Economic Policy Uncertainty and the Credit Channel…

I am grateful to John Duca at the Federal Reserve Bank of Dallas for highlighting a recent NBER paper that he co-authored with Michael Bordo and Christoffer Koch.

The authors find that “policy uncertainty significantly slows U.S. bank credit growth, consistent with it having an effect on broad loan supply and demand.”

These results corroborate our findings in recent years evaluating the performance of CFS Divisia monetary aggregates.

Bordo, Duca, and Koch also did fine work quantifying the regulatory and reporting burden on banks since Dodd-Frank (see Figure 2 on page 26). In fact, their data stretch back to 1960. For instance, the number of pages per regulatory filing for banks was less than 10 from 1960 into the early 1980s, gradually advancing to roughly 50 prior to the financial crisis. Since the crisis, the pages per filing are near 90 and advancing at a seemingly geometric rate.

The paper is available at

Investment Industry Groups Criticize SEC’s Proposal to Restrict Derivatives Use by Registered Funds

SIFMA AMG, the Managed Funds Association (“MFA”), the Alternative Investment Management Association (“AIMA”) and the Investment Company Institute (“ICI”) and, collectively, the “Fund Associations”) urged the SEC to make material changes to its proposed Rule 18f-4. In its current state, the proposed rule would restrict the use of derivatives by registered investment companies based on the notional size of derivative positions. The proposed rule also would impose size limits on such positions, expand asset segregation obligations by requiring funds to maintain specified values of “qualifying coverage assets,” and require certain funds to establish derivatives risk management programs.

The Fund Associations submitted three comment letters to the SEC that express similar concerns about the ways in which the SEC would trace and control derivatives risk under the proposed rule. The letters support other parts of the SEC’s proposal, particularly where they concern asset segregation, though the Fund Associations call for significant modifications to that aspect of the proposal as well.

The ICI’s comments contain a detailed analysis of the SEC’s proposal, provide suggestions for revisions, and include responses from an extensive survey of ICI members.

The deadline for comments on the proposal closed on March 28, 2016.

Lofchie Comment: The SEC’s proposal contains a number of aspects that should give pause to derivatives market participants.

First, the SEC’s use of the notional amounts of derivatives as a way to measure risk is inherently flawed. No one would accept the idea that investing $1,000 severally in U.S. government securities, junk bonds, S&P 100 stocks, gold and energy would entail comparable risks. The fact that a risk is taken with derivatives does not magically create parity. The risk originates with the underlying securities themselves and not from the bundling of those securities.

Second, the notion that derivatives are inherently more risky than other kinds of investments also is mistaken. During the financial crisis, it was not merely the derivatives market that crashed; it also was the housing market from which the funds were derived. The mistaken assumption that derivatives and not the underlying investments are the source of risk results in regulations that discourage the use of derivatives as a means to control risk (and, accordingly, those well-intended regulations increase risk). For an excellent discussion of this point, see “In Defense of Derivatives: From Beer to the Financial Crisis.”

Third, even if the SEC’s rule proposal is well intended and the proposed rule is good, it is still inappropriate for the SEC to reinterpret the term “senior security” to fit its current policy objectives. If the Investment Company Act does not serve the SEC’s purpose, then the SEC’s appropriate action should be to seek legislative change, not to create novel definitions for existing terms. Respect for the rule of law means that the government is not supposed to bend the meaning of established words to fit its immediate purpose.

CFTC Commissioner Cautions Global Regulators against Impeding Blockchain Technology Innovation

CFTC Commissioner J. Christopher Giancarlo cautioned global regulators against impeding innovation of blockchain technology. In an interview with Energy Metro Desk Editor-in-Chief John Sodergreen, the CFTC Commissioner reaffirmed remarks delivered at the Energy Metro Desk annual conference.

Mr. Sodergreen reported that Commissioner Giancarlo maintained a “decidedly not-so-grim . . . outlook” and expressed his enthusiasm for the potential of blockchain technology:

[T]he great promise of blockchain technology is in its ability to help market participants manage the enormous operational, transactional and capital complexity brought about by the legion of disparate mandates, regulations and capital requirements promulgated in the wake of the 2008 financial crisis.

Mr. Sodergreen reports that Commissioner Giancarlo stated that global regulators must be cautious not to impede blockchain innovation with “protracted regulatory uncertainty or an uncoordinated regulatory approach,” and instead should establish uniform principles.

Click here to view the article in the latest issue of Energy Metro Desk, which is published biweekly by Scudder Publishing Group, an energy trade news publishing company based in the Washington, D.C. metropolitan area.

SEC Solicits Further Comment on FINRA’s Proposed Rules for Capital Acquisition Brokers (Fed. Reg.)

The SEC requested additional comments on FINRA’s proposal to create a separate rule set that would apply to firms that met the definition of “capital acquisition broker” (“CAB”) and elected to be governed under that rule set. The SEC’s request for additional comments on the proposal was published in the Federal Register.

In the new request, the SEC paraphrased several responses to the initial comment request. Those initial comments recommended that FINRA should:

  • approve the membership application of a new CAB within 60 days of the filing of its application, subject to certain provisions;
  • confirm that CABs may hold all licenses previously sought and attained by their associated persons, including Series 53 and other licenses;
  • exempt CABs’ Chief Compliance Officers (“CCO”) from the proposed requirement that they obtain and maintain the proposed Series 14 CCO license because of the broad and comprehensive scope of that license;
  • create new examinations specifically for the registered representatives and supervisory principals of CABs that will test only that subject matter which is relevant to the business of CABs;
  • revise proposed FINRA Rule 328 (“Prohibition on Private Securities Transactions”) to exclude (1) the investment advisory activities of associated persons who are also the employees or supervised persons of an investment adviser registered with the SEC or a state, and (2) bank or trust company employees who are engaged in securities or advisory activities in which a bank may engage;
  • confirm the intent to include secondary transactions in the permitted activities of a CAB;
  • allow the continued operations of a firm as a CAB (provided that the firm is in regulatory compliance) during the interim in which an active Change in Membership Application (“CMA”) is being reviewed by FINRA, with the firm remaining subject to all CAB strictures pending a final decision by FINRA on the CMA; and
  • consider allowing a grace period for the registration of firms that unwittingly conduct activities that lie beyond the scope of CABs’ permissible activities;

Further recommendations included various changes to the proposed CAB rules concerning (i) the definition of “institutional investor,” (ii) suitability, (iii) commissions/fees, (iv) supervisory procedures and (v) cybersecurity.

In addition, the SEC asserted that FINRA’s proposal provides “grounds for disapproval under consideration.”

Additional comments on FINRA’s proposal must be submitted by April 13, 2016. Rebuttal comments must be submitted by May 9, 2016.

Lofchie Comment: A separate rule set for CABs is a good idea. The current system of broker-dealer registration and regulation is simply too much for firms that are engaged in limited kinds of securities activities. As a result, firms either must give up on registering, forgo the broker-dealer business, or get hit with excessive regulatory costs. Providing an appropriately tailored form of regulation should boost compliance significantly. When it comes to the details, firms should comment on what works and what doesn’t in light of their particular circumstances.

OFR Researchers Question the Utility of SEC Form PF as a Risk Management Tool

Office of Financial Research (“OFR”) researchers questioned the utility of SEC Form PF. In a published working paper, the researchers stated that they found “significant ‘wiggle room” in the application of the Form as a risk-management instrument. It made several recommendations for improvements.

The authors generated a range of simulated portfolios and equity options in order to assess the precision of Form PF as a measurement tool for risk exposure. They also considered the effect of basic options strategies on certain risks that Form PF is intended to measure.

Specifically, they examined the “cross-sectional distributions of standard risk and performance measures of simulated portfolios” in order to determine the “dispersion of the actual portfolio risk and performance of funds with identical presentation on Form PF,” with particular attention to value-at-risk (“VaR”) portfolios. Through these “cross-sectional distributions,” the authors found “significant and widespread dispersion in risk and performance among both VaR-unconstrained and VaR-constrained portfolios” despite their identical presentation on Form PF. The authors concluded that the inclusion of options has a “significant impact” on actual portfolio risks. The range of permitted actual risk is especially large for portfolios that include options but do not report VaR on Form PF.

The authors recommended that the SEC:

  • rearrange the strata of characteristics that are utilized by Form PF to represent complex portfolios or, alternatively, capture additional characteristics on Form PF in order to constrain the range of possible risk profiles more tightly; and
  • revise Form PF to require, as does SEC Form 13F, position-level details about portfolio holdings.

The paper’s publication is timely in light of the new provisions in Section 404 of the Dodd-Frank Act financial reform law that enable enhanced regulatory reporting on private funds seeking to protect investors and assess systemic risk.

Lofchie Comment: A comment published in 2013 in the Guide to Hedge Fund Regulation captured the prevailing view of Form PF at that time.

[M]any of the questions in Form PF are horrendously written with the result that it is not entirely clear that the Form is even getting at useful information. Even if the information might be useful, funds will inevitably answer the questions in quite different ways, making the information far less useful than it might have been if the Form were better drafted. The questions that are the most poorly designed are the ones that might in theory be the most important; i.e., the questions about leverage and borrowing by hedge funds. These questions are so poorly written that it is sometimes hard to know even what information the authors of the Form intended to collect or even how much they understood about leverage and collateral.

Three years later, researchers at the OFR engaged in a complicated study of options with “cross-sectional” data and determined that Form PF is useless. Any sophisticated professional who works in this area could tell by looking that the questions on the form never had value.

Crisis Detection: Implications for Investors and Officials…

At the Boston Economic Club, I discussed crisis detection and prevention based on experiences chairing an inter-agency crisis prevention group — while at the U.S. Treasury — and working as a strategist on Wall Street.

I concluded with eight actionable ideas to improve crises detection for investors and officials.

For full remarks:

CFTC Issues Comparability Determination for European CCPs (Fed. Reg.)

The CFTC published a notice in the Federal Register that it approved (i) a substituted compliance framework for dually registered central counterparties (“CCPs”) located in the European Union and (ii) a comparability determination with respect to certain EU rules. The CFTC’s determination allows European clearinghouses that are registered with the CFTC as derivatives clearing organizations, and that are also overseen by European regulators, to comply with EU requirements that satisfy equivalent CFTC requirements for financial resources, risk management, settlement procedures, and default rules and procedures.

The determination is effective immediately.

Lofchie Comment: At last, the CFTC is making meaningful progress in closing the regulatory rift between the United States and the European Union. Such progress is due to the persistence and determination of CFTC Chair Massad who managed to overcome his predecessor’s vision of a Europe surrendering to the dominance of U.S. regulation – a vision that failed completely and proved to be a waste of time and energy.


Financial Crises in Currency Board Systems

In recent years economists have done much work assembling information on episodes of financial crisis. In particular, Carmen Reinhart and Kenneth Rogoff’s 2009 book This Time is Different elevated the study of the issue to a new level by combining a wide-ranging survey with intensive data collection.

Because the subject is so large, work remains to be done on it. Miloni Madan and Alec Maki, two undergraduates at Johns Hopkins University, have made a useful contribution with a just-issued working paper that for the first time examines all currently known financial crises that have occurred in currency board systems. Madan and Maki wrote the paper for a class offered by CFS Special Counselor Steve Hanke. The working paper is from the Johns Hopkins Institute for Applied Economics, Global Health, and Study of Business Enterprise, which Hanke co-directs and which has a link to the CFS. Because of my interest in monetary history, I read the paper in draft and offered comments on it as it developed into an ambitious project.

Madan and Maki bring to light a few financial crises not previously discussed by economists who have gathered cross-country data. There may be other episodes yet to be uncovered relating to currency boards, but it seems unlikely there will be many other important ones. Given how widespread currency boards have been historically, it is remarkable how few crises currency board systems have experienced. Crises have been concentrated in Argentina, Hong Kong, and Eastern Europe.

NY Fed President Highlights Supervisory Objectives for Complex Financial Institutions

New York Federal Reserve Bank President William Dudley described the current state of supervision over large, complex financial institutions. At a conference of regulators on the subject, President Dudley stated that supervision of large financial institutions is guided by two key objectives: (1) enhancing the resiliency of a firm to lower the probability of its failure and (2) reducing the impact on the financial system in the event of failure or material weakness. He asserted that because “[t]he activities and practices at large, complex financial organizations are simply too intricate and evolve too quickly to be fully described ex ante in regulation,” banking supervisors collect information through examinations and analysis, and “the ultimate responsibility for risk identification and risk management remains with the supervised institution.”

President Dudley stated that the Federal Reserve instituted three major horizontal evaluations which are a key part of the new enhanced supervisory framework for large banking companies: (i) the Comprehensive Capital Analysis and Review, which applies to firms with at least $50 billion in total assets and assesses capital adequacy, (ii) the Comprehensive Liquidity Analysis and Review, which examines the liquidity positions and liquidity risk management of large, complex banking organizations, including internal stress-testing practices, and (iii) the Supervisory Assessment of Recovery and Resolution Preparedness which provides an annual evaluation of the firms’ options to support recovery and progress in removing impediments to orderly resolution. President Dudley posed the following question regarding the supervision effectiveness: “If a bank fails, is this evidence of poor supervision, or instead evidence that even good supervision can’t prevent all bank failures? Improving our ability to do this diagnosis is critical.”

In a panel discussion on defining the objectives of supervision, FDIC Vice Chair Thomas Hoenig asserted that (i) big banks should be subject to a more detailed examination process, (ii) banks should provide a fuller disclosure of any financial difficulties that they may be having to the public “at an earlier stage,” (iii) bank capital requirements should be higher, and (iv) capital adequacy should be based on tangible equity rather than on risk-based capital.  He also stressed the importance of bank regulators not backing down to industry pressures, citing the example of when regulators questioned the viability of commercial real estate leading up to the 2008 crisis, but succumbed to industry pressures.

Lofchie Comment: Taken together, these speeches seem to be calling for regulatory supervisors to have greater authority with less responsibility. It is a call for greater power yet an attempt to pre-avoid blame in the event of market failure since “the ultimate responsibility for risk identification and risk management remains with the supervised institution.” It is easy to be left with the impression that the regulators are not inclined toward self-criticism. In this regard, the worst that Mr. Hoenig can find to say about the bank regulators is that they were insufficiently confident of their own correctness as to the state of the commercial real estate market in 2006 and 2007. Perhaps, then, a good challenge for Mr. Hoenig would be to go back and look at the predictions of bank regulators over the last twenty or thirty years, and to see how well they have fared. Maybe it will turn out that the bank regulators are routinely smarter than the markets, but maybe it won’t. To be cynical, predicting that many things may go badly, and, sometimes, being correct, does not require any remarkable skills (lawyers are in fact quite good at that).

CFTC Chair Massad Cites Regulatory Progress and a Strengthened Financial System

In response to the public’s concern about the economy in these “anxious times,” CFTC Chair Timothy M. Massad stated that uncertainty and volatility in markets are the “very reasons” that the derivatives markets exist. In remarks delivered at the FIA International Futures Industry Conference in Florida, he delineated five areas where there has been significant CFTC progress toward a stronger financial system.

Common Approach to Transatlantic CCPs. Chair Massad stated that the first action exemplifying the CFTC’s progress is the agreement reached with the EU that establishes a common approach to central clearing counterparties (“CCPs”). The agreement resolves issues surrounding Europe’s recognition of U.S. CCPs and the CFTC’s recognition of European CCPs, which is effected through “substituted compliance” that permits such CCPs to comply with U.S. rules by adhering to the corresponding EMIR requirements. Separately, Chair Massad announced that the CFTC will consider measures to enhance trading on and participation in swap execution facilities, including formalizing past “no-action” positions and considering whether the CFTC should play a greater role in the “made available to trade” determination process.

Clearinghouse Resiliency. CFTC Chair Massad outlined the work that international regulators are doing to promote recovery and resolution planning. Additionally, the CFTC, the FDIC and the U.S. Treasury Department met to “engage in an exercise” that explored how U.S. regulators might respond if a clearinghouse faced credit or liquidity shortfalls.

Promoting Customer Protection and a Robust Clearing Member Industry. The CFTC held a roundtable in the earlier part of March to discuss the “residual interest rule,” which addresses the conditions under which a futures commission merchant must cover a customer’s account if it becomes undermargined. He reported that the conclusion drawn by the roundtable was unanimous: “we should not accelerate the residual interest deadline because it would likely lead to operational difficulties.”

Addressing Emerging Threats to the Financial System. The fourth action demonstrating progress, he asserted, consists of the comment deadlines for two important proposed rules: (i) the deadline for the proposal to enhance cybersecurity protection in the markets and (ii) the deadline for the proposal on automated trading. Both proposals, he argued, show that the CFTC is looking ahead to address future cyber threats.

Reducing Burdens on Commercial End Users. The fifth action, he announced, emerged from the unanimous approval of a final rule on trade options, which recognizes that trade options are different from the swaps that were the focus of Dodd-Frank reforms. The proposal eliminates certain reporting and recordkeeping obligations for commercial end users. Concurrently with these changes, he stated, the CFTC agreed on proposed guidance regarding the treatment of peaking supply and capacity contracts. He explained that the proposal is intended to make it easier for entities to use such contracts to maintain reliable energy supplies.

Lofchie Comment: Chair Massad deserves credit for undoing some of the damage that would have been caused by the prior CFTC Chair’s overreach. That said, the faster and more aggressively that Chair Massad can pursue the so-called “fine-tuning” of past mistakes, the better it will be for the economy. On a less positive note, the problems with central clearing are not easily correctable, and the solution will require far more significant action than simply shoring up individual clearinghouses in the event of their failure. (Assuming, of course, that the government will never let a clearinghouse fail.)