OFR Says “Brexit” Could Pose Risk to U.S. Financial Stability

The Office of Financial Research (“OFR”) asserted that “severe adverse outcomes in the U.K. from ‘Brexit’ could pose a risk to U.S. financial stability.”

In its biannual report, titled the Financial Stability Monitor, OFR provided the results of an assessment that focused on “vulnerabilities – weaknesses in the financial system that can originate, amplify or transmit shocks, potentially destabilizing the system.” The report was organized into five risk categories: macroeconomic, market, credit, funding and liquidity, and contagion.

The report found that risks to financial stability have stayed within the medium range, but also have risen as a result of the U.K. withdrawal referendum. The report specified that “Brexit” could pose moderate risks to the financial stability of the United States:

  • Trade: Although a recession in the United Kingdom or countries in the European Union would reduce the demand for U.S. exports, it is unlikely that the reduction would threaten U.S. financial stability due to the low percentage of U.S. exports to the European Union and vice versa. However, a reduction in exports could slow U.S. growth moderately.
  • Financial Exposures: The financial claims of the United States on the United Kingdom and, more broadly, the European Union could be vulnerable to losses due to (i) currency depreciations and volatility, (ii) declines in asset market prices, and (iii) increased defaults on debt claims.
  • Confidence and Indirect Effects: Financial instability in the United Kingdom or, more broadly, the European Union could do lasting damage to the confidence of global investors, and that damage could become “self-perpetuating.” Additionally, “U.S. long-term interest rates reached historic lows in the week after the [“Brexit”] referendum,” which in turn “underpin[ned] excesses in investor risk-taking.”
  • Funding and Liquidity Risks: Although “[k]ey funding risks are much lower than before the financial crisis due to major changes in short-term funding markets,” several vulnerabilities still persist. These include risks in certain money market funds and short-term investment vehicles, and sharp falls in market liquidity during certain moderate stress events.
  • Contagion Risks: “[C]ontagion risk is greater than available metrics indicate. . . . It is unlikely that the contagion risks disappeared as stress receded. It is more plausible that underlying factors – such as risky assets’ tendency to become more correlated during market stress – pose enduring contagion risks.”

The report stated:

Because the U.K. economy and especially the U.K. financial system are highly connected with the rest of Europe and the United States, severe adverse outcomes in the U.K. could pose a risk to U.S. financial stability.


Lofchie Comment: The value of these government reports is questionable. Statements in the OFR report like: “severe adverse outcomes in the U.K. could pose a risk to U.S. financial stability,” are trivial given the current economic environment, and they offer no useful insight for market participants. More remarkable, however, was the failure of the Financial Stability Oversight Council (“FSOC”) to identify “Brexit” as a risk in its own annual report, produced just before the “Brexit” vote. The OFR’s biannual report and FSOC’s annual report raise necessary but basic questions: (1) are these agencies particularly skilled at identifying risks before the fact, and (2) do they have anything useful to say about risks after the fact?

G20 Describes Path to Global Economic Recovery

The Group of 20 Finance Ministers and Central Bank Governors (“G20”) reviewed efforts to respond to “key economic challenges, as well as the progress . . . made since the beginning of this year.” The meeting was held over two days in Chengdu, China.

In a Communiqué issued at the end of the conference, the G20 members conveyed the following:

  • “The global recovery continues but remains weaker than desirable.” This is due in part to high financial market volatility and geopolitical conflicts, and to fluctuating commodity prices and low inflation, both of which could be prevented by sharing the benefits of growth within and among countries in order to promote inclusiveness.
  • The G20 will use “all policy tools – monetary, fiscal and structural – individually and collectively to achieve . . . strong, sustainable, balanced and inclusive growth.” Achieving that goal will involve making tax policy and public expenditure more “growth-friendly” by prioritizing high-quality investments.
  • Structural issues, such as excess capacity in certain industries, are “exacerbated by a weak global economic recovery and depressed market demand” and have affected trade and workers negatively.
  • Multilateral development banks (“MDBs”) have a “unique role in supporting infrastructure investment.” G20 has asked MDBs to undertake joint actions that support “quality infrastructure development, which aims to ensure economic efficiency in view of life-cycle cost, safety and resilience.”
  • The G20 supports the “continued effort to incorporate enhanced contractual clauses into sovereign bonds.”
  • The G20 prioritizes “building an open and resilient financial system,” by implementing the total-loss-absorbing-capacity standard and effective cross-border resolution regimes. Members will “continue to address systemic risk within the insurance sector,” along with “emerging risks and vulnerabilities in the financial system, including those associated with shadow banking, asset management and other market-based finance.”
  • The G20 recognizes “recent progress made on effective and widespread implementation of the internationally agreed standards on tax transparency.” The G20 recognizes the effectiveness of “tax policy tools in supply-side structural reform for promoting innovation-driven, inclusive growth, as well as the benefits of tax certainty to promote investment and trade.” The G20 will continue working on issues surrounding pro-growth tax policies and tax certainty.
  • G20 countries should participate in a “voluntary peer review of inefficient fossil fuel subsidies that encourage wasteful consumption.” Further, green financing must be increased if environmentally sustainable growth on a global scale is to be supported.

Lofchie Comment: Although the G20 Communiqué has no actual legal effect, the intellectual bent is clear: it supports globalism and government intervention while remaining either indifferent or hostile to private enterprise. The Communiqué begins with a recognition that the global economy is weak. It then pivots toward questions of infrastructure spending which inherently means either government spending or spending through international government agencies and “multilateral development banks.” The G20 seems to view private financing sources with suspicion and perhaps even hostility in its assessment of “vulnerabilities . . . associated with shadow banking, asset management and other market-based finance.”

The G20 stance on energy is that “green financing must be increased,” presumably, through additional government financing. At the same time, the G20 advocates for the reduction of “fossil fuel subsidies that encourage wasteful consumption.” It is difficult to understand the policy implications of these statements. Wouldn’t governmental subsidies of green financing also encourage wasteful energy consumption? If, for example, you wanted to reduce energy consumption, wouldn’t you have to raise the cost of energy, instead of subsidizing its production?

According to the G20, tax collection must be improved while “pro-growth tax policies” are implemented. Again, it is difficult to understand what is being advocated here. Is this an argument for reduced taxes? The G20 says that it favors the use of “tax policy tools in supply-side structural reform for promoting innovation-driven, inclusive growth, as well as the benefits of tax certainty to promote investment and trade.” What does this mean? Who possibly could be against “innovation-driven, inclusive growth”? Or better yet, how about this incomprehensible line: “We launch the Global Infrastructure Connectivity Alliance to enhance the synergy and cooperation among various infrastructure connectivity programs in a holistic way.”

In a passage from the Communiqué that seems particularly problematic, the G20 observes that “fluctuating commodity prices and low inflation . . . could be prevented by sharing benefits of growth within and among countries to promote inclusiveness.” Perhaps this is true, but since the Democratic and Republican parties both seem to oppose further trade agreements, and likely are in favor of reevaluating established ones, it is unclear what part or political faction of the U.S. government would endorse the G20’s position.

Treasury Secretary Lauds Wall Street Reform on Sixth Anniversary of Dodd-Frank

U.S. Treasury Secretary Jack Lew acknowledged the six-year anniversary of the passage of the Dodd-Frank Act. “Without question . . . Wall Street Reform has made our financial system safer and sounder,” he said.

In his statement, Secretary Lew emphasized that over the past six years:

  • “Banks have added more than $700 billion in additional capital.”
  • “The vast derivatives market has been pulled out of the shadows, with requirements that standardized derivatives be centrally cleared and traded transparently.”
  • “The Consumer Financial Protection Bureau . . . has put in place new safeguards for customers, and provided over $11 billion in relief for more than 27 million hardworking Americans.”
  • “[T]he Financial Stability Oversight Council has closed regulatory gaps exposed by the crisis, with regulators now working collaboratively and transparently to better identify and respond to potential threats to the financial system.”

Secretary Lew observed that “over the past year, the strength of our financial system has been tested repeatedly” by Brexit and other “episodes of market volatility.” He asserted that America has passed those tests:

[T]he U.S. financial system has demonstrated resilience, providing fresh evidence that Wall Street Reform is working and that with deeper capital, greater transparency, and detailed resolution plans, it can withstand far greater shocks than before the crisis.

Secretary Lew also argued against complacency. “If anything, recent events around the world underscore the need to remain vigilant,” he stated. “This means continuing to carry out Wall Street Reform and defend against efforts to roll it back.”

CFTC Proposal to Mandate Broader Clearing of Interest Rate Swaps Receives Conditional Support

Several leading industry groups and market participants offered support for a CFTC proposal to amend CFTC Rule 50.4(a). The proposal would require certain interest rate swaps that are denominated in certain currencies, or that have certain termination dates, to be subject to mandatory clearing.

In comments on the proposal:

  • The Managed Funds Association expressed strong support for the proposal and urged the CFTC to harmonize mandatory clearing with the requirements of other jurisdictions.
  • ISDA expressed strong support for CFTC efforts to harmonize its clearing mandate with those of other countries, but encouraged the CFTC to ensure that data on (i) the impact of its clearing mandate on liquidity and risk management for a particular product, and (ii) the mandate’s interaction with the mandatory trading requirement and “made available-to-trade” (“MAT”) process, “are appropriate and accurate.” ISDA also urged the CFTC to avoid “prioritizing harmonization of clearing mandates” over concerns relating to liquidity and risk management.
  • LCH Group Limited (“LCH”) voiced support for the CFTC initiative and for CFTC leadership in fostering international harmonization. LCH emphasized that the “OTC derivatives marketplace is global in nature and . . . this Proposed Determination . . . will promote certainty and international consistency for all market participants.”
  • CME Group Inc. (“CME”) expressed general support for the proposal, but recommended that “CFTC implementation of clearing obligations takes into account the timing of clearing mandates in other jurisdictions and ensures that the timing does not create an imbalance in the competitive landscape for market participants across jurisdictions.”
  • SIFMA Asset Management Group (“SIFMA”) expressed general support for the proposal, but argued that the determination “must not be considered in a vacuum in light of the clearing mandate’s status as a condition precedent” for a made-available-to-trade (“MAT”) determination. SIFMA urged the CFTC to harmonize clearing requirements with those in non-U.S. jurisdictions in a manner that is consistent with those jurisdictions’ “implementation timing.” Accordingly, SIFMA recommended that the CFTC defer the compliance date for any final clearing mandate until 180 days after a regulator in a non-U.S. jurisdiction has adopted an analogous mandate, and that it should do so with a phased-in approach by counterparty type.
  • Citadel LLC (“Citadel”) expressed “full support” for the proposal, and applauded the CFTC for “recognizing the important role of central clearing in achieving the Dodd-Frank Act objectives of reducing interconnectedness, mitigating systemic risk, increasing transparency and promoting competition in these markets.” Citadel urged the CFTC not to be concerned about the impact of its determination on the companion MAT requirement, and argued that such an assessment would not be “part of the criteria for determining whether OTC derivatives are suitable for mandatory clearing.”

Lofchie Comment: CEA Section 2(h) should be amended to specify that any determination that a swap is subject to mandatory exchange trading must be initiated by regulators, in light of market conditions, and not by exchanges. Unbundling the mandatory exchange-trading element of the CEA from the mandatory clearing element would give the CFTC more latitude to make its clearing determination without being forced to approve the mandatory exchange trading of the swap.

ICI Calls on FSOC to Reconsider Position on Financial Stability Risk and Mutual Funds

The Investment Company Institute (“ICI”), a global association of regulated funds, urged the Financial Stability Oversight Committee (“FSOC”) to reconsider the conclusion that liquidity and redemptions in mutual funds carry significant financial stability risks. The ICI was responding to an FSOC public update of a two-year review of asset management products and activities.

The ICI contended that although it recognizes the need for enhanced liquidity management for mutual funds, the FSOC provided “no basis . . . for its conclusion that there are financial stability concerns that may arise from liquidity and redemption risks in mutual funds, particularly funds investing in less liquid asset classes.” The ICI made the following assertions:

  • the FSOC’s concern that a “first mover” advantage in pooled investment vehicles may be attributed to either the mutualization of trading costs or funds selling their most liquid assets first to meet redemptions is unfounded and ignores data gathered in response to this very question by the ICI in December 2014;
  • the FSOC failed to substantiate concerns about destabilizing redemptions from mutual funds, which ignore the “modest net outflows from mutual funds in the aggregate, even during times of severe market stress”; and
  • the FSOC misconstrued the lessons to be learned from funds investing in less liquid assets (i.e., the Third Avenue Focused Credit Fund) despite the New York Federal Reserve’s economic modeling that suggests that “even extremely large outflows from high-yield bond funds – which assumed outflows far greater than ever seen in history – are simply too small to pose systemic risks.”

Lofchie Comment: The FSOC has shown a continuing interest in risks that relate to mutual funds and investment advisers, two areas that are not under the control of the banking regulators who dominate the FSOC. Meanwhile, the FSOC largely has ignored risks that seem far greater than, for example, the risks associated with government pension plans. Would it not be more prudent for the FSOC to address the unrealistically high levels of projected returns that these plans promise, along with the billions of dollars of long-term obligations they add, particularly given that governmental pension plans typically underestimate the life span of plan recipients? The FSOC should focus on risks that, despite being politically more difficult to confront, are greater in significance and certainty.

Largest Money Growth Since January 2013…

Today’s CFS Divisia M4 release highlights the fastest broad money growth rate since January 2013.  CFS Divisia M4 – the broadest and most important measure of money – grew by 5.9% in June 2016 on a year-over-year basis versus 2.8% one year earlier.

The last time that CFS DM4 growth approached this level, nominal GDP began an advance from 2.9% to 4.1%.  CFS data signals that nominal GDP will likely push meaningfully higher than the 3.3% year-over-year growth in Q1 2016.

Commercial bank savings deposits, demand deposits, and repurchase agreements are contributing to more rapid money growth.  Whereas, time deposits at commercial banks and thrifts are modestly weighing down the aggregates.  Nonetheless, growth – on balance – is very positive.

For more info on CFS Divisia, please see “Why CFS Divisia Money Matters, Now!” –

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’

The Ongoing Battle of Cybersecurity

Cybersecurity is not a technical issue. It’s a managerial problem that requires a new approach to risk management.

Imagine going down a river in a rowboat. Water seeps in, and you cannot see below the waterline — or, as it’s called in cyberese, the attack surface. While on the river, you bail the water out, and upon arriving back onshore you patch the most obvious holes. The very next day, you purchase a new product that ensures the bottom of your boat is absolutely water resistant. Now, feeling highly confident that you solved yesterday’s problem, you take the rowboat out on the river again. This time, you go over a waterfall and wreck the boat.

To read the rest of the article, click here:

Representative Peter DeFazio Introduces Bill to Tax Trading

Representative Peter DeFazio (D-OR) introduced legislation, titled “Putting Main Street FIRST: the Finishing Irresponsible Reckless Speculative Trading Act,” that would levy a 0.03% tax on certain securities purchases (including stock, partnership interests and debt instruments) and derivative transactions. Mr. DeFazio stated that the legislation is intended to “discourage the same speculative financial trading that led to the 2008 Wall Street collapse and 2010 ‘Flash Crash.'”

The Joint Committee for Taxation determined that the proposed tax would raise $417 billion over a ten-year period, according to Mr. DeFazio. He asserted the importance of that figure:

The only way we can level [the American economy’s “playing field”] is if we rein in reckless speculative financial trading and curb near-instantaneous high-volume trades that create instability in the stock market and our national economy. These financial practices have no intrinsic value, and exist to make a quick buck for already-wealthy speculators.

The proposed tax would apply to transactions that occurred after December 31, 2017.

Lofchie Comment: Financial trading had nothing to do with the market collapse in 2008 (although suggesting that it did clearly helped Michael Lewis sell books). Representative DeFazio appears to be either unfamiliar or unimpressed with evidence showing that a single trader’s activity (not one of the type disparaged by the Representative) precipitated the Flash Crash. See Findings Regarding the Market Events of May 6, 2010. Apart from that, the practices that would be taxed by his bill essentially are market-making activities. The focus on those specific activities is valuable, providing liquidity to the market and lessening the spread between buyers and sellers. There is a wealth of data contradicting Representative DeFazio’s assertions. Seee.g.The Diversity of High-Frequency TradersStudies Indicate That High-Frequency Trading Is Beneficial to Canadian Equity Market, and FIA Releases Futures Volatility Study.

Second, Representative DeFazio should consider how much business will be taken out of the country if punitive taxes are imposed on trading. Such financial regulatory measures, which have no basis in economic policy, are of a kind that give Brexit a real chance of succeeding. The United Kingdom has only to adopt sensible regulations and allow other countries to destroy their own markets for the exit to work in its favor.

Third, this bill is geographically biased. It hits the local economies of places that are financial centers: New York, New England and New Jersey. Let’s hope that local politicians reject this suicidal form of populism for the good of both national and regional economies.

If the Representative from Oregon is so interested in putting Main Street businesses “FIRST,” then perhaps he should, to borrow from the Representative’s own rhetoric, consider a tax on high-tech click-through businesses run by fabulously wealthy elitists that destroy local brick-and-mortar businesses. He wouldn’t even have to change the acronym in the bill’s title to accommodate his new target, since the bill could be called “FIRST: the Frenzied Internet Robots Stifle Two-legged store owners Act.” A better option, however, is for him to tone down his rhetoric and engage other representatives in a reasoned, grounded, reality-based discussion about doing what is right for the economy and the country as a whole.

Federal Reserve Board Governor Tarullo Calls for Regulatory Approach to “Runnable Funding”

Board of Governors of the Federal Reserve System Governor Daniel K. Tarullo discussed the regulation of financial activities related to shadow banking. He focused on the risk of “runnable liabilities,” which are defined as short-term, “pay-on-demand” transactions that are not insured explicitly by the federal government (e.g., repo transactions). According to the “working definition” cited by Governor Tarullo, these transactions are considered “runnable” because their pay-on-demand feature implies that – in the event of stress caused by credit-risk concerns, wide swings in short-term interest rates, or deteriorations in market liquidity – investors may behave as though they are on bank runs: they might redeem shares, unwind transactions, or decide not to roll over positions.

In order to fashion a regulatory approach to these transactions, Governor Tarullo suggested, the following “key questions” should be answered:

  • To what extent will the regulation apply uniformly to users of runnable funding, no matter what the characteristics of market actors and business models involved in the funding relationship might be?
  • What agency or agencies would be the appropriate regulators?
  • What form(s) would the regulation take (i.e., would it use methods such as outright prohibition, minimum margining requirements and practices, capital requirements, and taxation)?
  • To what extent is the supply of short-term funding a response to the persistent demand for safer assets?
  • To what extent must a comprehensive regulatory approach to shadow banking include mechanisms, which involve the government directly or indirectly, for the creation of genuinely safer assets, as well as limitations on runnable varieties that can precipitate or exacerbate financial stress?

Governor Tarullo emphasized that this fifth and final question “implicates some elements of monetary policy, as well as moral hazard issues and other recurring factors in financial regulation.”

Governor Tarullo delivered his remarks before the Center for American Progress and Americans for Financial Reform Conference in Washington, D.C.

Lofchie Comment: Governor Tarullo’s argument seems to be that, in one way or another, every participant in the financial markets is a bank; it is either regulated or shifts in the shadows. When he asks which agency should regulate all of these banks and shadow banks, the question practically answers itself: who better than the Federal Reserve?

Why CFS Divisia Money Matters, Now!

My remarks at the Society for Economic Measurement illustrate how the world may have been different had CFS Divisia money been on the Fed’s dashboard.

Even today, CFS Divisia M4 suggests that growth may be better than expected.

Takeaways for investors and officials from our experience producing monetary aggregates and measuring money in the U.S. since 2012 include: 1) private sector versus state money, 2) deflation and inflation scares, 3) a damaged monetary transmission mechanism, 4) collapse in shadow banking, 5) shortage of financial market liquidity, and 6) ideas for the future.

Whether you are a Keynesian, Monetarist, or simply agnostic, monetary and financial measurement and its integration into policy is essential for the future.

For full remarks: