FRB Proposes Rule Requiring Large Banks to Disclose Their Consolidated LCRs

The Board of Governors of the Federal Reserve System (“FRB”) proposed a rule requiring large banking organizations to disclose several measures of liquidity publicly. If the rule is approved, these measures will comprise the first required public disclosure of a quantitative liquidity risk metric for large banking organizations.

Under the Liquidity Coverage Ratio (“LCR”) rule adopted by the federal banking agencies last September, large banking organizations (with consolidated assets of $50 billion or more) and certain depository institution subsidiaries are required to hold a minimum amount of high-quality liquid assets (“HQLA”) that can be converted into cash easily and quickly. The amount of HQLA held by each large banking organization must be equal to or greater than its projected net cash outflow during a hypothetical stress scenario lasting for 30 days.

Under the proposed rule, large banking organizations would be required to disclose their consolidated LCRs each quarter based on averages over the prior quarter. Firms also would be required to disclose their consolidated HQLA amounts. Additionally, firms would be required to disclose their projected net cash outflow amounts, including retail inflows and outflows, derivatives inflows and outflows, and several other measures.

Comments on the proposal are due by February 2, 2016.

Lofchie Comment: Will this proposed rule motivate banking organizations to maintain appropriate liquidity, as defined by the rule? (Does the rule define liquidity appropriately, or at least correctly from a relative (if not absolute) perspective, in a way that verifies that more liquid firms do better than less liquid firms?) Most significantly, does the rule precipitate a bank run if a bank shows somewhat decreased liquidity? Although the idea that transparency is good is the common wisdom, it is not obvious that the good it provides is unmitigated.

The term “observer” is used in science to refer to the fact that the observation of an event may alter the event. Just so, regulators’ signals that a bank is having liquidity issues may turn a stumble into a fall. In a “nervous” market environment, a bank that discloses a dip in its liquidity, particularly relative to its peers, may find that it is subject to a run.

NY Fed VP Calls on Banking Industry to Restore Trust

Federal Reserve Bank of New York (“NY Fed”) Executive Vice President Alberto G. Musalem outlined the NY Fed’s initiatives to promote a positive banking culture. In his speech before the Goethe University in Frankfurt, Mr. Musalem explained that the initiatives are a response to recent incidents of misconduct, including the manipulation of LIBOR. He also stressed that the “responsibility to address these flaws” in the “culture of banking . . . rests with the banks themselves.”

Mr. Musalem described the NY Fed’s message to the banking industry as follows: (i) cultural problems are the banking industry’s responsibility to solve, (ii) a bank’s implicit norms – especially those reinforced through incentives – must align with the public purpose of banking and (iii) the aim of reforming bank culture should be to restore trust.

Mr. Musalem also referenced the following “insights” from a previous NY Fed workshop:

  • culture is a soft concept that is hard to measure, and perhaps even harder to manage and sustain, but it is as important to teh industry as capital and liquidity;
  • a bank’s culture must reflect public expectations and promote considered behavior toward the firm’s many stakeholders, including those who are part of the public;
  • managers at all levels must take action to promote a greater sense of personal responsibility and stewardship among employees;
  • sharing best practices across the industry could help firms to identify the common warning signs of problems within sub-cultures, as well as behavior that is incompatible with the firm’s values;
  • diversity of thought and background are valuable cultural assets because they generate better questions and decisions to contribute to effective challenge; and
  • certain basic principles – such as the fair treatment of customers and employees – cannot be open to debate.

Mr. Musalem delivered his remarks at an event titled “Towards a New Age of Responsibility in Banking and Finance: Getting the Culture and the Ethics Right.” The event was hosted by the Goethe University of Frankfurt’s Institute for Law and Finance.

Lofchie Comment: From time to time, banks and their employees violate the law and are punished for it appropriately. In that respect, banks are no different from companies in other industries or the government itself. The government’s job is to (i) go after those who break the law and (ii) make good laws. The notion that the government is able or should attempt to be an arbiter of “culture” seems dubious. Despite that vagary, the New York Fed seems sure enough about its own culture to devote significant resources to portraying itself as a model to others, since it has established a Web site devoted to raising cultural awareness. Illustrating the eccentricity of such an exercise, the pieces on the NY Fed’s Web site include a speech by the Archbishop of Canterbury on income inequality. Whatever one’s feelings about the Archbishop of Canterbury might be, or one’s views on the causes of income inequality, the New York Fed has a lot on its plate, and either promoting the Archbishiop’s views or championing income inequality ought not to be among them. If any representatives of the New York Fed feel strongly about this issue, then their support for it would be more appropriately displayed in their private capacity and not on the Web site of a governmental agency that mandates bank regulation and control of the money supply.

FRB Governor Powell Addresses Risk of ”Outsized Volatility”; Considers Developments in Treasury Market Structure

Board of Governors of the Federal Reserve System (“FRB”) Governor Jerome H. Powell discussed variables and possible adaptations to the current market structure that could provide greater or more stable liquidity.

In his remarks at the 2015 Roundtable on Treasury Markets and Debt Management, Mr. Powell addressed the October 15, 2014 episode of “sudden, outsized volatility” in the Treasury markets. He pointed out that further episodes could cause more market participants to react in ways that reduce liquidity, and add to pressures for changes in market structure.

Mr. Powell explained that his preference would be to see changes emerge from a process of experimentation in the marketplace, including both dealers and proprietary trading firms, but noted that regulators and the industry will only be able to evaluate structural innovations if “traders actually use them.” Among the potential changes he discussed were a central limit order book and what he described as high frequency “batch auction” (auction that would take place every millisecond rather than continuously). He concluded that there should be strong evidence that any change in structure represents an improvement before implementing it on a wide scale.

Referencing a recent New York Fed event on Treasury market structure, Mr. Powell mentioned a panel he moderated (which included an asset manager, a broker-dealer and one of the triparty clearing banks) in which there was agreement that: (i) expanded repo clearing would be positive for the market, and (ii) the regulatory requirements related to capital and liquidity are proving demanding for the private sector. Mr. Powell stated that the FRB is open to new solutions that would satisfy regulatory requirements while bringing the benefits of central clearing.

Lofchie Comment: Since the regulators seem so determined to push the benefits of central clearing at every opportunity, it may be useful here to explain why central clearing could be more appropriate in some markets than in others, and why it may not in other markets serve the purposes for which it was supposedly intended.

As a starting matter, central clearing has an obvious benefit in securities markets as compared to swaps markets: in securities markets, there is an object to be delivered, and having a central clearing repository can reduce the risk of failure because it allows for the set-off of delivery obligations. That advantage does not exist in swaps (or other notional) markets, as there is nothing to be delivered. Secondly, as we have previously observed, central clearing works best (in fact, it only works) in markets where the underlying security is extremely liquid, such as U.S. government securities, and thus the market would be perfectly well able to close out transactions without a central pricing mechanism. This is not to say that central clearing is not useful in some situations; rather, that the government would be better off letting the market decide where it is useful.

Notably, and unfortunately, Governor Powell does not say much about “demanding [new] regulatory requirements related to capital and liquidity,” issues of dispute that are within the FRB’s control.

SEC Commissioner Piwowar Discusses Improving IFRS, Interactive Data and Corporate Disclosures

In a recent speech, SEC Commissioner Michael S. Piwowar discussed the future role of international financial reporting standards (“IFRS”) for documents filed with the SEC. He also talked about improving the quality of interactive data in reports filed with the SEC, the SEC’s efforts to improve corporate disclosures, and his fear that “special interests have corrupted the disclosure process to the detriment of investors.”

Commissioner Piwowar made the following recommendations:

  • IFRS “should be investor-driven, not regulator-driven”;
  • regulators should consider an “incremental approach” to IFRS that would “allow, but not mandate, IFRS reporting as a supplement without reconciliation” to Generally Accepted Accounting Principles;
  • the SEC should address problems with the accuracy of interactive data filings by moving “away from the current model of filing the interactive data as a separate exhibit” and moving toward inline eXtensible Business Reporting Language; and
  • the SEC should stop allowing itself to be “used as a pawn of the union and social justice power brokers” and instead focus on “making sure that material information, with a substantial likelihood of being considered important to reasonable investors, is quickly and efficiently distributed to the market.”

Commissioner Piwowar delivered his remarks at the 34th Annual Current Financial Reporting Issues Conference.

Lofchie Comment: One approach to disclosure that might be interesting for the SEC to consider is this: (i) making various social disclosures (e.g., compensation ratios and political contributions) optional, but (ii) requiring issuers to allow proxy voting periodically on the topics. If proponents of these disclosures are correct in asserting that shareholders want them, too, then the shareholders will support them. If the critics are correct, then shareholders will reject them. Such an approach would be consistent with Commissioner Piwowar’s suggestion that the use of IFRS standards should be driven by investors instead of regulators.

Commissioner Piwowar’s passing remark that an accountant might (or should) become an SEC Commissioner one day is also worth noting. The bigger question posed by Commissioner Piwowar’s comment is whether SEC Commissioners should be drawn almost exclusively from the ranks of lawyers. Having lived so long among them, I find it obvious that we possess a limited skill set collectively. Frequently, our expertise lies in answering narrow questions and not in asking big ones.

Why shouldn’t SEC Commissioners be accountants, or economists, or perhaps actual business people or investors? In fact, the first Chair of the SEC was a rather slick business operator.

CFS Monetary Measures for October 2015

Today we release CFS monetary and financial measures for October 2015. CFS Divisia M4, which is the broadest and most important measure of money, grew by 3.4% in October 2015 on a year-over-year basis versus 3.8% in September.

CFS Divisia indices can 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:

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’

CFTC Chair Massad Highlights Clearing Efforts

CFTC Chair Massad outlined regulators’ ongoing efforts in central clearing. He also offered an overview of the regulatory framework itself, and emphasized aspects of that framework to consider as markets continue to evolve.

Speaking at the CME Group’s Financial Leadership Conference, Chair Massad devoted most of his remarks to the appropriate regulation of the clearing system. He also made a number of implicit concessions to critics and expressed his equally implicit worries about clearing.

Perhaps most notably, Chair Massad seemed to concede that at least some of the clearinghouses were too big to fail. In that vein, Chair Massad touched on what would happen if a clearinghouse did fail, how the markets and regulators would respond, and what might be done to alleviate the effects of that scenario:

“Some have suggested that a potential solution is to have more than one clearinghouse for each product. This idea is attractive in theory, but it may be difficult to achieve. . . . “

Chair Massad also expressed concern about the unintended consequences of regulation:

I started my speech by talking about the challenge regulators face in having to look backward and address the problems of the past, but still create a framework that works going forward. Our actions affect how markets evolve, and a challenge is to avoid unintended consequences. And I think we need to be mindful of that as we address these very important issues pertaining not only to clearinghouse resiliency but to financial stability generally.

Let me conclude on this note: I have described what I believe will be an intensive focus on clearinghouses over the next year or so.

His concerns notwithstanding, Chair Massad stated his belief that the “[central clearing] model remains sound,” and that “central clearing and clearinghouses will continue to play the vital role in the development of our markets.”

Moving from policy statements to specifics, Chair Massad described the CFTC’s domestic work in clearing, which he said includes strengthening the requirements in risk management and transparency, as well as focusing on recovery and resolution planning. He also provided information about the CFTC’s work abroad with other organizations, including the Committee on Payments and Market Infrastructures and IOSCO, which involves looking at the margin methodologies and resources available to clearinghouses in the event of a default. He asserted that these efforts are a means to work through the concerns and questions he raised.

As clearinghouse regulation continues to progress, he said, it is important to keep the following in mind: (i) daily risk management, (ii) continuity of function in the event of a default and (iii) the importance of a robust clearing member industry. He assured his audience that defining these aspects as pivotal to clearinghouse regulation will lead to the establishment of laws that are resilient and supportive of innovation.

Lofchie Comment: Chair Massad is to be applauded for acknowledging the risks created by central clearing, including the huge concentration of risk to the financial system that results from clearing. In light of various regulators’ belated realization that central clearing creates significant systemic risk and may, in Chair Massad’s words, have “unintended consequences” (see the related news stories below), it would be prudent for the CFTC to declare a moratorium on any further imposition of a mandatory clearing requirement until those regulators are able to demonstrate by reasonable argument that central clearing reduces systemic risk – notwithstanding the fact that it also increases concentration and interconnectedness, arguably decreases the ability of firms to net against their customers, and poses a material risk of creating a liquidity drain if the central clearinghouses demand more initial margin during a market crisis. If the various regulators are uncomfortable making such a demonstration – and their recent statements indicate that they are not – then it would be imprudent for them to continue down this path.

WSJ / Trump on Yuan and Hacking…

Today “The Wall Street Journal” published a letter “Trump’s Right on Hacking, Wrong on Yuan” by Kevin Brock (CFS senior fellow / cybersecurity strategy) and me on page A18.

Donald Trump’s “Ending China’s Currency Manipulation” (op-ed, Nov. 10) mistakenly conflates cyberbreaches and currency manipulation.

View the full letter.

Sincerely yours,
Lawrence Goodman

Center for Financial Stability, Inc.
1120 Avenue of the Americas, 4th floor
New York, NY 10036

OFR Director Says Financial Stability Hinges on Resilience

Director of the Office of Financial Research (“OFR”) Richard Berner discussed the importance of understanding how the financial system functions under stress. He emphasized the need to gather and standardize data for analysis and for policymakers to be able to respond to identified threats to market stability.

The Director argued that financial stability is not about constraining market volatility, but is instead about resilience. He identified two aspects of resilience that must be examined: (i) does the system have enough shock-absorbing capacity so it can still function? and (ii) are incentives, such as market discipline or transparent pricing of risk, aligned to limit excessive risk taking?

Director Berner pointed out that several of the OFR’s analytical initiatives are important for insurance and pension plan sponsors, including the “Financial Stability Monitor,” an OFR-developed tool used to assess risk. Mr. Berner stated that as a result of this tool, we know that overall threats to financial stability remain at a “medium” level, although credit risks are now “prominent.” Further, he noted, liquidity risks appear to have risen in major bond markets, and certain financial activities continue to migrate to presumably less-regulated and less-transparent areas of the financial system.

Finally, Mr. Berner stated that a “robust” stress-testing regime is one of the best tools available in risk management. The OFR is working with the Federal Reserve to suggest ways to conduct systemwide stress tests and to explore how stress tests can include runs and contagion.

Mr. Berner’s remarks were delivered before the Annual Meeting and Public Policy Forum of the American Academy of Actuaries.

Lofchie Comment: While Director Berner identifies his role as being that of a mere aggregator of information, and not as a policy maker, the information that he collects is largely determined by those who have certain policy views on what creates risk to the financial system. Thus, he is concerned with, for example, securities financing transactions, capital levels at banks, and the operation of central clearing houses.

Mr. Berner’s remarks also suggest that this data collection may not identify the real risks threatening the financial system. Start with his identification of credit risk as the largest risk facing the system, by which one may infer that he means a possible rise in interest rates that could lead to a drop in asset prices. Mr. Berner indicates that this problem may be addressed by stress tests at the banks, but how much good would such tests do if interest rates spike? What good are stress tests if ongoing low rates result in the inability of municipal and other pension plans to earn returns that satisfy their obligations?

Mr. Berner notes that “liquidity risks appear to have risen” and that “certain financial activities continue to migrate to presumably less-regulated and less-transparent areas of the financial system.” One may connect the dots and argue that these risks have risen, and that these financial activities have migrated, in response to regulation that may be overly burdensome.

More regulation does not inherently make a safer system. By analogy, the government cannot collect the maximum level of taxes by raising taxes to 100% of income, or by cutting them to 5%; the optimum level is inherently between the two extremes. The path that Mr. Berner should follow is whether the Office of Financial Research is asking a broad enough range of questions: (i) are they all pointed to demonstrating that “more” regulation is needed?; and (ii) are they covering cases in which regulation is not working, or where it is imposing unnecessary costs or requiring procedures that increase systemic risk?

NYU Finance Professor Praises Derivatives

In a policy paper titled “In Defense of Derivatives: From Beer to the Financial Crisis,” New York University Clinical Professor of Finance Bruce Tuckman extolled the benefits of derivatives. “Policies that recognize the usefulness of derivatives and of holistic risk management and supervision,” he wrote, “will encourage businesses to use derivatives appropriately and, at the same time, reduce systemic risk.”

Professor Tuckman made the following arguments against several regulatory initiatives:

  • mandatory clearing may break apart bilateral portfolios that previously had comprised diversified combinations of liquid products (that now must be cleared) and illiquid products (that cannot be cleared);
  • imposing punitive margin requirements on uncleared derivatives might reduce derivatives volumes and risks, but also can increase nonderivative business risks; and
  • “required databases of derivatives trades and positions are unlikely to be useful in crisis prevention and management because they focus on a one-dimensional slice of firm and system-wide risks.”

He also recommended possible reforms that could reduce systemic risk without impairing the business uses of derivatives, including:

  • joint work by authorities and the industry to create common entity identifiers in order to improve firms’ and regulators’ abilities to manage holistic counterparty risk;
  • “a protocol to coordinate the liquidations of a failing firm’s most liquid derivatives and nonderivative claims”;
  • making the compression of over-the-counter derivatives positions a higher priority;
  • improving accounting norms in order to provide better holistic risk reporting, which would incorporate derivatives exposures; and
  • a narrowed safe harbor for derivatives to prevent the providers of illiquid leverage from being subsidized by their ability to circumvent the bankruptcy system.

Lofchie Comment: This excellent article should be read by anyone who is involved in financial regulation, whether at the political or regulatory level (or in the press).

Professor Tuckman is clear and to the point in his explanations as to (i) the benefits that derivatives provide (as well as their potential risks); (ii) the limited role that derivatives played in the financial crisis; and (iii) why a number of the measures taken by financial regulators to address systemic risk (e.g., mandatory central clearing) very likely did nothing or made the situation worse. (See recent article that included a statement by FDIC Vice Chair Thomas Hoenig, who is himself a proponent of mandatory central clearing, in which he effectively concluded that mandatory clearing was not effective in reducing systemic risk)..

If the economy is ever going to fully recover, then the people involved in its recovery must have a reasonable understanding of how financial products and markets work. Only on that basis is it possible to have a meaningful discussion about how to make the products and markets work better (or at least how not to undermine them). This article takes a significant step in that direction.


SEC Commissioner Stein Calls on Regulators to ”Surf the Wave” of Innovation

SEC Commissioner Kara M. Stein called on the SEC and market participants to work “together to surf” the “wave of innovation” occurring in U.S. capital markets.

In her remarks at the Harvard Law School Fidelity Guest Lecture Series, Commissioner Stein made the following recommendations to regulators to help them keep up with innovation:

  • Being Proactive: A Competitive Necessity in the New Landscape. Commissioner Stein emphasized that regulators will have to determine how to regulate technological advances such as “robo advisors,” bitcoin and “blockchain,” which is a “database network where messages create a digital record of a transaction that cannot be changed once approved in the ‘chain.'”
  • Competing on Quality and Innovation in Asset Management. Commissioner Stein said that the main reason for the success of the asset management industry is investors’ “faith in the quality of the product,” which she argued could be jeopardized by exchange-traded funds (“ETFs”) because they “may act quite unusually in stressed market conditions and, frankly, break down in ways that we do not completely understand.” Commissioner Stein urged regulators to examine: (i) whether new rules are needed to address ETFs; (ii) the “roles that all of the individual players in this ecosystem play (such as authorized participants)”; and (iii) “how ETFs trade, as compared to mutual funds, and whether the way algorithmic traders utilize ETFs poses concerns to investors placing their retirement savings in these products.”
  • Innovation Drives Competitiveness: How Do We Drive on Our New Market Highways? Commissioner Stein highlighted the “flipside to innovation” and stressed that improved technology, such as algorithmic trading, “needs to be harnessed for the good of the markets, without allowing it to run roughshod over these markets.”

Commissioner Stein closed with a series of reflections on the technological mission of the United States. “Just like the role we played in the development of the Internet,” she said, “the U.S. should strive to be at the center of how the new financial market is framed and regulated. We are at a similar moment in time for financial markets. If we do not lead, someone else will.”

Lofchie Comment: Here are two excerpts from Commissioner Stein’s remarks:

“Why has the asset management industry in this country remained so competitive? There are many reasons, of course. But I believe that chief among them, as I have noted throughout my talk tonight, is that investors have faith in the quality of the product. Although they may not know it, investors are protected by a law called the Investment Company Act of 1940, which ensures that there are basic rules of the road that make these products predictable.”

“As I think about where the markets are being driven by innovation, I keep thinking back to the origins of the Internet and the pivotal role the United States played. Other countries certainly played a role, but the U.S. spearheaded and led the development of the Internet. The U.S. was at the forefront. And because of this leadership role, the United States has benefited immensely.”

These two observations reveal a certain inconsistency. In one of them, success is attributed to government regulation, but in the other, success occurs in an area where there was far less government regulation. There is nothing wrong with using historical events to draw opposing lessons or explore interpretations. That said, it would have been interesting to hear the Commissioner explain why she believes that government regulation is the key to growth in light of her reference to the internet as a place where the U.S. has spearheaded global leadership. Perhaps the common elements in her otherwise disparate examples might lead her to conclude that global market leadership results largely from the efforts of market participants, and that the government plays only a secondary – even if extremely important – role.