Sandor and CBOE Create Interbank Lending Exchange

We congratulate CFS Advisory Board Member, Dr. Richard Sandor on the creation of the American Financial Exchange (AFX) in partnership with Chicago’s CBOE Holding.  Richard is a source on unending financial wisdom for the CFS, given his interest in policy and role in creating some of the most innovative financial products over the last 40 years.  He is widely acknowledged as the “father of financial futures” and greenhouse gas derivatives.

Richard is now shifting his attention to a need for small and medium sized financial institutions to access short-term funding.  CFS Advances in Monetary and Financial Measurement data corroborates unique monetary challenges faced by regional and local financial institutions.

AFX is an electronic marketplace for small and mid-sized banks to lend and borrow short-term funds. It will be aimed at the 1,740 US Community and regional banks with between $500m and $125bn in assets.

For more information, please see related articles:

Sandor and CBOE team up to create interbank lending exchange Financial Times, September 10, 2015

Environmental Financial Products, LLC (EFP) and CBOE Holdings, Inc. (CBOE) Announce New Interbank Lending Exchange and Interest Rate Benchmark.

Video Part 1:
Smalls and Mediums: Richard Sandor Looks To Transform The Small and Mid-Tier Bank Sector – Part 1

Video Part 2:
Smalls and Mediums: Richard Sandor Looks To Transform The Small and Mid-Tier Bank Sector – Part 2

FRB Governor Tarullo Advocates for Broader Capital and Liquidity Regulations

Federal Reserve Governor Daniel Tarullo suggested that the U.S. central bank may have plans to “reshape” capital regulation for some large insurance firms, as well as for other financial market participants, including asset managers. As to insurance companies, due to a state-by-state implementation of the current U.S. rules for the insurance sector, Mr. Tarullo argued that the rules fail to make distinctions between traditional insurance firms and those that could pose risks to the broader economy. In light of the weaknesses exposed during the financial crisis, Mr. Tarullo stated that it is important to recognize that while some insurance products are not likely to play a role in a financial meltdown, other firm activities, such as derivatives, are more entangled with the financial system.

Further, Mr. Tarullo claimed that differences in the liability side of the balance sheet provide a good policy justification for having varying capital requirements even among the same types of financial intermediaries (that is, that different insurance companies might be subject to differing capital rules). He argued that “traditional capital regulation, with an implicit aim of protecting only conventional policyholders over time . . . does not reflect the balance risk sheets” of more complex insurance firms. He suggested that implementation of stricter rules would likely target big wealth-management or annuities businesses, rather than property insurers.

Mr. Tarullo then discussed the possible adoption of an integrated capital and liquidity regulatory regime, emphasizing his belief that insufficient regulatory attention has been paid to liquidity requirements, particularly to dependence on short-term wholesale funding.

Additionally, Mr. Tarullo discussed entities other than banks and insurance companies that would be appropriate targets of capital/liquidity regulation. In his view, broker-dealers present the “clearest case” for becoming subject to additional liquidity requirements.

Near the beginning of his speech, Mr. Tarullo conceded that “we should remind ourselves that the capital regulation of private corporations is unusual.” However, by the end of his speech, Mr. Tarullo indicated his support for the imposition of “prudential market regulation” on asset managers and rules about liquidity requirements and redemption limits on funds.

Lofchie Comment: Ultimately, Mr. Tarullo argues for a degree of governmental control over both public and private capital that is unprecedented both in its scope, but also in its subjectivity; i.e., government regulators creating rules that might be applicable to a single institution. Even if one were to believe that the government is capable of exercising as much wisdom as Mr. Tarullo seems to believe (on what basis?), one should be uncomfortable with conceding to the government as much power as Mr. Tarullo would have it take. In fact, it is not clear that there is any limit to the power that Mr. Tarullo would have the government assert over private investment and asset allocation decisions so long as he could argue that the government was acting in the public interest.

In this regard, it is somewhat telling that Mr. Tarullo feels it necessary that “we should remind ourselves that the capital regulation of private corporations is unusual.” Perhaps it is a such a good reminder that he ought to repeat it to himself several times a day.

SEC Commissioners Press for Completion of SEC Rules Governing Security-Based Swaps

In a public statement released by the SEC, Commissioners Daniel Gallagher and Michael Piwowar urged the SEC to prioritize the finalization of its rules governing the security-based swap market, echoing another recent statement by Commissioner Aguilar.

The Commissioners pointed to the wide range of rules remaining to be finalized, including those related to clearing and execution facilities, capital, margin, segregation, recordkeeping, and business conduct. They argued that finalization of these rules is important because the derivatives markets need regulatory certainty. Additionally, they stated that the lack of final rules has created a void that “impacts Main Street as much as Wall Street.”

The Commissioners asserted that once these rules are finalized, the SEC can and should focus its attention on non-mandated endeavors squarely within the SEC’s core mission of protecting investors, facilitating capital formation, and maintaining fair, orderly and efficient markets. They expressed that the SEC has “wasted all too much time” prioritizing rules that do nothing to advance this mission. They hope that the SEC will make a “positive pivot” going forward.

Lofchie Comment: It is certainly the case that Congress has adopted too many statutory requirements for the SEC to adopt rules implementing them all within the required time period and thus, there is more than good reason for the SEC to have fallen behind in its rulemaking obligations. That conceded, the Commissioners are certainly right that the SEC has adopted rules governing matters such as conflict minerals and compensation disclosure (which are “political” rules having nothing to do with the primary purposes of the Exchange Act), while there are issues that actually matter to the financial markets that have been left unaddressed.

Global Regulators Release CCP Progress Report and 2015 Workplan

The Financial Stability Board (“FSB”), the Basel Committee on Banking Supervision (“BCBS”), the Committee on Payments and Markets Infrastructures (“CPMI”) and IOSCO released the 2015 central counterparties (“CCPs”) workplan and a progress report detailing the agencies’ efforts to enhance the “resilience, recovery planning and resolvability” of CCPs. The workplan focuses on CCPs that are systemic across multiple jurisdictions.

Lofchie Comment: The plan, perhaps naturally enough, focuses on the financial soundness of, and resolution plans for, CCPs. However, this may miss the greater systemic risk: that the authority of the CCPs to call for unlimited margin from clearing participants drains liquidity from the markets, with the result that, in a market crisis, the CCPs are able to save themselves, but they pull others down.

OFR Publishes Working Paper on Liquidity Dynamics During Crises

The Office of Financial Research (“OFR”) published a working paper, “An Agent-based Model for Crisis Liquidity Dynamics,” that examines the effect of financial crises on (i) the balance sheets of market makers and their ability to take on inventory; and (ii) the difference in time frames between liquidity demanders and liquidity suppliers.

In order to “successfully model the dynamics of liquidity during market crises,” the authors of the working paper claim that it is important to understand demander and supplier (i) decision cycles, (ii) market dislocation; and (iii) stress to their portfolio adjustments. As to market makers, the authors state it is important to understand: (i) their capacity for taking on inventory; (ii) how long are they willing to hold these positions; (iii) the cycle of feedback for how these are affected by the market dislocations; and (iv) how they in turn further affect funding, leverage, and balance sheets.

The authors recommended that policymakers combat illiquidity by:

  • reducing the speed and size of liquidity demand, which has “taken the form of circuit breakers or a slowing of the cycle of margin calls”;
  • increasing the capacity and holding period of the market makers through infusions of funding, which (i) allows the broker-dealers to apply a larger balance sheet in their marketing activities; (ii) reduces the pressure on leveraged investors, which is “possibly stemming mushrooming liquidity demand;” and (iii) adds more funding for liquidity suppliers to enter and take larger positions; and
  • increasing the speed and size of the liquidity suppliers, which “has taken the form of government policy to step in as a liquidity supplier of last resort buying up assets when ready liquidity supply from the marketplace is flagging.”

The authors concluded that liquidity is “intricately linked” to the funding and capital structure of the markets. The authors cautioned that projecting the course of liquidity during a crisis without taking into account the real-time specifics of leverage, balance sheet, portfolio construction and decision process is “likely to fail”.

Lofchie Comment: Increased capital requirements on dealers, combined with the prohibition on bank dealers taking material positions, should significantly increase market volatility because market makers are much less likely, and are less able, to dampen such volatility. In fact, with a system of strict capital regulation, one should expect to see market makers very quickly being forced to liquidate into declining markets.

To counter the possibility of a market crash, the report suggests increasing the speed and size of liquidity suppliers – but actually, it is apparent that government policy is largely going in the opposite direction.

FDIC Chair Praises ”Impressive” Progress of FDIC Framework under the Dodd Frank Act

FDIC Chair Mark J. Gruenberg, in remarks to the FDIC Banking Research Conference, boasted of the FDIC’s “impressive and somewhat underappreciated” progress in developing a framework under the Dodd-Frank Act for “the orderly failure of a large, complex, systemically important financial institution while avoiding the taxpayer bailouts and the market breakdowns that took place during the recent financial crisis.” In particular, Chair Gruenberg discussed so-called “living wills” and the Orderly Liquidation Authority.

Chair Gruenberg recommended that within the living will process, firms reduce internal interconnectedness between legal entities within firms in order to improve their resolvability in bankruptcy. His recommended steps to do so are: (i) first, mapping material legal entities to business lines; (ii) next, addressing cross-guarantees and potential cross-defaults that spread risk and tie disparate legal entities and operations together; and (iii) finally, ensuring that information technology and other services essential to the functioning of their material legal entities would continue under their resolution strategies.

Chair Gruenberg called the Orderly Liquidation Authority a “backstop” that “effectively [provides] a public-sector bankruptcy process for institutions whose resolution under the U.S. Bankruptcy Code would pose systemic concerns.” He asserted that the advantages of the Orderly Liquidation Authority include providing the FDIC the authority to:

  • establish a bridge financial company;
  • stay the termination of certain financial contracts;
  • provide temporary liquidity that may not otherwise be available;
  • convert debt to equity;
  • coordinate with domestic and foreign authorities in advance of a resolution to better address any cross-border impediments; and
  • utilize a large team of professionals in financial institution resolution.

In Chair Gruenberg’s conclusion, he pointed out that, “To be clear, if the FDIC had to use the Orderly Liquidation Authority, it would result in the following consequences for the firm: shareholders would lose their investments, unsecured creditors would suffer losses in accordance with the losses of the firm, culpable management would be replaced, and the firm would be wound down and liquidated in an orderly manner at no cost to taxpayers.”

Chair Gruenberg suggested that “there has been no greater or more important regulatory challenge in the aftermath of the financial crisis than developing the capability for the orderly failure of a systemically important financial institution.”

Lofchie Comment: Perhaps Chair Gruenberg is indeed correct in his assessments, but they seem to add up to be a rather extraordinary assertion of confidence as to the outcome of a crisis, which is inherently a situation whose defining characteristics are panic and uncertainty. Previous bank regulators were equally convinced that the world was under good control, before it turned out to be not so much. So perhaps some degree of greater modesty is now in order.

Nor is it obvious that the leaders of a failed bank or institution are “culpable,” if that implies moral or criminal guilt. In a market, businesses fail, including banks. Had the federal government not provided liquidity during the last financial crisis, probably most of the financial institutions in the United States would have failed, but that does not mean that every leader of a financial institution is culpable. Finally, the notion that there is some way in which it can be ultimately determined that losses to unsecured creditors can be allocated “in accordance with the losses of the firm” presumes an objective calculation of these losses is possible: how can one possibly know what the bank would have been worth had the government not stepped in? Ultimately, it is more likely that the FDIC would announce what the unsecured creditors are paid, and deem this to be fair.

Leaving aside the question of Chair Gruenberg’s entitlement to be confident, the larger issue is whether this confidence is based on an approach informed by an aversion to risk that will actually both make it impossible for the economy to grow and ultimately push banks to failure; in a no growth, high compliance cost system, it is inevitable that there will be bank failures. See, e.g., European Supervisors Tell Banks to Be More Efficient (with Lofchie Comment) (September 14, 2015).

See: Chair Gruenberg’s Remarks to the FDIC Banking Research Conference.

Five Things to Watch for as the Federal Reserve Makes its Rate Hike Decision

Reporter James Puzzanghera interviewed CFS President Lawrence Goodman for an article published in today’s Los Angeles Times.

In “Five things to watch for as the Federal Reserve makes its rate hike decision”, Mr. Puzzanghera discusses the potential outcomes of today’s decision by Central bank policymakers. At 11:00am Pacific Time (2:00pm Eastern Time), the Fed will announce if the time has come for an increase, nearly a decade after the last increase in the benchmark federal funds rate.

While some experts do not believe a rise in interest rates would be constructive, others argue removing the questions about when the Fed would raise the rate would do more for financial stability, particularly in the long-term, than holding steady. “It’s this deep uncertainty surrounding the conduct of monetary policy that is exacerbating swings in financial markets,” said Lawrence Goodman, a former Treasury official who is president of the Center for Financial Stability think tank.

To read the complete article please go to

FDIC Vice Chair Hoenig Defends Higher Leverage Ratio

Speaking at the Exchequer Club of Washington D.C., FDIC Vice Chair Thomas Hoenig outlined the possible benefits of strengthening leverage capital requirements for derivatives. He also compared two primary approaches for setting regulatory capital requirements: (i) leverage and (ii) risk-based standards. Vice Chair Hoenig criticized efforts to weaken the leverage ratio’s treatment of derivatives, and declared that the alternative risk-based capital framework option has proved to be “entirely unsuccessful.”

In response to the argument “by some regulators” that the leverage ratio is a threat to the clearing of derivatives, Vice Chair Hoenig asserted that:

  • The leverage ratio sets capital requirements “in a simple way” by requiring that capital exceed a percentage of balance sheet assets;
  • The potential cost increase of hedging exposures from requiring capital for derivatives trades “reasonably reflects the reduction of a subsidy that resulted from artificially low capital”; and
  • The leverage ratio includes guarantees, whether for derivatives or other obligations, to ensure that banks “do not move significant sources of exposure off-balance sheet.”

Vice Chair Hoenig said that the new approach, which “scraps” the current “look-up table” used by the leverage ratio to measure the potential future exposure of derivatives, will become effective in 2017. According to Vice Chair Hoenig, this new approach will (i) be more risk-sensitive, (ii) provide incentives for clearing and margining and (iii) greatly reduce overall risk-based capital charge for derivatives. Striking a cautionary note, he added that extending this new measure of exposure for calculations affecting leverage ratio would be “grossly at variance with the goals of a simple, non-risk sensitive constraint on financial leverage” due to its erasure of large amounts of “meaningful” economic exposure to derivatives with a measured exposure of zero.

Vice Chair Hoenig concluded by saying that “the leverage ratio – because it is a relatively straightforward check on excessive debt financing and, yes, because it has teeth – has always been a lightning rod in the debate and always will be. If regulators can stay the course on this important measure, our financial system will be stronger and more resilient going forward.”

Lofchie Comment: The fact that the leverage ratio is simple does not mean that it is clever. Simple solutions share one attribute with complex solutions: both can be completely wrong. As Vice Chair Hoenig concedes, it is not only market participants who believe the leverage ratio (as proposed) to be impractical; many of his fellow regulators believe that, too. At some point, the argument that because there was a financial crisis, Rule X is good stops being persuasive (although it never should have been). The burden must be on the government to make clear why a particular rule makes sense and how it will change the behavior of individual participants and the market as a whole in a positive manner.

In a certain sense, arguing that higher capital requirements will reduce risk is a bit like saying that lower taxes will stimulate business and raise revenues. It may be true, but only to a degree. It cannot possibly be true in extreme cases. At a certain point, raising capital requirements without considering actual risk not only damages the economy, but also makes the markets more fragile, since market participants will find hedging too expensive.

See: Vice Chair Hoenig’s Remarks.

CFS Monetary Measures for August 2015

Today we release CFS monetary and financial measures for August 2015. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.5% in August 2015 on a year-over-year basis versus 4.0% in July.

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:

Sincerely yours,
Lawrence Goodman

Center for Financial Stability, Inc.
1120 Avenue of the Americas, 4th floor
New York, NY 10036
The Center for Financial Stability is a nonprofit, nonpartisan, independent think tank dedicated to financial markets for the benefit of investors, officials, and the public.

SEC Commissioner Stein Outlines Future of Accounting in ”Era of Digital Disruption”

SEC Commissioner Kara M. Stein delivered remarks at the Institute of Chartered Accountants in England and Wales (“ICAEW”). She expressed her belief in “certain opportunities in this data-driven world for accountants to lead and provide new approaches to the traditional disclosure space, including by enhancing financial reporting overall, by rethinking certain aspects of audits and by providing investors transparent, straight-forward information about the stability of a corporation.” She also emphasized the existence of “new opportunities for accountants to help firms protect themselves, and thus investors, by understanding new technology and its uses in the cybersecurity world.”

Commissioner Stein described the following “opportunities for accessible, transparent and reliable data”:

  • Gaps in Financial Reporting: Commissioner Stein said that existing accounting standards “provide little information about a company’s intellectual assets or its sustainability” and “need to evolve to meet the needs of the investors in the digital era.”
  • Accounting Standards in an Era of Borderless Business: Commissioner Stein called on companies to (i) use common taxonomies to provide up-to-date, accessible, and transparent information to investors and (ii) “reimagine how the delivery of information could change in the digital age.”
  • Structured Data: Commissioner Stein stated that “technology can enhance both the delivery and usability of financial reports” and called on the ICAEW to provide feedback on the unstructured eXtensible Business Reporting Language (“XBRL”) reports required of companies in the UK.
  • Audits: Commissioner Stein asked auditors to provide greater clarity and accessibility during the audit process to investors, specifically regarding the process of reaching materiality.
  • Going Concern: Commissioner Stein urged accountants and auditors to provide greater transparency in viability assessments and early warnings to investors instead of the current “binary” methodology behind current disclosures.
  • Cybersecurity: Commissioner Stein stated her belief that “accountants, with their experience integrating data, can play a leadership role in helping us address the risks of cybersecurity.”
  • Compliance Culture: Commissioner Stein stressed the relationship between accounting and “compliance culture” and called on auditors and accountants to “provide leadership” in preventing “unethical behavior.”

Commissioner Stein concluded by saying that “accountants have a unique role to play in our capital markets,” which comes with the “responsibility to move forward with strategies to help businesses, investors, and regulators in an increasingly digitally disrupted world.”

Lofchie Comment: Commissioner Stein’s remarks are certainly well intended, but it is unclear how one gets from here to there with, or even that there is a path to, many of her expressed goals. One example: even if their conclusions proved valuable, it is not obvious how accountants would make determinations regarding the sustainability of intellectual property, how they would develop the expertise to do so in an objective fashion, or who would pay them to make such determinations.

See: Commissioner Stein’s Remarks before the ICAEW.