “Hit the Road, State Street,” University of Houston finance professor Craig Pirrong discussed the recent exit of smaller firms from the swaps clearing business and argued that the industry has become “highly concentrated and dominated by major dealers.”

Professor Pirrong commented that State Street’s announcement that it is exiting the swaps clearing business to “focus on trading other types of derivatives, particularly more traditional exchange-traded futures, that have not been subject to broad new regulations,” is not surprising. Professor Pirrong had predicted that the Dodd-Frank-imposed regulations in the swap clearing business would increase scale economies, making the business so concentrated and connected that “only the truly huge can survive.”

Professor Pirrong also asserted that the derivatives marketplace is now dominated by a small number of central clearing counterparties (“CCPs”), each of which is dominated by a small number of large bank-clearing members who are members of all of the major CCPs. He concluded that those who implemented Dodd-Frank did not understand “the economics of clearing, clearing firm scale and scope economies, and how the complicated regulatory structure the CFTC put in place exacerbated these scale economies.”

Lofchie Comment: Ironically, under Dodd Frank, legislators who decried “too big to fail” have mandated a system that exacerbates the problem in two ways.

First, the central clearinghouses themselves are too big to fail, since the legislation forced a tremendous share of the derivatives business done in the United States (and potentially the world) through a few U.S. clearing corporations. Given that the government forced clearing in a manner in which there is no way for the U.S. markets to trade around the risk of the central clearing systems, and consequently, created a situation in which complete chaos would result in the financial markets if the clearing corporation failed, the clearing corporations can be assumed to be too big to fail.

The second problem, as pointed out by Professor Pirrong, is that not only are the clearing corporations too big to fail, but the clearing members that intermediate between the market and the clearing corporations also are too big to fail because of their massive scale. This scale results not from any wrongdoing on the part of the clearing members, but from the structure established by the regulators. That is, the regulators created a structure that (i) has massive fixed costs (a function of direct regulation and the technology required to comply with those regulations) and (ii) essentially is a “generic” service, meaning that there is no basis on which clearing parties can compete other than pricing. (To put this another way, a smaller competitor is not going to be able to beat a larger competitor by providing better or more personalized services at a price sufficiently high to compensate for its inability to achieve economies of scale. Even if the smaller competitor had the chance to win, making the attempt would be too risky.)

In short, before Dodd-Frank, we had an economic market in which there were many swap dealers trading on a bilateral basis with each other and with numerous other customers. We are moving toward a market in which there are likely to be far fewer swap dealers that will be required to clear through an even smaller number of clearing counterparties, which counterparties will funnel all of the United States’ (and a good part of the world’s) swap transactions into a handful of clearing corporations

See: Hit the Road, State Street,” by Craig Pirrong.


Senators Crapo and Johnson Send Letter to SEC Chair White Regarding SEC’s Equity Market Structure Review

Senate Banking Committee Chairman Tim Johnson (D-SD) and Ranking Member Mike Crapo (R-ID) wrote a letter to SEC Chair Mary Jo White regarding the SEC’s progress with respect to an equity market structure review.

Senator Johnson and Senator Crapo referred to a July Senate Banking Committee hearing, titled “The Role of Regulation in Shaping Equity Market Structure and Electronic Trading,” during which members stressed the importance of a holistic equity market structure review and questioned what the SEC is doing to help to build better markets for smaller companies.

According to the Senators, these topics appear not to have been advanced at the SEC. To gain a better understanding of how the SEC plans to proceed with its review of equity market structure, specifically with respect to market resiliency and issues facing small public companies, the Senators requested that Chair White indicate:

  • what progress has been made at the SEC since Chair White’s October 2013 speech regarding a review of equity market structure and of regulations, including Regulation NMS;
  • what is being done to ensure that the existing equity market structure is “resilient and durable”;
  • what data analysis and formulation for a holistic review the SEC has conducted to date and when the SEC will provide the public with the ability to comment on such a review; and
  • what the SEC is doing currently to address the market structure concerns of small companies and to ensure the liquidity of a secondary trading market for small company stocks.

Lofchie Comment: The task of developing a secondary market for small company stocks will require liberalizing regulations, which always entails the risk of some greater degree of wrongdoing. The SEC should be looking at how it can encourage the writing of research on small companies (which means allowing those who write the research to make a profit) because few investors are likely to have the resources to conduct their own investigations into small companies, and no one is going to write research on such companies if there is no way to profit from the writing.

See: Senators’ Letter to Chair White.


CFTC Commissioner Wetjen Remarks on CCP Risk-Management Issues

In a speech before the FIA Asia Derivative Conference, CFTC Commissioner Mark Wetjen called attention to the concentration of risk in central counterparty clearing houses (“CCPs”) resulting from the increase in clearing volumes, and suggested ways to address related areas of risk-management.

Commissioner Wetjen began his remarks by discussing progress made to implement the G20 goal of clearing standardized swaps on CCPs. He commended the successful market and regulatory efforts to increase centralized clearing for OTC swaps, noting that central clearing promotes financial stability by (i) mitigating counterparty credit risk, (ii) enhancing transparency, and (iii) facilitating more efficient use of capital through clearing’s netting effects.

The Commissioner’s FIA remarks primarily focused on three risk-management areas that could benefit from regulatory and market scrutiny:

  1. “Improving transparency, in particular with respect to standardizing stress tests;
  2. Assessing loss mutualization by considering a requirement for CCP capital contributions to the guarantee fund, as well as the appropriate allocation of losses in the default waterfall; and
  3. Ensuring that recovery and wind down plans are effective and realistic, including whether to prohibit CCPs from allocating losses to customers in their recovery plans.”

In regards to stress tests, Commissioner Wetjen suggested that more uniform, standardized stress tests would “enable greater coordination among global regulators in assessing the risk-management practices of CCPs.” This, he noted, would enhance transparency for clearing members who belong to multiple CCPs. Commissioner Wetjen urged the CFTC to begin a public dialogue to consider these issues through the release of a concept release or through one of its advisory committees.

On the topic of loss mutualization, Commissioner Wetjen urged the CFTC to consider a rule addressing appropriate CCP capital contributions to the default waterfall. Global harmonization, he suggested, may be appropriate on this point. He advised that this policy, too, should be pursued through a CFTC release seeking comment or one of its advisory committees.

Lastly, Commissioner Wetjen stated that – in an effort to minimize the “contagion risk” to the broader market – regulators should work closely with CCPs to help assess the effectiveness of clear and detailed recovery and wind-down plans. He noted that if a CCP operates in multiple jurisdictions, cross-border regulatory coordination and collaboration is crucial.

Commissioner Wetjen concluded by stating that he intends to call a meeting of the CFTC’s Global Markets Advisory Committee this winter where market participants and regulators can further examine and discuss these important CCP risk-management issues and produce a recommendation.

Lofchie Comment: Regulators and market participants (led by the JP Morgan study) are facing the harsh reality that central clearing corporations centralize risk to a degree far beyond what previously existed in the market. While there may be some benefits to greater standardization of CCPs, as Commissioner Wetjen suggests, this also exacerbates the problem of centralization of risk, since it forces all market participants to adopt the same standards of risk measurement. Now that the regulatory optimism over the risk-mitigation benefits of central clearing has crested, it seems like an appropriate time to consider holding off on further requirements to force central clearing on huge segments of the financial markets.

See: Text of Commissioner Wetjen’s Speech.
See also: JP Morgan Issues Paper on Resolution Plan for Central Clearing Parties (October 6, 2014).


OFR Director Berner Discusses Filling Gaps in Data

Office of Financial Research (“OFR”) Director Richard Berner delivered remarks to the 2014 Financial Stability Conference, discussing the importance of filling gaps in data in order to inform policy for financial stability.

According to Director Berner, policy tools, analysis, and data are interconnected: “success in our work must begin with good data” to inform analysis to create good policy.

In order to obtain adequate data, Director Berner said the industry needs data standards and to close data gaps. He explained that it is imperative in the financial stabililty policy community to share data appropriately without compromising confidentiality, and highlighted the importance of making financial data “usable and transparent.”

Additionally, Director Berner mentioned the OFR’s recently released 2014 Annual Report, which identified a number of areas in which progress has been made to fill data gaps, including, among other things:

  • a project with the Board of Governors of the Federal Reserve System to fill gaps in data regarding repurchase agreements, which will begin to gather data in early 2015;
  • the OFR’s evaluation of leverage across different hedge fund strategies, with a specific interest in sources of leverage; and
  • the assessment of data in the activities of the asset management industry, particularly in separately managed accounts.

Furthermore, Director Berner mentioned areas where more work needs to be done regarding gaps in data, including:

  • working with the CFTC to promote the use of data standards in swap data reporting to ensure data quality and utility; and
  • universally mandating the use of the Legal Entity Identifier (“LEI”) in order to, among other benefits, improve data quality for measuring and modeling counterparty networks.

Lofchie Comment: Across the entire financial industry, regulators seem to be engaged in a hasty, uncoordinated, and poorly conceived grab for “useful” information. It is time to slow down, formulate what information would actually be useful, stop collecting useless data, and develop long-range plans, with realistic timetables, as to how to collect the data that can actually be used.

See: Director Berner’s Speech.
Related news: OFR Issues 2014 Annual Report (December 3, 2014).


U.S. Treasury Deputy Secretary Raskin Provides Recommendations for Executives and Boards Regarding Cybersecurity

U.S. Treasury Deputy Secretary Sarah Bloom Raskin spoke at the Texas Bankers’ Association Executive Leadership Cybersecurity Conference, providing a “roadmap” for CEOs of information regarding cybersecurity and cyberattacks.

Ms. Raskin provided a series of questions and answers regarding steps CEOs and their firms can take before and after a cyberattack.

In her first set of recommendations, Ms. Raskin focused on “baseline protection,” or the policies and controls that firms can adopt to “prevent penetration of their networks and systems” and minimize damage. Ms. Raskin stated that cybersecurity should be an integral part of a firm’s “enterprise risk management framework,” which should include policies, procedures, and other controls that address, identify, and anticipate cyber threats that technology solutions cannot control. According to Ms. Raskin, the National Institute of Standards and Technology’s “Framework for Improving Critical Infrastructure Cybersecurity” provides a “well-considered” risk-based approach to strengthening critical cybersecurity infrastructure.

Ms. Raskin further explained that while vendors and third-party service providers expose certain companies to risk, that risk can be reduced by (i) knowing who has access to the bank’s system, (ii) ensuring that those parties have robust safeguards in place, and (iii) monitoring third parties to guarantee that everyone is adhering to protections and protocols. Ms. Raskin recommended that banks engage in “basic cyber hygiene,” which includes knowing what runs on the firm’s network, who has access to it and fixing bugs and vulnerabilities in a timely manner.

Next, Ms. Raskin addressed sharing “timely, actionable information” regarding cyber vulnerabilities and incidents among institutions, which she said allows firms to “benefit from the experience of others.” She mentioned that the Financial Services Information Sharing and Analysis Center provides declassified threat and vulnerability information to the information-sharing center, which disseminates information to member firms.

Lastly, Ms. Raskin made recommendations about response and recovery from cyberattacks, encouraging firms to create a detailed “cyber incident playbook” that, among other things, designates a “point person” for managing response and recovery. With regard to senior leaders and the board, Ms. Raskin explained that leaders should be well informed of their role during a cyber incident, including which matters should be reported to the CEO. Ms. Raskin advised leaders of firms to cultivate relationships with the U.S. Secret Service and FBI field offices, which have personnel dedicated to cybersecurity. Lastly Ms. Raskin recommended that when communicating with customers and the general public, firms provide clear consistent information while avoiding technical jargon and legalese. 

Isajiw Comment: With these comments, Treasury joins the SEC and other regulators in saying that cybersecurity must be a high priority in the c-suite of financial services intuitions. Arguably, cyber threats are a greater risk to the economy than terrorism. Even one serious breach could cause a customer confidence crisis that cripples a financial services firm.

Ms. Raskin’s 10 questions, and her detailed analysis of issues potentially involved in the answering of each, provide financial institutions with an excellent road map for evaluating the strengths and weaknesses of their cybersecurity protocols. Those 10 questions are:

1. Is cyber risk part of our current risk management framework?
2. Do we follow the NIST Cybersecurity Framework?
3. Do we know the cyber risks that our vendors and third-party service providers expose us to, and do we know the rigor of their cybersecurity controls?
4. Do we have cyber risk insurance?
5. Do we engage in basic cyber hygiene?
6. Do we share incident information with industry groups? If so, when and how does this occur?
7. Do we have a cyber-incident playbook and who is the point person for managing response and recovery?
8. What roles do senior leaders and the board play in managing and overseeing the cyber incident response?
9. When and how do we engage with law enforcement after a breach?
10. After a cyber incident, when and how do we inform our customers, investors and the general public?

Here, Treasury is giving firms an outline to prepare in advance for what is likely to be significant regulatory scrutiny of cybersecurity concerns. Firms are well advised to use this information to proactively assess and, where appropriate, remediate any cybersecurity weaknesses. Adherence to these best practices will likely benefit firms in connection with both responding to regulatory scrutiny, and defending civil lawsuits that will follow any high-profile breach.

See: Deputy Secretary Raskin’s Remarks.

FRB Governor Brainard Discusses Agenda to Promote Financial Stability

Governor Lael Brainard of the Board of Governors of the Federal Reserve System (“FRB”) delivered remarks at the Hutchins Center on Fiscal and Monetary Policy regarding the FRB’s ongoing work to safeguard financial stability.

Recognizing that the FRB is primarily a supervisor of banks and bank holding companies with limited access to market data regarding the activities of non-bank financial intermediaries, Governor Brainard stressed the importance for the FRB to utilize the tools under its authority to preserve the structural resilience of the largest and most complex financial institutions.

Governor Brainard summarized the FRB’s ongoing work to safeguard financial stability as being comprised of four pillars, which are in varying stages of advancement:

  1. Quarterly surveillance of a standard set of financial vulnerabilities, including asset valuations, risk appetite, leverage, maturity and risk transformation, and borrowing by households and businesses;
  2. A forward-looking macro-prudential “toolkit,” including rules promulgated to raise capital and liquidity charges for large institutions engaged in risky activities, as well as broad and sector-specific, time-varying tools for use during periods of rapid credit expansion, such as counter-cyclical capital buffers and additional margin requirements for securities credit;
  3. Enhancing cooperation with other independent financial regulators through involvement with the Financial Stability Oversight Council, as well as through joint rulemakings and supervisory efforts; and
  4. The use of monetary policy, which Governor Brainard described as a “powerful tool” to be used as a “second line of defense.”

See: Governor Brainard’s Speech


Comptroller Curry Discusses Efforts to Reduce Regulatory Burden

Comptroller of the Currency Thomas Curry delivered a speech at an Interagency Outreach Meeting in which he discussed possible ways to reduce regulatory burdens for smaller institutions.

According to Comptroller Curry, while most regulations should provide benefits that outweigh the burdens they impose, the way regulatory rulebooks add more requirements over time can be “onerous for small banks.”

To remove unnecessary regulatory burdens for smaller institutions, Comptroller Curry proposed:

  • to raise the asset threshold from $500 million to $750 million in order to qualify 300 additional banks and thrifts for the 18-month examination cycle, thereby reducing the burden on those institutions as well as allowing the federal banking agencies to focus supervisory resources on banks and thrifts that may present capital, managerial or other issues of supervisory concern;
  • to exempt community banks, or banks and thrifts with less than $10 billion in assets, from the Volcker Rule; and
  • to authorize a basic set of powers for federal savings associations and national banks so that savings associations can change business strategy without moving to a different charter.

Comptroller Curry stated that the OCC is hopeful that Congress will act on these proposals in the next legislative session.

Lofchie Comment:  Comptroller Curry’s common sense perspective, that regulations should provide benefits that outweigh the burdens they impose and his concern about the way regulatory rulebooks add more onerous requirements over time, provides an appropriate starting point for reassessing recent regulatory overreach and over-burden. It is not just that regulatory overreach is a drag on small banks; it is a drag on medium-sized banks, big banks and the economy as a whole. In fact, the remarkable thing is that large sections of Dodd-Frank have still not been memorialized in rules, and many of the rules that have been adopted have been delayed in effectiveness. So, even as regulators begin to confront the costs of onerous rules, there are many more rulemakings in the pipeline. Without a full-fledged, intellectually aggressive reassessment of what rules make sense, small banks (and medium and big banks) will be subject to a lot more rules in a year – and in two years – than they are today. It’s not enough to slow the tide; regulators need to push back the ocean.

See: Comptroller Curry’s Speech.