Federal Register: Banking Agencies Propose Enhanced Cyber Risk Management Standards

The Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency and the FDIC (collectively, the “Agencies”) requested comments on an Advanced Notice of Proposed Rulemaking (“ANPR”) that would enhance cyber risk management standards for large and interconnected entities under their supervision and those entities’ service providers. The agencies are considering more stringent standards for the systems of those entities that are most critical to the functioning of the financial sector in order to increase their operational resilience and reduce the impact they would have on the financial system if they experienced a cyber event. The request for comments was published in the Federal Register.

Comments on the ANPR must be submitted by January 17, 2017.

SEC Commissioner Champions High-Quality Economic Analysis as “Essential Part of Regulatory Processes”

SEC Commissioner Michael S. Piwowar remarked that “high-quality economic analysis is an essential part of regulatory processes” for the Public Company Accounting Oversight Board (“PCAOB”). At the PCAOB 2016 Conference on Auditing and Capital Markets, the Commissioner described “common myths and misconceptions about the process.”

Commissioner Piwowar emphasized that high-quality economic analysis: (i) serves as the cornerstone not only for individual rulemakings but for setting the rulemaking agenda as well; and (ii) is necessary not only for the [PCAOB] to satisfy its statutory obligations to find that a proposed rule serves the public interest and protects investors but also as a prerequisite for the Commission to satisfy its own oversight obligations. He stated that the PCAOB’s guidance on rulemaking recognizes “four main elements: (1) the need for the rule, (2) the baseline for measuring the rule impacts, (3) the alternatives considered, and (4) the economic impacts of the rule and alternatives.”

In discussing myths and misconceptions of the regulatory process, Commissioner Piwowar stated that economic analysis:

  • is not interchangeable with cost-benefit analysis – economic analysis is “much broader” and “complements cost-benefit analysis, because it provides a more complete view of the trade-offs and consequences of alternative approaches, thereby providing the tools for ‘thinking through’ the cost-benefit analysis”;
  • does not slow down the rulemaking process, it “actually speeds up the rulemaking process,” by easing compliance burdens;
  • is not a partisan political issue – “[s]olid economic analysis is . . . something that both political parties can agree upon”;
  • is relevant not only to rulemaking but also to other activities such as SEC examinations and investigations; and
  • is not “a fad that will disappear” – it “has become part of the SEC’s DNA . . . [and] will become part of the PCAOB’s DNA, too.”

Commissioner Piwowar commended the PCAOB for “including, as part of its strategic plan, the use of economic analysis tools in conducting post-implementation review of new standards.” He concluded that:

I hope the [PCAOB] is more effective at post-implementation review than the [SEC]. In fact, I hope the Board is so successful in its post-implementation review efforts that the Commission can learn from them.

Lofchie Comment: It is almost certainly not the case that economic analysis is something that both political parties can agree upon. To the extent that either party seeks to use financial regulation as a device for political gain, economic analysis will always run a distant second in importance to polling.

Fed Governor Examines Post-Crisis Financial Regulation

Governor Daniel K. Tarullo of the Board of Governors of the Federal Reserve System described a “shift of perspective” in regulation since the financial crisis. In a speech on the “New Pedagogy of Financial Regulation” at Columbia Law School, he examined the transition from banking regulation to financial regulation and its effects on policy and scholarship.

Governor Tarullo identified two gaps highlighted by the crisis. These included “the inadequate prudential regulation of the most systemically important financial institutions (‘SIFIs’) and the sometimes nonexistent prudential regulation of the many activities now denominated as ‘shadow banking.'” He opined further that as regulatory stringency is strengthened for larger banking organizations, a less demanding regime is needed “for smaller institutions whose contribution to systemic contagion would almost surely be somewhere between modest and inconsequential.”

Governor Tarullo addressed questions raised by a system-wide perspective on financial regulation. He stated that it would be useful to distinguish three possible targets of regulation: (i) financial institutions; (ii) financial business models; and (iii) financial transactions. He noted that this “taxonomy” would categorize regulation as targeted at a specific institution when it applies because of the particular characteristics of that institution, not simply because of its business model (or models). For example, “a transaction-based requirement . . . would be binding on anyone involved in such a transaction (with perhaps some de minimis exceptions), regardless of their status as a particular kind of financial intermediary.”

Further, he discussed the scope and allocation of government authority for financial regulation under the Dodd-Frank Act, which created the Financial Stability Oversight Council. To consider whether this “new configuration of authorities” proves optimal over time, he suggested looking at “factors of efficacy, expertise, and excessive concentrations of authority.”

Governor Tarullo stated that further academic examination would be helpful on:

  • measures and standards for evaluating systemic risk;
  • corporate governance in a prudentially regulated institution;
  • oversight of regulatory agencies;
  • the implications of technological innovation for financial services regulation; and
  • the organization of the international system for financial regulation.

Governor Tarullo urged academics to emphasize “the liability side of the balance sheets of financial institutions” and liquidity and funding issues, particularly in the context of systemic risk.

Lofchie Comment: Governor Tarullo’s assertion that all types of institutions engaged in the same activity should be subject to the same regulation seems commonsensical. Upon closer consideration, however, that conclusion is less obvious. For example, should it really be the case that a bank, a broker-dealer that is not affiliated with a bank, and an unregulated hedge fund be subject to the same requirements when entering into a repurchase transaction or a swap? Banks take in large amounts of deposits that they are free to lend back and that are guaranteed by the federal government; broker-dealers hold customer cash but cannot use it in their business in the same ways that banks do; hedge funds don’t custody assets or take deposits. Further, it is considered ok if a hedge fund goes insolvent and loses its shareholders’ money; private businesses sometimes do that.  Conversely, banks have access to the Federal Reserve window for borrowing, which is not true of other types of institutions. When all of these other factors are considered, it becomes a lot less commonsensical to assume, for example, that banks and hedge funds should be subject to the same regulation on the same transaction.

Governor Tarullo believes that the Federal Reserve Board should have considerably more power. See, e.g., Governor Tarullo Delivers Speech Regarding Shadow Banking and Systemic Risk Regulation; Federal Reserve Board Governor Tarullo Calls for Regulatory Approach to “Runnable Funding.” But it seems fair to ask: how much more power, to what ends and under whose control? As to broader questions, what is the role of private decision-making in an economy managed as Governor Tarullo imagines? What is the role of international regulators in regard to U.S. financial institutions?

SEC Chief of Staff Anticipates Future Challenges for Compliance Professionals

SEC Chief of Staff Andrew J. Donohue outlined future compliance challenges in his remarks at the 2016 National Conference of the National Society of Compliance Professionals.

Mr. Donohue predicted, among other things, that:

  • compliance expertise will encompass “a far broader set of subjects, including expertise in technology, operations, market, risk, and auditing, to name a few”;
  • because the “general trend of declining or stagnant top-line revenue growth will trigger an ever-increasing fixation on expenses,” compliance departments will have to ensure that “they have the funding necessary for discharging their critical function as well as the technological and other resources that are essential to their success”;
  • because compliance is “often expected to develop front-end controls that will prevent the business from violating regulations or disregarding established policies and procedures,” technology will catalyze a “more holistic model”;
  • globalization and increasing business complexity will force firms to determine “which regulatory requirements apply, and how they should be interpreted and implemented”; and
  • firms and regulators will have to monitor technological developments and increasingly automated systems in order not to establish a “variety of separate systems that perform similar or overlapping functions.”

Mr. Donohue concluded that preparation for a future of compliance is key:

Much like in medicine, when it comes to compliance, an ounce of prevention is truly worth a pound of cure.

Lofchie Comment: Mr. Donohue predicts a future in which compliance expenses increase significantly. He does not acknowledge, however, the problems that rising costs may cause our economy and society. This is not to decry regulation in general; one does not have to be a libertarian to acknowledge that regulation’s costs sometimes can outweigh its benefits. It should be clear, however, that as regulatory costs rise, (i) there is a reduction in services or an increase in the cost of those services, and (ii) increases in cost generally affect small firms more than larger ones since regulatory costs tend not to rise in proportion to the size of a given firm.

Mr. Donohue’s analogy between compliance costs and medical expenses is worth considering. Certainly, it is better to avoid an illness than to suffer from it. The bleak reality is this: no one can afford to spend an unlimited amount of resources on preventing problems. Even if a person or government did so, things still would go wrong, since human bodies and regulatory systems are enormously complex and often unpredictable. The cost of medical care in the United States is much higher than it is in the rest of the world, and the benefits of that care are not always commensurate with the cost. As with our healthcare system, so with our system of regulation.

One final note: Mr. Donohue is right when he says that the challenges of being a compliance professional have grown enormously. Meeting those challenges means mastering a range of skills that surpasses the compass demanded by most professions.

NY Fed President/CEO Calls for Cultural Reform in Financial Services Industry

Federal Reserve Bank of New York (“NY Fed”) President and CEO William C. Dudley opined that in recent years, the financial services industry has suffered from “deep-seated cultural and ethical problems.” He emphasized the importance of supervisors in shaping industry culture and setting incentives and standards. Mr. Dudley also urged regulators to consider the ways in which their work might help to “overcome perennial collective action and first-mover problems” that prevent change in the industry.

Mr. Dudley delivered his remarks at the NY Fed conference, “Reforming Culture and Behavior in the Financial Services Industry: Expanding the Dialogue.”

Lofchie Comment: On previous occasions, Mr. Dudley has expressed his view that the “culture” of the financial industry is fundamentally flawed. On what basis does Mr. Dudley avow that ethical sins are more prevalent in the financial industry than in other industries or fields of human endeavor? Obviously, regulators should pursue financial institutions and professionals that break the law, but answering one’s calling is quite different from claiming that those who work in the financial industry are likelier to be sinners than those who toil in other industries or even in the government. Moral self-assurance is neither becoming nor appropriate to the regulatory task.

ISDA Analyzes Key Trends in Clearing

In its latest Research Note, ISDA examined recent trends in the clearing business in the United States and the European Union.

The ISDA Research Note found, among other things, that:

  • shifts occurring in the business models of futures commission merchants (“FCMs”) due to the impact of new capital requirements and rising operational costs have led to significant changes in the market share of top FCMs in the United States;
  • some derivatives users were dislocated from their existing FCMs and needed to establish relationships with new FCMs in order to continue using swaps mandated for clearing;
  • FCMs are imposing increased costs on smaller derivatives users (survey results in the United States estimated fees from $60 to $150K over the life of a cleared swap); and
  • monthly mandatory minimum clearing fees and minimum revenue thresholds among larger clearing members in the European Union could range from $100,000 to $280,000 per year, and that range of costs is becoming increasingly common in the United States.

In conclusion, ISDA noted, one of the main effects of the increased cost of cleared swaps is this: end users are being pushed to choose alternative hedging measures and/or accept greater risks by either not hedging or using imperfect hedges.

Lofchie Comment: The bottom line of ISDA’s analysis is that, (i) despite all of the outcry about too-big-to-fail, regulatory costs weigh most heavily on smaller institutions, whether buy-side or sell-side, and (ii) increasing the costs of entering into derivatives transactions makes hedging more expensive, which increases risk in the economy generally, even if the risk of derivatives specifically is decreased. To put this in practical terms, if a small firm is prevented from hedging with derivatives in a way that would reduce that firm’s risk, then (a) the risk of derivatives seems to be reduced (since you can’t default on a derivative into which you can enter), but (b) the actual risk to the business (and to the economy generally) is increased because the small firm can’t hedge.

Gain in money growth…

Today’s CFS Divisia M4 release highlights an acceleration of growth in monetary and financial aggregates. CFS Divisia M4 – the broadest and most important measure of money – grew by 5.5% in September 2016 on a year-over-year basis versus 4.9% in August and 3.6% a year ago.

Many regulatory and global macro cross currents are reshaping the financial system. The impact of these broad changes is resoundingly evident in CFS monetary data.

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’

Senator Urges President to Replace SEC Chair

Senator Elizabeth Warren (D-MA) “strongly urge[d]” President Obama to “immediately designate another SEC Commissioner as Chair of the agency.”

In her letter to the President, Senator Warren explained that “Chair White’s refusal to move forward on a political spending disclosure rule serves the narrow interests of powerful executives who would prefer to hide their expenditures of company money to advance their own personal ideologies.” Senator Warren highlighted Chair Mary Jo White’s “Disclosure Effectiveness Initiative” as part of her “anti-disclosure agenda” and charged that the SEC never has produced data to support Chair White’s presumption that investors experience “information overload.” She further noted that Chair White “has also refused to say how much time and agency resources have been spent on this voluntary initiative,” which Senator Warren had previously requested in a letter to Chair White. Senator Warren continued:

Giant public companies have every right to advocate for less transparency in public markets, whatever the broader economic consequences. But the SEC was not created to work for them. Under a new Chair, the agency can re-direct its limited discretionary resources away from actively undermining the interests of investors and back toward its core purposes.

Senator Warren also pointed out that, “[a]s of October 2016, the SEC has yet to finalize nineteen mandatory rules under the Dodd-Frank Act.”

Lofchie Comment: Senator Warren appears to take the view that financial regulation is but the continuation of politics by other means (paraphrasing Prussian strategist von Clausewitz). The attack on the SEC Chair is not the first shot fired by the Senator. She has launched a number of attacks on regulators and academics who have not aligned their views with hers. Seee.g.Senator Warren Asks CFTC to Withdraw EEMAC Report on Position LimitsSenator Warren Questions “Good Intentions” behind Study Challenging DOL’s Fiduciary Proposal.

The Senator’s latest missive follows closely upon the D.C. Circuit Court decision that the CFPB structure, which is commonly viewed as the Senator’s creation, is unconstitutional because the Director of the CFPB was immune from dismissal by the President. Yet now, the Senator calls for the SEC Chair to be fired because she has failed to follow “Congressional mandates.” To be consistent, the Senator should acknowledge that the CFPB’s original structure was inherently flawed in that it inappropriately insulated the agency from both Presidential and Congressional control. The President could remove the CFPB Director only “for cause.” Senator Warren seems to be arguing that SEC Chair White’s actions don’t amount to appropriate “cause” for removal, but are sufficient to designate an alternative Commissioner as Chair. Under the CFPB’s structure, that would not be possible, given that there is only one Director.

Senator Warren and her Congressional colleagues should revisit the CFPB’s design in toto, ideally replacing the single-director model with a five-person bipartisan model (i.e., similar to that of the SEC), and provide for Congressional control over the CPFB’s budget. Sauce for the goose (the SEC, the CFTC, and a host of other federal agencies) should be sauce for the gander (the CFPB).

As far as the Senator’s actual request, there is no possibility of it being granted. (Unsurprisingly, the White House indicated support for the SEC Chair.) If the President were to take the action that the Senator calls for, Chair White would resign, which would leave the SEC with only two Commissioners and, thus, the Democrats would lose their majority.

CFTC Commissioner Giancarlo Urges Regulators to Analyze Post-Dodd-Frank “Flash Crashes”

CFTC Commissioner J. Christopher Giancarlo called for a “thorough and unbiased analysis by U.S. financial regulators and their overseas counterparts of the systemic risk of unprecedented capital constraining regulations on global financial and risk-transfer markets.” Commissioner Giancarlo observed that there have been “at least twelve major flash crashes since the passage of the Dodd-Frank Act” including last week’s “abrupt ‘flash crash'” of the British pound. He asserted that:

[Regulators] can no longer continue to avoid the question of whether the amount of capital that bank regulators have caused financial institutions to take out of trading markets is at all calibrated to the amount of capital needed to be kept in global markets to support the health and durability of the global financial system [emphasis in original].

In reference to a Cabinet comment by Steve Lofchie on May 27, 2015, Commissioner Giancarlo asked the following question: “How big will the next flash crash have to be before we realize that markets in which few are able to take risks are markets that are very risky?”

Lofchie Comment: In addition to Commissioner Giancarlo’s concerns about market liquidity, his request for an “unbiased analysis” of the the systemic risk of “unprecedented capital constraining regulations on global financial and risk-transfer markets” is noteworthy. Regulators seem either reluctant or incapable of assessing whether their rulemakings have been successful, or whether certain benefits of the rulemakings might be outweighed by unintended consequences. On that topic, see this recent story about central clearing, in which we ask whether regulators are capable of judging their own work.


Streetwise Professor Examines “Fundamental Tension” Underlying CCP Resolution Authority

In response to reports that the European Commission (“EC”) is finalizing legislation on Central Counterparty (“CCP”) recovery, University of Houston Finance Professor Craig Pirrong outlined the sources of “fundamental tension” that underlie the final resolution authority. Citing a statement in the EC’s Executive Summary Sheet that the contemplated framework is likely to involve “a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders” (emphasis supplied), Professor Pirrong concluded that the prospect of trampled rights “calls into question the prudence of creating and supersizing entities with such latent destructive potential.”

Professor Pirrong argued that the resolution authority potentially will “impose large costs on members of CCPs, and even their customers, [which] raises the burden of being a member, or trading cleared products,” and consequently, disincentivizes membership. He also asserted that “[t]he prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that push[] it over the edge.” According to Professor Pirrong, the irony is that these measures to protect CCPs will lead to a “reduced supply of clearing services, and reduced supply of the credit, liquidity and capital that [such CCPs] need to function.”

In addition, Professor Pirrong cautioned that with discretionary power comes “inefficient selective intervention” and the potential to influence costs. “[T]his makes it inevitable,” he warned, that the body will be subjected to intense rent-seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens.”