FDIC Vice Chair Hoenig Discusses Regulatory Capital

FDIC Vice Chair Thomas M. Hoenig asserted that “while there has been progress in improving capital regulation, much remains undone.” In remarks made before the 18th Annual International Banking Conference at the Federal Reserve Bank of Chicago, he argued “there is no place for complacency regarding the stability of our financial system” within “the context of the future of large, internationally active banks.”

Vice Chair Hoenig emphasized that global banks “are not as well capitalized as some within the industry would have you believe.” As to:

  • Risk Prediction: Vice Chair Hoenig questioned “whether the effect of such a requirement that is designed to make a firm more resolvable once that firm has failed, could – prior to failure – increase the firm’s leverage and thereby its likelihood to default” and noted that it would be unlikely that “regulators would . . . successfully anticipate the source of future crises.”
  • Equity Capital: Vice Chair Hoenig stressed that this approach: (i) is “based on equity capital and thus would not require such extraordinary insight from regulators”; (ii) “acknowledges that regulators cannot predict events and it ensures a safer system because well capitalized institutions are better able to withstand shocks and survive crises”; and (iii) uses simple leverage measures instead of risk-based capital measures, “which eliminates relying on the best guesses of financial regulators to guide decisions.”

Vice Chair Hoenig described the “ever-changing sources of risk” in the derivatives market and highlighted “the potential for unanticipated events and risks, including resolution challenges, associated with the growing use of Central Counterparties.” Among other issues, Vice Chair Hoenig stressed that “we cannot ignore the reality that international financial linkages across countries are more important now than they were even just five years ago” and urged global banks to adjust their risk models accordingly.

In addition, Vice Chair Hoenig called on regulators to promote “trust built on equity capital” and argued that “the system-wide benefits of strong equity capital would appear to far exceed the aggregate economic costs over the business cycle and thus should not be ignored.” He stated that “contrary to some claims, equity capital, in fact, supports sustainable risk taking over the course of the cycle by removing the necessity of regulators to pick winners and losers, thus allowing the owners of the capital to take their own risks, run their own firms and absorb their own losses without public support.”

Lofchie Comment: While the tone of this speech suggests that the regulators should be praised for their accomplishments in making the financial system better, one may also make a fair argument that the speech describes a series of regulatory mis-judgements and regulatory over-confidence, with the result being a financial system that is in many respects more fragile than it was before the crisis.

Let’s start with central clearing. In the words of Vice-Chair Hoenig: “Increased use of clearing has changed the locus of these exposures, it has not lessened risks to the system. The migration of standardized derivatives to clearing was a policy decision intended to make the system safer, but without question it elevates the systemic importance of safe and sound operations by central counterparties (CCPs). The potential for unanticipated events and risks, including resolution challenges, associated with the growing use of CCPs is a subject of concern to many observers and is being studied by international groups.”

Contrast Vice-Chair Hoenig’s current realization, with, for example, a snippet from a 2012 piece written by Craig Pirrong:

“[In] the aftermath of the financial crisis, clearing has become a deus ex machina to solve all the problems inherent in derivatives markets. In particular, clearing has been advanced as a panacea for systemic risk arising from derivatives markets; that is, the risk that derivatives contracts can serve as the cause of insolvency of major financial institutions, and a channel of contagion by which the failure of one institution could cause the failure of others. There is considerable room for skepticism about these claims. They are not predicated on a thorough analysis of the economics of clearing. Indeed, many of the claims made on behalf of clearing are patently wrong.”

It should be noted that the above quote from Mr. Pirrong is fairly representative of his remarks over the last several years.

How is it that Mr. Pirrong can be so out front on this issue? One possibility is that banking regulators tend not to fully consider the multiplicity of reactions that market participants may have to regulatory change; i.e., regulators calculate that if one raises the capital ratio for banks, banks will be safer (not considering that liquidity will be reduced, credit will move outside of banks and the economy will be generally dampened). This does not mean that increasing capital is a zero sum game; rather, it probably is beneficial to a point, but at another point, it can arguably turn harmful as liquidity is reduced. Mr. Pirrong, by contrast, seems to think of the markets in more fluid terms; when one condition (or rule) is changed, market participants react to that change. For the most part, those changes are reasonably predictable; i.e., raise fixed costs/reduce the number of market participants, and Mr. Pirrong, at least as to central clearing, has done a reasonably good job at thinking through the consequences.

The Money Makers

Eric Rauchway’s new book The Money Makers: How Roosevelt and Keynes Ended the Depression, Defeated Fascism, and Secured a Prosperous Peace will interest most of you who read this blog. The economic parallels between the 1930s and recent years are more instructive than we may care to admit.

Eric Rauchway is a professor of history at the University of California-Davis. He spoke at the CFS conference at Bretton Woods last year, giving a foretaste of some of the material in the book. The subtitle gives a pretty complete idea of what the book is about. Franklin Delano Roosevelt is first in the subtitle as he is dominant in the book. Rauchway is determined to rescue FDR’s reputation from former advisers who had their own agenda to promote when they wrote, years later, that FDR was a dilettante with no real understanding of monetary policy. Rauchway argues that FDR had coherent ideas and that his policy on the gold standard through the whole of his administration was well considered both in its economics and its politics. Rauchway points out that FDR made some formal study of economics as a student at Harvard; that well before his presidential bid he showed interest in monetary questions; and, perhaps most important of all, he was open to ideas and sources considered unorthodox, such as the Cornell University professor George Warren Pearson.

As one who is no expert on FDR but who has worked for two politicians, I have observed that politicians rarely have the time or inclination to become expert on the arcana of monetary theory and policy. However, the astute ones—and FDR was a superlatively astute politician—have an ability to rank issues, examine varying views on them more open-mindedly than many experts (because they are less attached to particular approaches), and gauge whether public opinion on them is ripe for change. FDR came into office facing economic catastrophe, and he found a way out that worked.

A generation later, Milton Friedman and Anna Schwartz would argue that the Federal Reserve bore a large measure of blame for the Depression, and that different policy by the Fed would have avoided deflation and limited the downturn to being an ordinary recession. Over the course of another generation, other economists would come to accept their argument. In 1933, FDR did not have the luxury of waiting for those conclusions and he lacked control of the Fed. The gold policy was the one tool at his disposal. I think Rauchway exaggerates the depth of FDR’s monetary thought, but he is correct that FDR’s gold policy—which jolted the American economy back to life—showed a high level of strategic thinking. The advisers who later branded FDR a dilettante misunderstood that he was in reality an experimenter, willing to be unorthodox and eclectic because the times called for experimentation.

What FDR gave with one hand, though, he partly took away with the other. Many of the regulatory policies of the New Deal hampered recovery, working against the benefits of appropriately loose monetary policy. As with the responsibility of the Federal Reserve for creating or at least greatly aggravating the Depression, Rauchway glosses over the clumsiness of New Deal regulation and the harm it did.

The book really shines in its weaving of the interplay between monetary policy, wider economic policy, domestic politics, and geopolitics. The Depression was more than an economic calamity: it threatened to cast the world political order into the flames. FDR understood the dangers posed by aggressive dictatorships and the role that economic policy could play in helping contain them in peace and winning the fight against them in war. Rauchway assesses the interplay between the economic and political forces of the time more judiciously than any previous account I have read.

I will not discuss Keynes, who also appears in the book’s subtitle, because here both Rauchway and I have less to say that might be new to you, though it will be new to the average reader. Suffice it to say that, as with the material on Roosevelt, it ably assesses both the economics and the politics of the time.

Did I mention that Rauchway can really write? He has an ability to keep different narrative threads clear through the warp and woof of events. He also has a knack for crisp summary (example: in 1944 “The United Nations was still very much a notion; so too were many of the nations in it” under German or Japanese occupation.)

The book is pleasing to the eye and to the hand. I have only one complaint for the publisher: having met Eric Rauchway in person, I can attest that the jacket photo does not do him justice. Something to be corrected for the paperback edition, perhaps.

NY Fed Hosts Workshop on Reforming Culture and Conduct within Financial Services Industry

The Federal Reserve Bank of New York (“NY Fed”) hosted a workshop on the challenges of reforming culture and conduct within the financial services industry. Participants discussed firm-specific best practices and opportunities for future collaboration.

Mr. Dudley called the workshop a “progress report on the industry’s efforts” and urged regulators to focus “less on the search for bad apples and more on how to improve the apple barrels.” Mr. Dudley emphasized that the Dodd-Frank Act not only “strengthened bank balance sheets,” but also “did little to curb misconduct,” which remained “a possible source of systemic risk.”

The workshop hosted the following panels:

  • Panel One: Group of Thirty Report on Banking Conduct and Culture;
  • Panel Two: Engagement – Diagnosis and Communication;
  • Panel Three: Accountability – Performance Management, Controls and Metrics; and
  • Panel Four: Skill Development – Recruiting and Developing Talent to Sustain Change

Mr. Dudley remarked that “[r]eciprocity – in other words, the expectation of a quid pro quo in the relationship between society and the financial services industry – is the basis of public trust in financial institutions. There is, however, a widespread sense that this principle has been compromised.”

Lofchie Comment: President Dudley challenges us to consider why there is a “widespread sense” that the principle of “reciprocity” (defined as “the expectation of a quid pro quo in the relationship between society and the financial services industry [and] the basis of public trust in financial institutions) has been compromised. It may have something to do with regulators portraying participants in the financial industry as joint members of an illicit enterprise. There are bad people in finance, just as there are in all other enterprises and all governments. Likewise, there are reasonably ethical people in all such places (we wouldn’t go further than that in making claims about other people’s morality). The notion that an inherently beneficent government watches over an innately corrupt financial sector reflects unbecoming overconfidence on the part of the regulator who asserts it.

CFTC Chair Massad Recommends Ways to Improve to Swap Data Reporting

CFTC Chair Timothy Massad provided updates on the CFTC’s efforts to improve swap data reporting.

Chair Massad recommended the following measures for the improvement of swap data reporting:

  • Making Sure the Data Is Complete: Chair Massad (i) encouraged swap data repositories (“SDRs”) to utilize heat maps and similar tools to improve the quality of reporting; (ii) asserted that the CFTC should “empower” the SDRs to validate the completeness and accuracy of the data prior to submission; (iii) specified that if a SDR rejects a participant’s submission, then the participant should be considered out of compliance with CFTC requirements; and (v) urged the CFTC to hold the SDRs accountable for manner in which they collect, compile and report their data.
  • Making Sure the Data Is Consistent and High Quality: Chair Massad highlighted the CFTC’s development of proposals to standardize fields in swap data reporting in order to “reduce reporting burdens and enhance quality of data for everyone.”
  • Refining Swap Identifiers: Chair Massad said that the CFTC is developing effective means for identifying swaps and swap activity by participant, transaction and product type throughout the life cycle of a swap by utilizing measures such as the Legal Entity, Unique Transaction and Unique Product Identifiers.
  • Clarifying Reporting Obligations and Eliminating Unnecessary Reporting Obligations: Chair Massad listed the CFTC’s efforts to clarify (i) who has the obligation to report data, (ii) what data they must report and (iii) which reporting obligations are unnecessary – all of which will be implemented by the creation of a simple and consistent process for the reporting of cleared swaps.
  • Enforcing Reporting Obligations: Chair Massad emphasized that the CFTC “will not hesitate to carry out enforcement actions” against industry participants who do not effect timely, complete and accurate reporting.

Chair Massad announced that he expects a preliminary report on the swap dealer de minimis exception to be released for public comment before the end of the month. He also touched on the following topics: margin for uncleared swaps, automated trading, Swap Execution Facility registration and cybersecurity.

In his closing remarks, Chair Massad affirmed his belief that progress has been made in swap data reporting. “Today,” he said, “we have much greater transparency, which benefits regulators as well as market participants. As we refine the data and reporting system over time, we will further enhance that transparency and the resiliency of our financial system.”

Chair Massad delivered his remarks before the Futures Industry Association Futures and Options Expo.

Lofchie Comment: For the CFTC to look at the quality of the data that it requires is certainly to the good. Unfortunately, the reality is that the financial industry has spent huge amounts of money providing useless information to regulators. All of the financial regulators, and not only the CFTC, should (i) determine which information is useful among themselves, (ii) identify the most efficient way to obtain that information and (iii) agree not to impose any information requirements on the industry until after they nail down the process through which the information will be provided, received and analyzed.

CFTC Commissioner Bowen Highlights Importance of Robust CCP Risk Management

In her opening statement before the Market Risk Advisory Committee (“MRAC”), CFTC Commissioner Sharon Y. Bowen stressed that (“the importance of effective, robust risk management of Central Counterparties (“CCP”), which she said “cannot be understated.” She also outlined the agenda for the meeting.

Commissioner Bowen began by announcing that the CCP Risk Management Subcommittee would present its recommendations to CCPs on how to make the efforts outlined in their presentations more reflective of actual market conditions in the case of the default of a significant clearing member. Commissioner Bowen also announced that CCP Risk Management Subcommittee members planned to recommend ways in which CCPs could further coordinate their efforts to prepare for the default of a significant clearing member “early next year.”

Lofchie Comment: Strong risk management at a clearinghouse connot eliminate the risks created by mandatory clearing. In fact, it may exacerbate systemic issues, since the ability of the CCP to demand more collateral, or to require the closeout of positions, may benefit the position of the CCP at the cost of both (i) causing a sell-off in the financial markets and (ii) withdrawing liquidity from the markets at a time when all participants are rushing toward the safety of cash and the U.S. government. See, e.g., Streetwise Professor Discusses Limitations of Dodd-Frank (July 22, 2015). To the extent to which the larger is not risk that a clearinghouse will fail, but rather that it will scramble to survive and damage the broader economy, a question arises: should the CFTC be the only regulator dealing with an issue that involves a broad systemic risk?

Chair White Describes Globally ”Shared Arsenal” of ”Key Enforcement Tools”

SEC Chair Mary Jo White gave a speech in which she highlighted the SEC’s relationship with international regulators. Focusing on the SEC’s cooperative efforts with and reliance on the regulators, she described the key “enforcement tools” in their shared “arsenal.”

Chair White urged regulators to use the following “enforcement tools”:

  • Strong Remedies: Chair White emphasized that tough sanctions capture the attention of boards and shareholders who are in a position to bring about constructive corrective action that can range from changes in management and compensation to an overhaul of corporate culture.
  • Individual Liability: Chair White stressed that individual accountability, particularly at the most senior levels, is a core part of the SEC’s enforcement program because “firms can only act through their people and it is people to whom we are trying to send our strong message of deterrence.”
  • Whistleblowers: Chair White stated that in Fiscal Year 2015, the SEC received over 4,000 tips. Additionally, the agency has paid out more than $50 million in whistleblower awards since the program began.
  • Data and Technology: Chair White described the SEC’s development of the Advanced Relational Trading Enforcement Metrics Investigation System, which “analyzes suspicious trading patterns and relationships among multiple traders and uses the Division’s electronic database of over 6 billion electronic equities and options trading records.”

Chair White delivered her opening remarks at the 21st Annual International Institute for Securities Enforcement and Market Oversight.

Lofchie Comment: Perhaps because it is driven partly by politics, the culture of financial regulation has become so hostile to businesses that the Chair’s description makes “regulatory cooperation” sound as though financial regulators were banding together to crack down on international drug cartels. In fact, most people in the financial industry try to comply with the law, though, like people in other industries, not all do. Financial industries also provide significant benefits to society as a whole, such as allocating capital, affording opportunities for savings and contributing to the possibility of economic growth. Even at a conference that is focused on enforcement, there ought to be some acknowledgment of the fact that the regulated entities are businesses without which the country likely would not succeed (unless one believes that the government would be more successful than businesses at allocating capital and running enterprises). If the regulators ever let loose with their full arsenals without any restraint, they will soon discover that their weapons are pointed in the wrong direction.

FINRA Chair and CEO Richard Ketchum to Retire

FINRA Chair and CEO Richard Ketchum announced his plan to retire in the second half of 2016. FINRA noted that Mr. Ketchum has been one of the foremost industry regulators for more than three decades, which included his tenures as CEO of NYSE Regulation, president of NASD and The Nasdaq Stock Market, Inc. and the director of the SEC’s division of Market Regulation.

Mr. Ketchum reflected that FINRA’s “accomplishments are founded on a commitment to excellence in our core competencies: examinations, enforcement, rulemaking, market transparency and market surveillance.”

In a public statement, SEC Chair Mary Jo White remarked that Mr. Ketchum “is rightly recognized as a strong regulator who combines brilliance with a deep knowledge of our markets” and “worked tirelessly to protect and educate investors while also improving the integrity of the markets.”

SIFMA President and CEO Kenneth E. Bentsen, Jr. stated that Mr. Ketchum “had a distinguished career as a regulator and practitioner who has been at the forefront of every major milestone in the evolution of the U.S. securities markets over the last 40 years.”

Lofchie Comment: Mr. Ketchum’s retirement is a significant loss to the financial markets. He brought a tremendous depth of real-world experience to the job of market regulation, and was consistently open to hearing opposing viewpoints.