The Bank for International Settlements Issues 85th Annual Report

The Bank for International Settlements (“BIS”) issued its annual report for the financial year ending on March 21, 2015.

In the report, the BIS stated that interest rates have been low for the longest time in history. According to the BIS, those rates fueled costly financial booms instead of sparking sustainable and balanced global expansion.

The BIS maintained that monetary policy continued to be “exceptionally accommodative,” with many regulators delaying tightening regulation, and noted that central bank balance sheets remained at unprecedented high levels. The BIS argued further that the international monetary and financial system amplified financial imbalances by “transmitting exceptionally easy monetary and financial conditions to countries that did not need them.”

As a solution to the imbalances, the BIS suggested “a triple rebalancing in national and international policy frameworks,” which would require regulators to enact policies that paid greater attention to the “medium term” and the costly interplay of domestic-focused decisions.

The report also provided information pertaining to post-crisis behavior and the business models of financial institutions. Specifically, the report noted that the prolonged period of low interest rates was particularly challenging for institutional investors.

Lofchie Comment: The BIS report’s conclusions about systemic risk are far more negative than FSOC’s, and far more explicit in pointing to governmental policies as creating that risk by focusing on the short term. As we have noted previously, U.S. regulatory policies now prohibit or limit banks and broker-dealers from taking, or even holding, risk positions (i.e., buying assets). The result is this: a fall in asset prices and the consequent sell-off have the potential to create a significant downward spiral. In short, if there is a sell-off, who will be a buyer?

GAO Report Proposes Framework for Monitoring Financial Emerging Risks and Regulatory Responses

The Government Accountability Office (“GAO”) issued a report titled “Lessons Learned and a Framework for Monitoring Emerging Risks and Regulatory Response.” The report outlines a framework the GAO will use to monitor regulators’ efforts to identify and respond to emerging risks to the banking system.

The GAO reviewed its prior studies and those of federal banking regulators, the regulators’ inspectors general, and academics that evaluated regulators’ efforts to identify and respond to risks that led to bank failures in past crises.  In its review, the GAO determined that there are a number of regulatory lessons to be learned from previous banking-related crises including the importance of:

  • early and forceful action by bank management;
  • forward-looking assessments of emerging risk; and
  • emerging risks in the context of a broader financial system.

The GAO Report outlines a framework for monitoring regulators’ efforts to identify and respond to emerging risks to the banking system. The framework has two strategic goals: (i) to monitor known emerging risks to the safety and soundness of the banking system; and (ii) to monitor regulatory responses to these risks, including detecting trends in regulatory responses that might signal a weakening of regulatory oversight.

Part one of the two-part framework incorporates quantitative information in the form of financial indicators that can track and analyze emerging risks and qualitative sources of information on emerging risks – such as regulatory reports and industry and academic studies. The second part of the framework monitors regulatory responses to emerging risks, such as agency guidance, aiming to flag issues for further review where the effectiveness of the regulatory responses may not be clear or questions have arisen as to whether these measures have mitigated risk.

Lofchie Comment: Apparently, no one informed the GAO that the “official” cause of the recent financial crisis was derivatives entered into by institutions outside of the control of the banking regulators. The report (at pp. 14-15) seems to assume that the major cause of the financial crisis was a boom in mortgage-lending, followed by a bust. Indeed, the GAO discussion of the causes of the financial crisis is closer to the dissent published by Peter Wallison as part of the Financial Crisis Inquiry Commission’s report than the official assumed view of the majority. The GAO’s report also criticizes the failure of the bank regulators to respond to known weaknesses in the banks that they regulated before the 2007-2009 financial crisis.

Notwithstanding these assumptions, a good part of the implicit conclusion of the report is that the bank regulators want, and should have, more regulatory authority over non-banks. See, for example (at page 2), where the banking regulators complain about the fact that “shadow banking activities largely were not subject to consistent and effective regulatory oversight.” To put this argument differently, any failure by a federal regulator in the exercise of its power should be attributed to a great extent to the fact that it has insufficient power.

Perhaps there is some truth to this; but we should nonetheless be wary of an economic system where the banking regulators control banks and non-banks alike.  Non-banks should be entitled to risk failure by default.

OFR Updates Its Assessment of Risks to Financial Stability

The Office of Financial Research (“OFR”) issued an update to its assessment of threats to financial stability. According to the update, overall risks to financial stability remain moderate.

The OFR’s latest assessment of vulnerabilities in the financial system was informed by updates to the OFR’s financial stability monitor and the monitor’s underlying data. Specifically, the monitor provided a high-level summary of five areas of risk: macroeconomics, markets, credit, funding and liquidity, and contagion. The update noted that the risks weren’t elevated significantly in any one of these five risk areas in comparison to their levels in the OFR’s last update six months ago. However, the update also noted that key risks within these main areas include elevated U.S. equity price valuations, low-risk premiums in U.S. government bonds, weakness in U.S. corporate credit fundamentals and fragile liquidity in some securities markets.

Overall, OFR Director Richard Berner cautioned, “the current moderate level of threats to financial stability should not be cause for complacency.” He added that “our analysis suggests the need to remain vigilant about emerging threats.”

Lofchie Comment: To a surprising extent, the identified risks are the direct result of government policies: e.g., very low interest rates resulting in high equity prices, and restrictive capital regulations, combined with regulations like the Volcker Rule, leading to a withdrawal of liquidity from the market. This is to say nothing of the risks of central clearing that have been acknowledged only recently. (See here: CFTC Chairman Bowen describing the risk of clearinghouse failure as unlikely, but potentially “devastating.”) OFR or, more importantly, FSOC should consider the extent to which government regulation, however well intentioned, is a material cause of risk.

SEC Commissioner Gallagher Discusses ”Short-Termism” in Relation to Activism

SEC Commissioner Daniel Gallagher delivered a speech at the Stanford Law School’s Annual Directors’ College. He talked about shareholder activism and the role of the SEC in corporate governance. He also discussed different types of activism, and considered the reappraisal of each by asking the question, “Is [such activism] aimed at creating long-term shareholder wealth, and does it actually do so?”

Commissioner Gallagher’s remarks were both extensive and extensively footnoted. The big-picture questions that he raised were (i) whether the regulatory process encouraged private actions that helped to create long-term economic wealth and (ii) whether those who bore fiduciary responsibilities to shareholders (e.g., the directors of corporations and institutional asset managers) were fulfilling their obligation to shareholders to create long-term economic wealth.

Effectively, the Commissioner distinguished between three types of activism: (i) political or cause activism, in which a shareholder seeks to influence a company’s actions for reasons that often are adverse to the interests of other shareholders; (ii) short-term economic activism, in which a shareholder urges an issuer to take an action that could create a short-term pop in the issuer’s stock, but also could diminish the issuer’s long-term prospects; and (iii) long-term activism, in which a shareholder exhorts an issuer to conduct itself in a manner that could lead to the best long-term outcome. The Commissioner criticized the first type of activism and discussed some of the difficulties in distinguishing between the second and third types.

Regarding its role as an overseer of issuer conduct, Commissioner Gallagher argued that the SEC should return to its previous role as a regulator of disclosure, but qualified that advice with the observation that the SEC was not well suited to regulate corporate governance. Matters of governance, the Commissioner said, would be better left to the oversight of individual states. The Commissioner also discussed the process by which the SEC should respond to requests from issuers relating to proxy matters, and cited a number of possible fixes that he had proposed previously. He added that, in addition to the earlier fixes he proposed, the SEC also should consider converting the shareholder proposal no-action process to an SEC advisory opinion process.

On the subject of activist hedge funds, the Commissioner said that the key question to ask is whether (i) activist hedge funds drive long-term value creation or (ii) short-term gains to activism come at the expense of long-term corporate growth. He “admitted” that he remained skeptical of the idea that the answer could be found in econometrics alone, and turned instead to the SEC’s role in regulating activist hedge funds, focusing on Section 13 reporting obligations and how the investor-focused purpose of the rule might be better served.

Commissioner Gallagher also expressed concern that advisers to institutional investors are paying insufficient attention to their fiduciary obligations when they decide whether or not to support a particular activist’s activity, and stated that “even if advisers to these funds are not SEC-registered, they are fiduciaries, they are in the markets we oversee, dealing with SEC registrants, and they should be held accountable for their activities.” The Commissioner was sharply critical of big proxy advisory firms and of advisers that effectively delegate their fiduciary obligations to such firms. He said that the SEC and state regulators are not policing this area sufficiently.

Regarding the creation of a corporate culture that favors long-term wealth creation over short-term stock pops, Commissioner Gallagher offered a number of “radical” ideas, including the following:

  • the assignment of greater voting rights to shares that are held for long-term appreciation,
  • dual share classes and
  • specifying that directors’ duties to shareholders should be tailored to shareholders with long-term investment horizons.

Ultimately, Commissioner Gallagher said, the best results would be obtained if the SEC hosted a roundtable where representatives from interested groups could debate different solutions, with the SEC acting as a neutral intermediator.

Lofchie Comment: The most surprising part of the Commissioner’s speech was the distinction he made between investors who have a short-term economic attachment to an issuer and those who take the long view. Assuming that such a distinction can be practical and not merely theoretical, the question is whether the government (state or federal) is able to play a role in making that distinction without itself becoming the arbiter of defining issuers’ long-term interests.

That said, it is also notable that Commissioner Gallagher’s views on “short-termism” were on the same page with those of Commissioner Stein in the related news story linked below. Although one might doubt that Commissioner Stein would share Commissioner Gallagher’s negative views of politically motivated activism, or his general skepticism about the role of the federal government, the fact that two Commissioners were able to agree on so much could be evidence of an emerging consensus at the SEC.

Australian Parliament Passes Investment Manager Regime Legislation

The Australian Parliament passed Investment Manager Regime (“IMR”) legislation. According to the Alternative Investment Management Association (“AIMA”), this will allow Australia to become a destination for foreign capital and fund trading operations.

The Bill to implement Element 3 of the IMR was introduced on May 27, 2015 and passed by the Senate on June 17, 2015. It now awaits Royal Assent.

General Manager of AIMA Australia Michael Gallagher explained that IMR is designed to ensure the fair treatment of all investment segments, including Australia’s “young and growing” hedge fund community. According to Mr. Gallagher, the new regime “levels the playing field with other hedge fund centers around the world” and “promises to transform the hedge fund sector in Australia.”

Lofchie Comment: At some point, U.S. regulators will realize that financial businesses, like all other businesses, require reasonable and sensible regulation. In the meantime, other jurisdictions will improve their competitive positions when they see advantage. By lowering regulatory barriers, Australia is seeking to become a more meaningful competitor. It is a logical step given Australia’s proximity to Asian investors and investments. Other countries, as well, would be happy to acquire many of the jobs involved in our financial investment activities.

House Holds Hearing Regarding FSOC 2015 Annual Report

The House Financial Services Committee held a hearing on the Annual Report of the Financial Stability Oversight Council. Secretary of the Treasury Jacob Lew’s testified.

In his remarks, Secretary Lew reported that the FSOC 2015 report focuses on 11 themes that warrant “continued attention” and further action. In particular, FSOC recommended:

  • the establishment of a national plan for cyber incident responses to the private sector, coordinated by the Treasury, in order to identify and articulate the roles of law enforcement, the Department of Homeland Security and financial regulators regarding cybersecurity;
  • that supervisors, regulators and firm management continue to closely monitor and assess the heightened risks resulting from continued search-for-yield behaviors, as well as the risk of potential severe interest rate shocks;
  • that its members and member agencies “remain vigilant to the confluence of factors driving changes in market structure,” and that regulators enhance their understanding of firms that may act like intermediaries while remaining outside the regulatory perimeter;
  • that the Board of Governors of the Federal Reserve System, the CFTC and the SEC coordinate the supervision of all central counterparty clearinghouses closely and evaluate whether recently enhanced rules and standards are “sufficiently robust” to mitigate potential threats to financial stability;
  • a “timely resolution” to the weak economic growth and political uncertainty in Greece, as well as reforms to fiscal policy tools and other structural issues in a number of advanced economies to help support monetary policy;
  • continued efforts by regulators to promote the full implementation of Orderly Liquidation Authority by phasing in enhanced prudential standards in the coming years; and
  • that U.S. regulators cooperate with foreign regulators regarding their assessments of market practices for benchmarks and reference rates.

At the hearing, Secretary Lew answered a number of questions about the report and discussed several other topics, including liquidity, systemically important financial institution designations, the oversight of the asset management industry, access to capital and trade negotiations, among others.

Lofchie Comment: A number of the major risks cited by Secretary Lew are government induced; i.e., (i) the so-called “search for yield” created by extraordinarily low interest rates, (ii) the vulnerability of the markets to clearinghouse failures (though clearinghouse failure is less of a risk than a sudden increase in clearinghouse margin, which would create a liquidity drain), (iii) the movement of financial activities away from regulated entities (in light of regulatory burdens) and (iv) continued uncertainty regarding the housing market. (In terms of government-induced problems, Greece’s don’t apply here, since its government is not the same as ours.) To put it differently: in order for the United States to have a sound financial system, the government must examine its own activities and rules using the same critical approach with which it examines the activities of private market participants. If it did so, it might reach the conclusion that there were areas where its regulations, however well intended, actually did harm.

NERA Publishes Paper on Stress Testing by Money Market Mutual Funds

NERA experts published a paper titled “Money Market Mutual Funds: Stress Testing and the New Regulatory Requirements.”

The introduction to the paper provides a brief description of the failure of the Reserve Primary Fund, a money market fund that “broke the buck” following the failure of Lehman Brothers, which is regarded as one of the signal events in – and causing – the 2008 financial meltdown. The paper then provides a brief summary of the changes to the regulation of money market funds made under ICA Rule 2a-7 in response to the failure of Lehman.

Following that background, the bulk of the paper concerns the creation of an “econometric and data simulation framework” that aims to bring a money market fund into full compliance with the SEC’s stress testing requirements that become effective in 2016. The paper outlines three stress test scenarios: (i) an increase in short-term risk; (ii) a widening of spreads generally; and (iii) a significant downgrade in an issuer to which the fund has exposure.

The paper also provides seven stress-testing questions for firms to consider when assessing results of stress tests, including:

  • Do the scenarios cover all SEC-mandated stress testing scenarios?
  • Is fund management making full use of the testing framework by including other relevant scenarios of business interest?
  • Are the parameters chosen for the stress testing scenarios realistic?
  • How often are the parameters of the approach recalibrated to reflect changes in the portfolio?
  • How effective is the internal validation of the methodology used?
  • What is the margin of error (confidence interval) of the results presented?
  • What is the best way to summarize and present the results of a set of stress tests?

Lofchie Comment: Bringing home the risk that directors of money market funds face if they do not institute – and follow – the procedures required by revised ICA Rule 2a-7, the authors also cite the SEC enforcement action against Ambassador Capital Management, a money market fund that took significant risks in order to boost returns, and whose directors were unaware of the degree of risks to which the fund was exposed. Directors should also be mindful of the various SEC enforcement actions that have been brought against funds and their affiliated persons for improper valuation procedures.

50,000 More Dates

No, not at, but at Historical Financial Statistics. Our apparently unique calendar spreadsheet (accompanied by a detailed documentation file) shows dates from 1500 to the present according to ten calendars: Julian day number, Julian, Gregorian (the standard calendar for most of the world today), traditional Chinese, Ethiopian, French Republican, Hebrew, Islamic, Iranian, and Ottoman.

There are, however, some gaps. One that has just been filled concerns Chinese calendar dates during the Ming Dynasty (1341-1644). Keith Hazelton, an information technology guru, used his expertise to calculate the correspondence of dates between the Chinese calendar and Western calendars in an old research paper I only recently came across. He has kindly allowed Historical Financial Statistics to use his data.

Some other gaps remain. The Iranian (hijri) calendar was reformed in 1925, and mechanically extending the current rules backwards does not always give correct dates. The Hebrew calendar is complex, and I could only readily find dates in spreadsheet format since since the founding of the State of Israel. The Buddhist calendar is not shown at all in the spreadsheet because I could not readily find easily usable information on its correspondence to Western calendars. I would appreciate any information readers can offer to fill these gaps or to include other calendars that have been important in some part of the world over the last 500 years.

IOSCO Publishes Report on Deterrence Approaches

IOSCO published a report titled “Credible Deterrence in the Enforcement of Securities Regulation.” The report outlines key enforcement factors that may deter misconduct in the international securities and investment markets.

The report, which was produced by the IOSCO Committee on Enforcement and the Exchange of Information, reflects the collective experience and expertise of IOSCO’s members.

The seven key elements for credible deterrence outlined in the report are as follows:

  • legal certainty: consequences for misconduct must be certain and predictable;
  • detecting misconduct: regulators must be well connected and obtain the right information;
  • cooperation and collaboration: safe havens must be eliminated by teamwork;
  • investigation and prosecution of misconduct: enforcement must be bold and resolute;
  • sanctions: strong punishments must be meted out to wrongdoers to stymie attempts to profit from misconduct;
  • public messaging: public understanding, transparency, and caution must be promoted; and
  • regulatory governance: good governance is necessary to deliver better enforcement.

In addition to the seven key elements, the report outlines considerations for the regulators of emerging and fully developed markets regarding how they might integrate credible deterrence into new or existing enforcement strategies. The report also provides real examples of effective approaches to achieving deterrence.

Lofchie Comment: According to IOSCO, the best ways to prevent crime in the financial industry are (i) not to allow bad people into the financial industry, (ii) if any do get in and happen to do bad things, to catch them quickly and (iii) to punish those who do bad things severely but appropriately. One suspects that few regulators were surprised by these conclusions.

If anything of real interest appears in the IOSCO report, it is the statement that “Regulators can deter misconduct when they . . . enhance the quality of legal and regulatory frameworks to provide legal certainty” (at page 8). If this is true, and I am not sure that it is, it seems predicated on a good idea: that the essence of decent government is for the governed to know the rules to which they are subject, and for such rules not to be modified ex post to “catch” persons whom the regulators decide that they do not like. If there is one suggestion in the IOSCO Report to which I hope that U.S. regulators will attend, it is this: rules should be made as clear as possible; prohibitions and requirements that are imposed on a “facts-and-circumstances” basis should be found inherently troubling.

CFS Monetary Measures for May 2015

Today we release CFS monetary and financial measures for May 2015. CFS Divisia M4, which is the broadest and most important measure of money, grew by 2.8% in May 2015 on a year-over-year basis versus 3.1% in April.

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

1)  {ALLX DIVM <GO>}
3)  {ECST<GO>} –> ‘Monetary Sector’ –> ‘Money Supply’ –> Change Source in top right to ‘Center for Financial Stability’
4)  {ECST S US MONEY SUPPLY<GO>} –> From source list on left, select ‘Center for Financial Stability’

CFS Divisia indices can also be found on our website at  Broad aggregates are available in spreadsheet, tabular and chart form.  Narrow
aggregates can be found in spreadsheet form.

For Monetary and Financial Data Release Report: