Market Experts Criticize Sarbanes-Oxley, Urge Capital Formation Reforms

At a hearing before the House Financial Services Subcommittee on Capital Markets, Securities and Investment, market experts discussed the decline in public offerings, the effects of the Sarbanes-Oxley Act of 2002 (“SOX”) and other federal corporate governance requirements. The panelists made recommendations for promoting capital formation, particularly in the area of public offerings. (See Committee Memorandum and Written Testimonies.)

Most of the witnesses criticized SOX Section 404, which imposes internal control requirements. New York Stock Exchange President Thomas W. Farley asserted that “designing, implementing, and maintaining complex systems required to satisfy SOX’s internal controls over financial reporting requirements can command millions of dollars in outside consultant, legal, and auditing fees, in addition to other internal costs.” John Berlau of the Competitive Enterprise Institute argued that Section 404 “has done little to prevent massive mismanagement or outright fraud at troubled firms.”

By contrast, University of Denver Sturm College of Law Professor J. Robert Brown argued that SOX has been unfairly maligned, and said that its mechanisms raise investor confidence with higher quality disclosures. However, Professor Brown echoed the expressed sentiment that the current system of financial disclosure must be updated overall and that current disclosure requirements are excessive or unnecessarily complicated. U.S. Chamber of Commerce Center for Capital Markets Competitiveness Executive Vice President Thomas Quaadman said that compliance costs have risen as a result of the SEC’s “overly complex and confusing disclosure regime, which even institutional investors have a difficult time understanding.” Mr. Quaadman cited a 2011 IPO Task Force report finding that “92% of CEOs found that the administrative burden of SEC reporting requirements was a significant challenge to going public.”

Several panelists advocated for enhancements to the JOBS Act as a way to catalyze growth of the public markets. Mr. Quaadman and Mr. Farley lauded the recent extension of a JOBS Act provision that will allow all companies to submit confidential draft registration statements (see previous coverage). aTyr Pharma Vice President of Finance John Blake advocated for the extension of a JOBS Act provision that grants certain SOX compliance exemptions for former emerging growth companies (“EGCs”) that have surpassed the five-year window for classification as EGCs.

Lofchie Comment:  However Congress and the SEC may come out on the trade-off between corporate regulation and the expense of that regulation, this hearing makes plain that Congress and the regulators are focused on substantive issues such as capital formation and corporate disclosure (and not on questions such as conflict minerals disclosure, as if the SEC had the means to end civil conflicts in Africa). As a result, now that they are focusing on real questions, it seems possible for Congress and the SEC to reach reasonable answers on issues of importance to the U.S. economy. See also SEC Chair Jay Clayton Lays out Regulatory AgendaA Regulatory Philosophy at Last (Statement of Former SEC Commissioner Paul Atkins).

CFS Monetary Measures for June 2017

Today we release CFS monetary and financial measures for June 2017. CFS Divisia M4, which is the broadest and most important measure of money, grew by 3.7% in June 2017 on a year-over-year basis versus 4.4% in May.

For Monetary and Financial Data Release Report:

For more information about the CFS Divisia indices and the data in Excel:

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’

Senate Finance Committee to Discuss Tax Reform

The United States Senate Committee on Finance (the “Committee”) will hold hearings on July 18, 2017 to discuss options for overhauling the tax code and to consider the nomination of David J. Kautter as U.S. Treasury Assistant Secretary for Tax Policy.

The first hearing will focus on catalyzing economic growth, competitiveness and job creation. Senate Finance Committee Chair Orrin Hatch (R-UT) explained that the purpose of the hearing will be to give committee members the opportunity to explore how Congress can “act to implement a simpler, fairer tax system.”

Following the hearing on tax reform, the Committee will consider the nomination of David J. Kautter to serve as U.S. Treasury Assistant Secretary for Tax Policy. Currently, Mr. Kautter serves as Partner-in-Charge at RSM US, an audit, tax and consulting firm in Washington, D.C.

SEC Commissioner Kara Stein Addresses Capital Markets Issues

SEC Commissioner Kara Stein shared her views on the current state of U.S. capital markets and addressed several key issues.

In remarks before the Healthy Market Structure Conference held in Boston, Commissioner Stein asserted that the relationship between issuers and investors should not be viewed as a “zero-sum game”; that both sides of the market spectrum benefit from strong market structures that address the needs of all participants.

Focusing on the issue of the decline of initial public offerings, Commissioner Stein explained that private equity capital and capital available through private debt allow companies to fund operations without turning to the public market. In an era of low interest rates, she said, companies often view debt financing as a tenable method of funding growth. Commissioner Stein admitted, however, that the regulatory environment has made “going public” less attractive. As a consequence of the decline, there has been a reduced volume of information available to the public, making price discovery more difficult for both public and private companies. She questioned whether a system that is affected by perpetual price discovery difficulties will eventually cause significantly adverse liquidity effects.

Commissioner Stein noted the effect of emerging technologies and their contribution to information disparities. In particular, she expressed concern about the effects of “dark pools” on price discovery. Commissioner Stein expressed hope that the SEC would move forward on initiatives to improve access to information as well as market transparency. She highlighted a 2016 SEC proposal regarding order routing disclosures and a 2015 SEC proposal regarding dark pool disclosure requirements as ripe for finalization.

Lofchie Comment: Commissioner Stein’s remarks point out a core conundrum. “More” regulation may have some benefits, but as the cost of those benefits increases, more issuers and investors determine that the costs of regulation outweigh those benefits. Regulators must confront honestly the trade-offs between the regulatory burdens that they impose and the number of issuers that will elect to operate under those burdens. Finding the right trade-off point is difficult, but before the search can begin, regulators must concede that there is a trade-off.

CFS Special Counselor Steve H. Hanke Honored by the University of Liechtenstein…

CFS congratulates Steve H. Hanke, CFS Special Counselor and Professor of Applied Economics and Co-Director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins University in Baltimore, on receiving a Doctorate Honoris Causa from the University of Liechtenstein.

At the University of Leichtenstein, located in Vaduz, Hanke was conferred the Doctorate by Rector Jürgen Brücker during a University Day ceremony. The ceremony concluded with a dinner hosted by H.S.H. Prince Phillip von und zu Leichtenstein and H.S.H. Prince Michael von und zu Leichtenstein.

Professor Hanke’s honor was in recognition of his standing as “one of the world’s leading authorities on currencies and alternative currency regimes” and as “the world’s authority on measuring and stopping hyperinflations.” This is Professor Hanke’s sixth Doctorate Honoris Causa.

For further detail:

CFTC Acting Chair Giancarlo Appoints Chief Innovation Officer

CFTC Acting Chair Christopher J. Giancarlo named Daniel Gorfine as Chief Innovation Officer and Director of the LabCFTC initiative (see previous coverage). Mr. Gorfine will be responsible for coordinating with U.S. regulators and international regulatory bodies as the CFTC develops digital regulatory frameworks and strives to “promote market-enhancing FinTech innovation and incorporate emerging regulatory technologies.”
Most recently, Mr. Gorfine served as director of financial markets policy and legal counsel at the Milken Institute think tank.

OCC Releases Semiannual Risk Report

The Office of the Comptroller of the Currency (“OCC”) described the principal risks facing national banks and federal savings associations in its Semiannual Risk Perspective for Spring 2017 (the “Report”).

In the Report, the OCC identified the following key risk themes:

  • strategic risk due to a changing regulatory climate, low interest rates and competition from nonfinancial firms, including fintech companies;
  • increased credit risk and relaxed underwriting standards due to strong risk appetite and competitive pressures;
  • elevated operational risk as a result of increased reliance on third-party service providers and attendant cybersecurity risks; and
  • high compliance risk as banks navigate money laundering risks and new consumer protection requirements.

OCC supervisory priorities for the next 12 months will remain broadly the same as in 2016 and will include the objective of identifying and assigning regulatory ratings and risk assessments. The OCC also pledged a continued commitment to monitoring and evaluating risks presented by third-party service providers.

In remarks on the Report, Acting Comptroller of the Currency Keith A. Noreika stated:

“The OCC employs a risk-focused approach to supervision, and tailors examination strategies to the individual risks of each of its supervised institutions and will pay close attention to these key risk areas over the next six months.”


Lofchie Comment: A material portion of the “risk” that banks face, according to the report, is regulatory risk. The Comptroller’s remark that “[m]ultiple new or amended regulations are posing challenges” to banks and the financial system also echoes the comment made by the SEC’s Investor Advocate in his recent report to Congress that he would “encourage Congress to consider giving the [SEC] a respite from statutory mandates” (at 3). It is clear that the very rate and extent of regulatory change has itself become a threat to the financial system.

CFTC Acting Chair Giancarlo to Move Past Dodd-Frank and Focus on How CFTC “Applies Reforms”

In the June 23, 2017 issue of The Risk Desk, editor John Sodergreen offered his take on CFTC Acting Chair J. Christopher Giancarlo’s efforts to work on regulatory reform.

Mr. Sodergreen noted a sharp distinction between the friendly reception Mr. Giancarlo received at recent congressional hearings with that of his predecessors, who, he said, “often managed to draw fire from Republicans and Democrats alike.” Mr. Sodergreen emphasized how little controversy was generated at Mr. Giancarlo’s budget hearing, stating:

“[U]p and down the line, Republican and Democrat alike seemed to praise the acting chairman for submitting a budget request that exceeds the president’s number by over $30 million. We sensed no pushback at all, which had to be some sort of first.”

Mr. Sodergreen was also taken by how Mr. Giancarlo was endorsed at his nomination hearing before the Senate Agriculture Committee. Mr. Sodergreen called it “a slam-dunk, a fan-fest almost,” and added: “[i]t was the fastest confirmation hearing we had ever seen and we covered them all since Jim Newsome’s hearing.”

Mr. Sodergreen highlighted Mr. Giancarlo’s non-confrontational approach to regulatory reform, as reflected in these congressional appearances. Concerning Dodd-Frank, Mr. Sodergreen (i) stated that Mr. Giancarlo “didn’t see the value in debating whether Dodd-Frank is good or bad” and (ii) explained that Mr. Giancarlo chose to focus on high-frequency trading and cyberattacks, which are two “massive” areas of concern for the CFTC. In this regard, Mr. Sodergreen pointed out that Mr. Giancarlo is calling for a forward-looking agenda. Mr. Sodergreen further highlighted Mr. Giancarlo’s explanation of the Project KISS (“Keep It Simple, Stupid”) initiative, which Giancarlo described as focused on how reforms are applied rather than repeal or rollback (see previous coverage).

Based on these hearings, Mr. Sodergreen predicted an easy confirmation. “[We]’d bet the farm Giancarlo sails through,” he said.

Lofchie Comment: On the one hand, there is a good amount of Dodd-Frank that should be repealed or rolled back, particularly in the commodities world. On the other hand, there is something to be said for avoiding partisan disputes.

FRB Governor Powell Examines Liquidity Risks in Central Clearing

At the Federal Reserve Bank of Chicago Symposium on Central Clearing, Board of Governors of the Federal Reserve System (“FRB”) Governor Jerome H. Powell detailed the risks faced by central counterparties (“CCPs”) and their members.

Because they advocated for central clearing, Mr. Powell noted, global authorities (i) have a responsibility to make sure that CCPs do not become a point of failure in the system and (ii) must ensure that bank capital rules do not discourage central clearing.

Regarding bank capital, Mr. Powell argued that the supplementary leverage ratio for U.S. global systemically important banks fails to account for the relatively low risk of central clearing, as compared to riskier activities, and could discourage central clearing. He explained that the Basel Committee on Banking Supervision is considering a “risk-sensitive” approach to evaluating counterparty credit risk for certain centrally cleared derivatives, which could help to encourage central clearing. He also noted that the FRB is considering implementing a “settlement-to-market” approach for some cleared derivatives that would treat daily variation margin as a settlement payment, which means that banks would not have to hold capital against it.

On the subject of liquidity, Mr. Powell outlined the risks associated with central clearing. He noted the challenges that CCPs face with regard to outgoing and incoming payment flows. In the event of a member default, for instance, CCPs would need to be able to convert large amounts of non-cash collateral into cash in order to make payments to non-defaulting parties. For that reason, they must have lines of credit and ready access to the repurchase market. Mr. Powell’s example of a payment flow challenge led him to consider where CCPs should store their available cash. He mentioned central bank deposits as a safe and flexible option.

Mr. Powell also described the risks associated with incoming payment flows. Market volatility can trigger events that lead to an abnormal number of margin calls, which, in the first instance, requires liquidity on the part of clearing members to meet the margin call. It also requires a series of payments to be made simultaneously, so that the CCPs can obtain funds from the settlement bank quickly to meet margin requirements for its members. (In most instances, clearing members have an hour to meet intraday margin calls.) By way of example, Mr. Powell noted that data from the CFTC suggests that the top five CCPs requested $27 billion in additional margin over the two days following the Brexit referendum, which is about five times the average amount. Fortunately, members and CCPs were prepared in that instance, and were able to make the necessary payments.

In order to manage liquidity risk, Mr. Powell suggested, regulators should conduct expanded stress tests for CCPs:

“Conducting supervisory stress tests on CCPs that take liquidity risks into account would help authorities better assess the resilience of the financial system. A stress test focused on cross-CCP liquidity risks could help to identify assumptions that are not mutually consistent; for example, if each CCP’s plans involve liquidating Treasuries, is it realistic to believe that every CCP could do so simultaneously?”

He also urged regulators to (i) facilitate innovations that help to reduce liquidity risks, such as exploring the utilization of distributed ledger technology, (ii) make Federal Reserve bank accounts available to major CCPs, and (iii) take global market implications into account when developing solutions for managing liquidity risk for CCPs.

Lofchie Comment: The CFTC and the banking industry have long argued that the Basel III capital rules that require banks to reserve against collateral posted to a central clearing agency are mistaken. Governor Powell is coming around belatedly to that view. The existence of central clearing parties does not decentralize risk; it concentrates it. Yet a further risk of clearing emphasized in Governor Powell’s remarks is the power that the clearing agencies have to suck tremendous amounts of liquidity out of the market: $27 billion of additional margin in the two days following Brexit. (What this means is that, in demanding more margin to protect their own liquidity in a financial crisis, clearing agencies may bring down everyone else.)

It is certainly time for a full review of the benefits and risks of central clearing. Many of the concerns raised by clearing skeptics are being proved valid.