NY Federal Reserve Bank President Cites Progress in Cross-Border Regulation

Federal Reserve Bank of New York President and CEO William C. Dudley voiced optimism about the “substantial progress” made in “strengthening the global banking system.” He cited the establishment of capital and liquidity standards for internationally active banks as an example. In addition, he noted that “steps have been taken” to respond to the failure of systemically important financial firms on a cross-border basis.

Even so, Mr. Dudley asserted, “more needs to be done.” His recommendations include: (i) identifying and dismantling the impediments to orderly cross-border resolutions, and (ii) enhancing cross-border regulatory cooperation through the “greater exchange of confidential supervisory information so that national regulators can be fully informed about the conditions of the banks that operate within their borders.”

Mr. Dudley asked the following questions, which he said were raised by the idea of a convergent transcontinental economy:

  • Can policy strategies ensure that the global economy will escape from this long period of low inflation and real interest rates? If so, what are those strategies?
  • Does fiscal policy have sufficient scope to assume part of the burden of ending this period of persistently low inflation and interest rates?
  • Is the economy going through a period of secular stagnation or is it simply at the midpoint of a deleveraging process that will dissipate gradually?
  • Why hasn’t investment spending reflected the low level of interest rates?
  • What underlying factors have contributed to the recent slowdown in the growth of global productivity?
  • Is it possible for Europe to realize a banking union with a common deposit guarantee scheme?
  • Are there practical opportunities for furthering additional regulatory and supervisory convergence between the United States and Europe?

Mr. Dudley delivered his remarks at a conference hosted by the European Commission, the Federal Reserve Bank of New York and the Centre for Economic Policy Research: “Transatlantic Economy: Convergence or Divergence?”

Lofchie Comment: Since Mr. Dudley is pondering the lack of growth in investment spending and whether the economy is going through a period of secular stagnation, the ideal question for him to ask might be this: are there regulations that are materially damaging to economic growth? New rules have imposed billions of dollars’ worth of compliance and transactional costs. Many of those rules are not particularly sensible and a fair number are actually destructive. The time for regulators to exercise self-criticism is long past due. Unfortunately, too many seem to believe that economic growth can be achieved only by adding more regulations, without first conducting a meaningful analysis of which rules might work, which rules might fail, and which are not worth the costs their implementation would demand.

CFS Monetary Measures for March 2016

Today we release CFS monetary and financial measures for March 2016.  CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.6% in March 2016 on a year-over-year basis versus 4.1% in February.

CFS Divisia indices can be found on our website at http://www.centerforfinancialstability.org/amfm_data.php.  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:

3) {ECST} –> ‘Monetary Sector’ –> ‘Money Supply’ –> Change Source in top right to ‘Center for Financial Stability’
4) {ECST S US MONEY SUPPLY} –> From source list on left, select ‘Center for Financial Stability’


SEC Approves Concept Release on Corporate Disclosure Requirements

At an open meeting, the SEC decided to issue a concept release for comments on modernizing certain business and financial disclosure requirements in Regulation S-K.

SEC Chair Mary Jo White asserted that the concept release (i) considers the history and purpose of disclosure requirements, (ii) establishes an accessible framework for achieving a better understanding of customers’ and investors’ experiences with disclosure requirements, and whether investors are receiving adequate information, and (iii) seeks broad input from all constituencies. Chair White stressed that the SEC’s work on disclosure effectiveness “obviously does not stop with this release.”

SEC Commissioner Kara M. Stein voted to support the concept release as a “step towards starting the dialogue on how to modernize and improve the [SEC’s] disclosure framework,” but argued that “it is only a tentative first step.” Commissioner Stein asserted that the Concept Release failed to address the following issues:

  • the “fundamentally different” views of investors in 2016 as compared to those of investors from over 30 years ago, when the main requirements of Regulation S-K were adopted originally;
  • the “antiquated” form-based system used by the SEC, and whether the Electronic Data Gathering Analysis and Retrieval system should be reimagined;
  • whether SEC rules should be changed to address abuses in the presentation of supplemental non-GAAP disclosures, which may mislead investors, and to address other corporate governance and transparency issues;
  • whether environmental, social and corporate governance measures should be required in company disclosures; and
  • whether the disclosure regime should incentivize registrants to provide quality information to the market before allowing them the “privilege” of scaled disclosure.

SEC Commissioner Michael S. Piwowar expressed support for the concept release, but also opined that the SEC “has still not done enough to provide fair, efficient and robust capital markets.” Additionally, he emphasized the “pivotal role” of “materiality” in Regulation S-K examination by the SEC.

“Materiality” plays a pivotal role in understanding the disclosure obligations under the federal securities laws. It is not sufficient that information might merely be useful. Nor is it sufficient that only some investors might find a bit of information to be important. Rather, as Justice Thurgood Marshall wrote for a unanimous Supreme Court in the seminal case of TSC Industries v. Northway [426 U.S. 438, 445 (1976)], “[t]he question of materiality, it is universally agreed, is an objective one, involving the significance of an omitted or misrepresented fact to a reasonable investor.” This is an objective legal standard, not a subjective political one. While certain shareholders may have their own particular pet interests, the reasonable investor standard prevents an individual investor from hijacking corporate resources to serve their own specific agenda.

Commissioner Piwowar urged regulators to keep in mind certain requirements in the Fixing America’s Surface Transportation Act, which address the concerns first raised by Justice Marshall, when they implement subsequent Regulation S-K reforms. Commissioner Piwowar noted that these requirements instruct the SEC to (i) examine how information can be disseminated to investors by using a company-by-company approach that avoids the use of boilerplate language or static requirements, and (ii) explore methods for discouraging repetition and the disclosure of immaterial information.

Lofchie Comment: The fundamental debate between Commissioners Stein and Piwowar concerns the SEC’s social disclosure requirements, which Commissioner Stein claims will effect a “modernized disclosure regime [that addresses such matters as] . . . diversity and inclusion.” Commissioner Stein believes that “[t]oday, investors make their decisions based on an array of information, which goes beyond mere profit and loss” – a situation that in her view contrasts sharply with that of the past, when such social-value information “may not have been material to an investor at all in 1982.” The opposing view to Commissioner Stein’s is this the requirement to provide such information is not coming from investors at all and is being used primarily to further a political agenda.

The most reasonable way to respond to Commissioner Stein’s question is to allow the investors in any particular company to answer it. Let the company ask regularly in proxy statements whether its shareholders want it to make such disclosures. Presumably, the investors will vote either to mandate such disclosures, if they believe that the market finds them desirable, or against such disclosures, if they believe them to be a waste of corporate resources. It would not be surprising if investors in 2016 proved to be more similar than dissimilar to investors in 1982. That said, if the intent of Commissioner Stein is to allow investors to express their true selves, then she should allow them to vote according to their wishes.

House Financial Services Committee Splits along Party Lines, Approves Amendments to Dodd-Frank

The House Financial Services Committee approved two amendments to the Dodd-Frank Act that would (i) bring the CFPB within the ordinary Congressional appropriations process and (ii) eliminate the “orderly liquidation authority.” The vote was partisan with all Republicans voting in favor of the amendments and all Democrats voting against.

The amendments were as follows:

  • H.R. 1486, The Taking Account of Bureaucrats’ Spending Act (33-20). The bill would repeal the current independent funding of the CFPB and instead subject it to the annual Congressional appropriations process.
  • H.R. 4894, To Repeal Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (34-22). The bill would repeal the Orderly Liquidation Authority (“OLA”) in Title II of the Dodd-Frank Act, which authorizes the resolution of a financial institution the failure of which otherwise would threaten the financial stability of the U.S. economy.

Lofchie Comment: There is no justification for setting the CFPB’s budget outside of congressional processes. As the Republican’s press release notes, the Pentagon and the Justice Department have their budgets approved by Congress. Is the CFPB more important than those agencies? Even if one believes that protecting consumers from banks is more important morally than protecting citizens from enemies, what does that say about the Environmental Protection Agency and the Department of Health and Human Services? Why are they subject to a budget process from which the CFPB is exempt?

Conversely, while there are reasons to disapprove of the Orderly Liquidation Authority, the notion that the Federal Reserve should allow every major financial institution to fail during some future liquidity squeeze is not one of them. During the kind of real-life liquidity squeeze that we’ve endured in the past, it is not merely the “big banks” that collapse; it is also the entire financial system. Had the Federal Reserve Board not supplied liquidity to the system during the last crisis, numerous banks and money market funds would have failed, which in turn would have wiped out the savings of millions of investors.

SIFMA Executive Highlights Issues Concerning the Changing Role of Exchanges in the Equity Market Structure

At the 2016 SIFMA Equity Market Structure Conference, SIFMA Executive Vice President of Business Policies and Practices Randy Snook maintained that several issues must be “rethought” if financial professionals and regulators are to “strengthen market structure and increase market resiliency.” In his remarks, Vice President Snook focused on the role of exchanges as self-regulatory organizations (“SROs”). He asserted that the status of exchanges as SROs creates unnecessary conflicts of interest and duplicative regulations, and that even though an exchange should supervise trading that is specific to its own market, “having exchanges establish market-wide regulation and policy no longer works.”

Vice President Snook also addressed several other market structure issues, such as increased disclosure to investors and improvements in the ways in which market data is disseminated.

Lofchie Comment: The SRO structure was developed at a time when the various exchanges were nonprofit membership organizations controlled by their member broker-dealers. Accordingly, the actions of an exchange/SRO reflected the decisions of its member broker-dealers. More recently, the exchanges have become global private corporations that, to a considerable extent, either are in competition with broker-dealers or have an interest in maximizing the fees they charge to broker-dealers. Nothing is inherently wrong with competition or fee maximization, but the two activities become problematic when combined with regulatory authority, the ability to control market structure, and the power to impose sanctions. In short, the SRO regulatory structure, which dates back to the 1930s, is in need of a revisit.


NY Federal Reserve V.P. Discusses the Role of Bank Supervision

Executive Vice President of the Federal Reserve Bank of New York (“FRBNY”) Kevin Stiroh discussed the necessity of governmental supervision of the financial industry (oversight of firms’ governance, internal controls and financial condition) as opposed to mere regulation (rulemaking).

Mr. Stiroh, who is head of the FRBNY’s Supervision Group, discussed the theory and practice of bank supervision – considering the need for supervision, the FRBNY’s role in supervising banks, and some of the practical realities of conducting such supervision.

Mr. Stiroh stressed three developments which will be relevant to the FRBNY in executing its supervisory responsibilities.

  • Cybersecurity. Because the state of cybersecurity readiness varies across firms, Mr. Stiroh explained, supervisors must develop common principles for addressing cybersecurity risks and defending operations that are critical to the financial services sector.
  • FinTech. Mr. Stiroh questioned whether FinTech will “enhance or fundamentally disrupt” the financial service and payment industries. In that regard, he noted, investment in FinTech companies rose 10% between 2010 and 2015. Mr. Stiroh noted that firms and supervisors should be mindful of how technological change impacts bank risk and the supervisory framework.
  • Reputational Risk. Mr. Stiroh encouraged financial institutions to “consider the many factors that have contributed to recent, widespread misconduct and the perceived lack of trust in the financial sector.” He argued that firms should have strong incentives to manage their reputations, and that supervisors should support that goal.

Mr. Stiroh also cited two recent Federal Reserve Supervisory letters on capital planning (see Premium Content links on the right) as “specific examples” of how regulators approach firms that are more or less complex.

Mr. Stiroh delivered his remarks at the SIFMA Internal Auditors Society Education Luncheon at the Harvard Club in New York City.

Lofchie Comment: One of the reasons that the financial services industry is under pressure is because the government attacks its reputation constantly, and not always for good reasons. (To be fair, Mr. Stiroh noted both actual misconduct and a perception of a lack of trust.) With that in mind, consider the following observations: (i) most persons (including the government) tend to be less critical of themselves than of others, (ii) misconduct by government officials and a perceived lack of trust seems at least as common in government as in the financial services, and (iii) mistakes by those in government seem as frequent as mistakes by those in the financial sector. It is not true that the only so-called mistake made by government is insufficient regulation; many regulations are either unnecessary or spur conduct that undermines monetary growth. When the government becomes as critical of itself as it is of the financial industry, then both will improve together.

Treasury Secretary Defends FSOC’s Designation of MetLife

Treasury Secretary Jacob Lew issued a statement arguing that the federal court’s decision to rescind the determination that MetLife was a so-called “systemically important financial institution” leaves one of the “largest and most highly interconnected financial companies in the world subject to even less oversight than before the financial crisis.”

Secretary Lew argued, among other things, that the court “imposed new requirements” that never have been enacted by Congress regarding SIFI designation, asserting that:

Congress chose not to require FSOC to conduct a formal cost-benefit analysis of designations for good reasons. Such a requirement would impair the Council’s ability to address the risks of a future financial crisis that could severely damage the financial system and the U.S. economy.

Secretary Lew stated that he will continue to “vigorously” defend the SIFI designation process and the integrity of FSOC’s work.

Taking the other side of the matter, American Council of Life Insurers (“ACLI”) President and CEO Dirk Kempthorne expressed satisfaction with the federal court’s decision, noting ACLI doesn’t “believe the facts support the conclusion that any life insurer presents a systemic risk to the nation’s economy.” Mr. Kempthorne further recommended that FSOC offer companies “a clear exit ramp” so they can understand and implement de-risking strategies they could use to be de-designated from SIFI oversight.

Lofchie Comment: The District Court’s harsh rejection of FSOC’s analysis of MetLife motivates a reexamination of that analysis and other commentary on it. One of the more detailed public reviews of FSOC’s analysis was produced by Peter Wallison (see “MetLife Calls the Regulators’ Bluff” published in The Wall Street Journal on July 7, 2015). His specific criticism of the FSOC analysis, e.g., with respect to securities lending, is a reasoned indictment of FSOC’s ability to understand the business lines it addressed in the analysis.

However harsh the District Court and Mr. Wallison were, there is nothing so damning to FSOC as FSOC’s own words. The report is frequently long on generalizations and short on specific analysis.  For example, reading the report’s analysis of MetLife’s securities lending business suggests that FSOC gave only a cursory overview of securities lending, generally, without much to suggest that MetLife’s business was particularly risky.  In fact, reading FSOC’s analysis, it seems clear that FSOC believes that all persons in the securities lending business should be prudentially regulated (which can’t possibly be true).

D.C. District Court Calls FSOC’s Review of MetLife’s Status “Fatally Flawed”

The U.S. District Court for the District of Columbia (the “Court”) rescinded the Financial Stability Oversight Council (“FSOC”) designation of MetLife, Inc. (“MetLife”) as a so-called “systemically important financial institution.” The Court found “fundamental violations of established administrative law” in the FSOC designation.

The Court found: (i) that FSOC made unexplained “critical departures” from two standards outlined in the guidance that it issued years before the designation, and (ii) that FSOC “purposefully omitted any consideration of the cost of designation to MetLife.” The Court also noted that in assessing MetLife’s threat to U.S. financial stability, FSOC “hardly adhered to any standard.”

MetLife argued that FSOC violated its prior guidance by failing to assess MetLife’s “vulnerability to material financial distress” before addressing the potential effect of that distress. The Court found that FSOC conflated these issues in its conclusion. The Court rejected FSOC’s argument that any change in its method of analysis was sufficiently justified and explained.

MetLife also claimed that FSOC failed to abide by its prior assertion that a non-bank financial company could threaten U.S. financial stability only if there was “an impairment of financial intermediation or financial market functioning that would be sufficiently severe to inflict significant damage on the broader economy.” The Court agreed with MetLife’s allegations that FSOC’s determination failed to abide by its own standard because it never projected what the losses would be, or established any basis for finding that MetLife’s distress would “materially impair” counterparties. The Court stated it was unable to determine whether MetLife’s distress would cause severe impairment of financial intermediation or financial market functioning because FSOC “refused to undertake that analysis itself.”

The Court also maintained that FSOC’s omission of any consideration of the cost of designation to MetLife “was not by accident.” In its Exposure analysis, FSOC avoided accounting for collateral and other mitigating factors and instead posited that these factors would only worsen asset liquidation impact. By doing so, FSOC considered the upside benefits of designation but not the downside costs of its decision. The Court found that the impact of neither financial distress nor asset liquidation was actually quantified.

Lofchie Comment: Given how much discretion the Dodd-Frank Act affords FSOC to create its own rules, the Court’s finding that the FSOC failed to follow those rules is nothing less than embarrassing.

The decision casts doubt on whether FSOC and its closely related affiliate (also established by Dodd-Frank), the Office of Financial Research, (i) can provide any meaningful value and (ii) are really more political creatures than regulatory or academic entities. FSOC’s annual reports on the state of the financial markets seem to provide little in the way of worthwhile economic analyses. They do, however, make political sense as running defenses of the regulations adopted by Dodd-Frank.

If FSOC is to be saved (and nothing about its performance to date makes that goal seem remotely important), it should de-politicize its governing rules by amending them to require members of both political parties (and not just administration-appointed officials who are Democrats) to serve as FSOC members. This would prevent FSOC from issuing pronouncements that are not susceptible to internal challenge or debate. Conversely, if it is to continue to function as a one-party organization, whether Democrat or Republican, then the pretense that it is something other than the political instrument of the executive branch should be abandoned (seee.g., FSOC Voting Members Testify at Financial Services Committee Oversight Hearing).

Soviet Monetary Statistics

A big omission in many databases of economic statistics for the 20th century is the communist countries, which at one time included more than a third of the world’s people. Their governments were secretive. They did not publish certain statistics and they fabricated others.

Historical research is going back and filling some of the gaps, or replacing bad data with better data. Starting a decade ago, the Central Bank of Russia began issuing a series of print monographs about money and banking in the Soviet period. Michael Alexeev of Indiana University, an expert on the Soviet and post-Soviet economy, recently made me aware that the series is now available online. It is in Russian, but readers interested in the subject whose knowledge of Russian is quite poor, like mine, can use Google Translate to understand the gist of the papers. I will eventually incorporate some of the data into Historical Financial Statistics.

Another central bank that has done much to make available material from its communist period is the Bulgarian National Bank, though the material is likewise not in English.

SROs Caution Firms to Distinguish between Debt “Securities” and “Loans

FINRA and the MSRB jointly reminded member firms of obligations connected to: (i) privately placing municipal securities directly with a single purchaser; and (ii) using bank loans as alternatives to traditional public offerings in the municipal securities market.

FINRA and the MSRB stated that many firms failed to:

  • conduct sufficient due diligence and analysis to determine whether financing the instruments are municipal securities or bank loans when the financing instrument is described as a “loan”;
  • fully understand the nature of their roles in transactions where they have engaged in placements of these instruments; and
  • fully consider how federal securities laws and the regulations and rules thereunder (i.e., FINRA and MSRB rules) apply to these transactions.

FINRA and the MSRB urged firms to:

  • undertake a threshold analysis of whether the nature of the financing instrument of the municipal entity constitutes a security or a loan, as determined by Securities Exchange Act Section 3(a)(10) and the decision of the U.S. Supreme Court case, Reves v. Ernst & Young, Inc. (494 U.S. 56 (1990));
  • review transaction documentation when considering whether a particular financing instrument is a municipal security or a loan;
  • consider consulting with counsel to determine whether a particular financing instrument is a municipal security or a loan; and
  • voluntarily disclose the existence and terms of bank loans in a timely manner.

FINRA and the MSRB expressed mutual concern that the increasing use of direct purchases of municipal securities and bank loans as alternatives to publicly-offered municipal securities may: (i) increase compliance risks for firms engaging in this activity; and (ii) ultimately “erode market transparency.”

Lofchie Comment: The problem with this guidance is that the dividing line between a loan and a debt security is economically indeterminate. That said, the guidance does point out “bad language” in documents that would indicate that a credit obligation to a bank might be deemed a security rather than a bank loan; e.g., the use of the instrument of terms such as “bond” or “security” or “purchaser.” In short, if it is desired that a credit instrument be treated as a “loan,” then the instrument should use loan terminology and not debt security terminology.