Australia at Bretton Woods

Selwyn Cornish and I have a CFS working paper out on “Australia’s Full Employment Proposals at Bretton Woods: A Road Only Partly Taken.”

At the Bretton Woods conference, Australia proposed that full employment be a primary goal of international economic cooperation. Australia’s ideas were connected with its historical experience: three enormous financial and economic shocks in the two generations before Bretton Woods that disrupted employment.

The United States in particular opposed Australia’s proposals. They did receive a hearing after Bretton Woods, but never became part of the fabric of international economic cooperation. Happily for Australia, since Bretton Woods it has avoided shocks of the magnitude it experienced in the two generations before. Australia’s proposals remain of interest, though, both because many countries are still far from full employment and because the Bretton Woods institutions have become involved in labor market reforms as part of broader structural economic reforms in member countries.

The paper takes advantage of the knowledge of Australian archives that Selwyn Cornish has built up over the course of his career, which includes a longtime position as the official historian of the Reserve Bank of Australia. I presented the paper at a conference about Bretton Woods held at Yale University in November. A revised version will likely appear in a volume springing from the conference, to be published by Yale University Press. Selwyn and I welcome comments, which we will consider for incorporation into the revised version.

FSOC Voting Members Testify at Financial Services Committee Oversight Hearing

Eight of ten voting members of the Financial Stability Oversight Council (“FSOC”) testified at a House Financial Services Committee oversight hearing on FSOC’s agenda, operations and structure.

In opening remarks, Representative Jeb Hensarling (R-TX) observed that FSOC has earned “bipartisan condemnation” through measures such as (i) its designation of non-bank financial institutions as “systemically important financial institutions” (“SIFIs”) and (ii) its annual report, that was intended to identify emerging threats to financial stability, but “omit[ted] any references to specific government policies or agencies as helping [to] cause the systemic risk it identifies.”

Witnesses included:

  • The Honorable Mary Jo White, SEC
    • SEC Chair White asserted that “the SEC’s historical tripartite mission necessarily gives the SEC unique insight into many areas on which [FSOC] is focused, such as the potential financial stability risks of asset management activities and products, the ongoing changes to market structure and the role of central counterparties.”
  • The Honorable Timothy G. Massad, CFTC
    • CFTC Chair Massad stated that “one of the most valuable functions of the FSOC is simply to bring together the regulators and agencies that have responsibilities for our financial markets and institutions on a regular basis.”
  • The Honorable S. Roy Woodall, Jr., Independent Member with Insurance Expertise
    • Mr. Woodall recommended “a set of specific, concrete proposals for additional legislative technical corrections relating to the position of the Independent Member.”
  • The Honorable Debbie Matz, National Credit Union Administration (“NCUA”)
    • NCUA Chair Matz argued that FSOC “has thus far promoted collaboration across financial regulators, established appropriate rules and procedures which reflect public input, identified four systemically important nonbank financial companies and furthered greater public awareness of threats to our financial system.”
  • The Honorable Melvin L. Watt, Federal Housing Finance Agency (“FHFA”)
    • Director Watt stated: “Through FHFA’s active participation in all FSOC committees, including the Deputies Committee and all standing committees, FHFA engages regularly with other members on information sharing, policy matters and risk assessments of the entities subject to FSOC jurisdiction and the markets in which they operate.”
  • The Honorable Martin J. Gruenberg, FDIC
    • FDIC Chair Gruenberg outlined the FDIC’s and FSOC’s mutual effort to identify and address systemic risk and designate SIFIs. He also asserted that “FSOC fills a significant gap in the regulatory framework that existed prior to its creation.”
  • The Honorable Richard Cordray, Bureau of Consumer Financial Protection
    • Director Cordray argued that “[t]he creation of the FSOC provides, for the first time, a means of comprehensively monitoring the stability of our nation’s financial system.”
  • The Honorable Thomas J. Curry, Office of the Comptroller of the Currency
    • Comptroller Curry emphasized that “[m]any of the areas of financial risk on which the OCC focuses as part of its bank supervision – for example, credit, liquidity, interest rate and operational risk – are the same risks that the FSOC evaluates with respect to nonbank financial companies.”

Lofchie Comment: SEC Chair White and CFTC Chair Massad said almost nothing about the most controversial aspect of FSOC’s authority: its ability to regulate non-bank financial institutions. Further, little or nothing in the written testimony of the other FSOC voting members seemed to endorse the regulatory power granted to FSOC over non-banks or the manner in which the FSOC operates. Notably, the tone of the witnesses seemed flat and their statements were largely limited to descriptions of the FSOC, or praise for it as a means through which the government could share information.

FSOC’s so-called “independent” representative, who has significant experience as a state insurance regulator, was in many respects quite critical of its operations. He reported that other FSOC members had actively excluded him from participation in deliberations – even those that concerned insurance – and that he had no budget to support his role. Perhaps the other FSOC members were mean to the insurance representative because he alone disagreed with them. For example, acting in his area of expertise and in contrast to all of the other FSOC members, he voted against naming Met Life as a non-bank-SIFI. Notwithstanding the fact that the independent commissioner was appointed because of his expertise in state insurance regulation, none of the federal regulatory appointees deferred to or agreed with him.

On the issue of agreement, SEC Chair White reported in her testimony that “[e]ach of the Council’s five reports [i.e., its annual reports on risks to the U.S. financial system] has been approved unanimously. . . .” The question is this: is that actually a good thing? Does it speak well of FSOC that all of its members agree on everything? If ten very intelligent people can all agree on something as complicated and uncertain as the constitution and cause of risks to the U.S. financial system, it would seem to follow that either (i) they have agreed to something trivial and obvious (and so why bother) or (ii) their agreement is political insofar as it does not allow for disagreement. Unfortunately, because the members of FSOC are all the political appointees of a single party, it is not a useful body to foster discussion and disagreement. If one were truly seeking to create a board of experts to ferret out emerging risks to the U.S. economy, wouldn’t it be better to assemble a group of less like-minded individuals?

BIS Authors Identify Systemic Risks Due to Central Clearing

In a paper titled “Central Clearing: Trends and Current Issues,” Bank for International Settlements (“BIS”) officials identified increased systemic risks due to central clearing. Head of Policy Analysis Dietrich Domanski, Research Adviser Leonardo Gambacorta and Secretariat of the Committee on Payments and Market Infrastructures Cristina Picillo discussed the implications of central clearing for the financial system under normal and stressed conditions.

The paper identified potential risks regarding central clearing that included the following:

(i) Whether central counterparties (“CCPs”) “might spread losses in the case of defaults, or intensify deleveraging pressures in ways that add to systemic stress.”

(ii) Financial regulators do not really understand the interaction between CCPs and the rest of the financial system.

(iii) Risks relating to the function of a CCP, including risks that stem from the management of its activities (general business and operational risks).

(iv) The risk that a participant is unable to meet its trading obligations. This may give rise to liquidity risk if the CCP has to advance payments that a participant cannot make, and to counterparty credit risk if the participant is unable to cover losses on its positions because of its default.

(v) Larger CCPs have a relatively small number of clearing members, and fewer still that offer clearing to their clients.

(vi) A conflict of interests may arise when banks own CCPs and when they do not. The report finds that when clearing banks do not own the CCPs, the main objective for a non-user-owned CCP is to maximize profits and increase participation.

(vii) Economies of scale create incentives for concentration and favor larger CCPs; at the end of 2014, two CCPs accounted for nearly 60% of the total volume of cleared transactions.

(viii) Because of fixed CCP participation costs, many small banks or financial intermediaries with limited activity in centrally cleared markets choose indirect access to comply with clearing obligations.

(ix) As long as the negative shocks are sufficiently small, a more densely connected financial network enhances financial stability. Once losses exceed a CCP’s prefunded resources, the same features that make a financial system more resilient may become sources of instability. As a consequence, financial networks may be “robust-yet-fragile.”

(x) When a large number of clearing participants – potentially including the providers of liquidity lines – become liquidity-constrained, domino effects may be triggered. The activation of a CCP’s unfunded liquidity arrangements or other recovery instruments may impose financial strains on clearing participants. The result of the strain is unexpected liquidity demands that could impose stress on other clearing members and, in extreme cases, trigger a cascade of defaults (emphasis supplied).

(xi) Such a failure could have system-wide effects. Clearing participants might find it difficult to manage positions if a CCP fails, and all clearing participants would have to find alternative ways of closing trades at a time when there might be heightened uncertainty about the value of the underlying exposures and the associated market and counterparty risk.

(xii) Given the overlapping memberships of many CCPs, liquidity problems at one CCP may well coincide with similar issues at others, propagating systemic risk.

(xiii) On the other hand, an unexpected tightening of CCP risk management still could lead to liquidity pressures on participants that might ultimately trigger fire sales and a self-reinforcing deleveraging.

(xiv) In difficult times, a request for additional resources from a CCP could put pressure on participant banks and indirectly affect the rest of the system.

(xv) A large decline in the market value of collateral – particularly if accompanied by high volatility in collateral markets – would reduce the value of initial margins posted to the CCP (also in a non-linear fashion) and trigger requests to members to replenish this value. This could force members to deleverage and lead potentially to fire sales at the precise moment when the rest of the system is under stress. The risk of such liquidity strains and deleveraging could be anticipated by the market, triggering “runs” on participants who were perceived as vulnerable and stoking expectations that became self-fulfilling.

Lofchie Comment: After discussing the risks of central clearing for approximately seventy-five pages, the paper concludes with a passage that begins with these words: “The shift to central clearing has started to mitigate the risks that emerged in non-centrally cleared markets before and during the Great Financial Crisis.”

Unfortunately, this conclusion has nothing to do with the rest of the paper. The authors make another statement that is more to the point, though it figures less prominently: “It is possible that CCPs can buffer the system against relatively small shocks, at the risk of potentially amplifying larger ones.”

In other words, CCPs may be of some use in situations where they are not needed at all, but in situations where they are truly needed, CCPs risk making things much worse.

People who are interested in the subject of this report also may be interested in the writings of the “Streetwise Professor,” a/k/a Craig Pirrong. Professor Pirrong has been discussing the risks of central clearing for at least five years.

Federal Reserve Vice Chair Fischer Discusses Financial Stability and Shadow Banking

Board of Governors of the Federal Reserve System Vice Chair Stanley Fischer: (i) offered an assessment of vulnerabilities in the financial system; and (ii) identified gaps in the current understanding of conditions inside and outside of the banking sector that should be addressed by regulators and researchers.

In discussing the current financial system’s cyclical developments, Mr. Fischer mentioned the following “five factors that contribute to financial fragility”: (i) high debt burdens at households and firms; (ii) elevated leverage and maturity transformation within the financial sector; (iii) complexity and interconnectedness in intermediation chains; (iv) low risk premiums on assets, especially assets funded with debt; and (v) complacency on the part of investors, supervisors and decision-makers in the private sector of the financial system.

Mr. Fischer made the following assertions regarding what needs to be understood to monitor financial stability:

  • A Closer Look at Shadow Banking: The reduction in leverage and maturity transformation associated with better regulations leaves the financial system “much more resilient – even if such regulations have modestly affected market liquidity.”
  • What We Know and What We Do Not: Data on a range of activities – including securities lending, bilateral repos, and derivatives trading – that create funding and leverage risks “remain inadequate and hence could prove destabilizing if sufficiently large or widespread.”
  • Data Are Not Enough: We Need Theory Too: An “important area in need of development” is economic modeling on interconnectedness, particularly on the interaction of shadow banking, banks and the broader financial system. Further, research that distinguishes between banks and nonbanks, or highlights how their interactions are driven by economic incentives, could guide regulator efforts to collect data and set policies to limit possible instabilities associated with interconnectedness.

“An essential element of [the federal regulatory] infrastructure is learning the lessons of history – both the lessons of what happened, and the fact that supervisors and regulators will on occasion be surprised,” he stated.

Mr. Fischer delivered his remarks at the “Financial Stability: Policy Analysis and Data Needs” 2015 Stability Conference sponsored by the Federal Reserve Bank of Cleveland and the Office of Financial Research.

Lofchie Comment: In his remarks, the Vice Chair of the Federal Reserve announced that “the Federal Reserve will be developing regulations that would establish minimum margins for securities financing transactions on a marketwide basis. The margins would apply to all market participants, thereby mitigating the risks associated with regulation along institutional lines.”

It is not clear under what process, or under what authority, the Federal Reserve will propose and implement these regulations governing all market participants. Whatever the process is, the proposed rulemaking would seem to be of a type that goes materially beyond the Federal Reserve Board’s historical discretionary authority to regulate the money supply. If the Federal Reserve Board believes that such broad rulemaking should not be subject to Congressional oversight, it would at least be useful for the Federal Reserve Board to indicate what it believes are the furthest reaches of its discretionary authority.

Further deference to the Federal Reserve Board might be all to the good if one were really convinced that the Federal Reserve is consistently correct in its actions. The strength of that argument is, however, uncertain. Similarly uncertain is the assertion that the economy is now more structurally resilient than it was before the crash. By what measure? How resilient would the economy (or housing prices) be if interest rates were to soon rise 2 or 3%?

Vice Chair Fischer’s prescriptions are important to consider in the debate over the degree of control that Congress should exercise with respect to the Federal Reserve. Even if one questions the wisdom possessed by legislators (and is there anyone who does not at one time or another?), one should still accept that certain powers are properly exercised by the legislative branch, or at least are properly overseen by the legislative branch. The powers to be exercised by the legislative branch should include the oversight of the making of rules by the federal financial regulators.

CFTC Commissioner Giancarlo Is Concerned about the Future, not the Past

CFTC Commissioner J. Christopher Giancarlo warned that while “backward-looking debate” around global financial markets is prevalent, the key to preparing for the next financial crisis is facing new challenges head-on. In a lecture at Harvard Law School, Commissioner Giancarlo brought attention to six developments transforming the global and financial environment:

  1. Cyber threats: “relentless assault by hostile cyber predators”;
  2. Disruptive technology: “rapid habitat transformation by new digital technologies”;
  3. Government intervention: “single species overexpansion and dominance by ‘Washington Whale’ central banks;
  4. Market illiquidity: “nutrient and habitat diminishment through deterioration of trading liquidity”;
  5. Market concentration: “reduction in biodiversity of key market service providers”; and
  6. De-Globalization: “habitat fragmentation of global trading environments.”

According to Mr. Giancarlo, regulators and others with responsibility for financial markets must do the following to address these challenges: (i) prioritize cyber risk resiliency; (ii) foster best practices for new trading technologies; (iii) counter the distortions caused by central bank market intervention; (iv) acknowledge and address the diminishing liquidity in trading markets; and (v) review and reduce the “numerous poorly designed rules and regulations” that are causing service-provider concentration and market fragmentation.

He further commented that market fragmentation has been exacerbated by recent government regulation: “Trading market fragmentation caused by ill-designed rules and burdensome regulations – and the application of those rules abroad – is harming market liquidity and market safety and soundness, increasing the systemic risk that the Dodd-Frank Act was predicated on reducing. Amidst the current tide of de-globalization and slowing world economic growth, market regulators cannot continue to ignore the growing systemic risk caused by market fragmentation.”

Lofchie Comment: Among the difficulties of having a forward-looking discussion about the regulation of global financial markets is that any such discussion necessarily involves making implicit concessions that: (i) at least some of the rule changes are not working out as planned and are having quite negative effects (e.g., increasing market concentration, decreasing liquidity, and separating the American, European and Asian markets) and (ii) rules that are bad for the financial system are often bad for the economy and thus, rules that are adopted to “punish” the banks or the financial system are bad for the economy. The U.S. government has demonstrated that it will win in a war against the financial system, but the value of the territory it conquers will decline.

SEC Commissioner Aguilar Offers ”Helpful Tips” to Future SEC Commissioners

In a public statement, SEC Commissioner Luis A. Aguilar provided “a set of principles, thoughts, and ideas” that he hoped “future Commissioners, and their counsels, may find useful.” His statement follows the November 16 announcement of his departure from the SEC at the end of December.

Commissioner Aguilar’s “high-level roadmap” included the following recommendations:

  • Personal Staff. Commissioner Aguilar stressed that choosing the right counsels “may be one of the most important decisions [that one can] make as a Commissioner.” He urged future Commissioners to consider their counsels to be their alter egos.
  • Internal Procedures. Commissioner Aguilar emphasized that future Commissioners must familiarize themselves with the Reorganization Plan No. 10 of 1950, which provides that the SEC Chair “alone determines the Commission’s agenda, as well as the content of the recommendations [they] will be asked to vote on.” He also urged future Commissioners to “understand the substantive rules and procedural processes at the SEC, e.g., how rulemakings work, how enforcement recommendations work, how seriatim votes work, etc.”
  • The Role of a Commissioner. Commissioner Aguilar noted that being a Commissioner requires a “fresh perspective.” He urged future Commissioners to stay well informed, be “proactive” in reaching out to other federal or state regulatory agencies, remain “open” to various viewpoints, dig into “so-called precedents” and “practice healthy skepticism.”

In closing, Commissioner Aguilar called on future Commissioners to do their “homework.” “The American people cannot afford to have you ‘wing it,'” he said.

FRB Approves Final Rule on Procedures for Emergency Lending

The Board of Governors of the Federal Reserve System (“FRB”) approved a final rule specifying its procedures for emergency lending under Federal Reserve Act Section 13(3) (“Discounts for Individuals, Partnerships and Corporations”).

The FRB’s authority to engage in emergency lending has been limited to programs and facilities with “broad-based eligibility.” The final rule defines “broad-based” as a program or facility that is not designed for the purpose of aiding any number of failing firms and in which at least five entities would be eligible to participate. The final rule also broadens the definition of “insolvency” to cover borrowers who fail to pay undisputed debts that become due within 90 days before borrowing or who are determined by the Board or the lending Reserve Bank to be insolvent.

Like the proposal, the final rule incorporates the requirement in the Dodd-Frank Act that all lending programs under Section 13(3) be approved by the Secretary of the Treasury. The Board still must find that “unusual and exigent circumstances” exist as a precondition to authorizing emergency credit programs.

In extending emergency credit, the Board’s practice has been to set the relevant interest rate at a penalty rate designed to encourage borrowers to repay emergency credit as quickly as possible. The final rule was revised to improve the original proposal to incorporate this practice by requiring the interest rate for credit extended under section 13(3) to be set at a level that is a premium to the market rate in normal circumstances, affords liquidity in unusual and exigent circumstances, encourages repayment, and discourages the use of the program as circumstances are normalized.

Concerning these revisions, FRB Chair Janet L. Yellen said this: “The ability to engage in emergency lending through broad-based facilities to ensure liquidity in the financial system is a critical tool for responding to broad and unusual market stresses.”

The final rule will take effect on January 1, 2016.

Lofchie Comment: The question is whether depriving the FRB of the authority to make emergency loans to a beleaguered financial institution (unless others are in similar kinds of trouble) prevents it from saving the financial institution, and whether the failure of that financial institution then becomes the trigger for broader market failures. If one believes that the FRB acted appropriately in making emergency credit available to financial institutions during the financial crisis (which seems the proper role of a central bank in a liquidity crisis), then depriving the FRB of this power going forward seems illogical. Limiting the FRB’s power to act as a regulator without its being subject to the same constraints as other regulators seems much more logical than reducing the power of the FRB to provide liquidity in a time of market crisis.