FT: “Learning British Financial Stability Lessons. Seriously!”

Today, the Financial Times‘ Robin Wigglesworth released a well-researched article “Learning British Financial Stability Lessons.  Seriously!” – which covered CFS reports – https://on.ft.com/3ZZ8Rpc

CFS will put a finer point on on aspects of the reports in two upcoming events.

Please take a look at this article and our papers, which can be found on CFS’ website- www.CenterforFinancialStability.org.

US regulators are setting a dangerous precedent on Silicon Valley Bank

Former FDIC Chair and CFS senior fellow Sheila Bair penned “US regulators are setting a dangerous precedent on Silicon Valley Bank” in the Financial Times (FT).  The piece covers:

– Systemic risk determination,
– Use of FDIC insurance,
– Fed policy.

To view the piece:
https://www.ft.com/content/b860ebb6-f202-4ec6-a80c-8b1527c949f4

U.S. Government Announces Uninsured SVB/Signature Depositors to Be Made Whole

In a joint statement, the U.S. Treasury, the FDIC and the Federal Reserve Board announced that all depositors, both insured and uninsured, of Silicon Valley Bank and Signature Bank, would be made whole for their deposits. Each bank had been closed this past Friday, SVB by the FDIC and Signature Bank by the New York State banking authorities.

The regulators described the protection of the depositors as not requiring funding from taxpayers as the funding would come from a special assessment on banks that will be paid into the Deposit Insurance Fund.

The regulators had previously said that shareholders and other unsecured creditors of the bank would not be protected (and thus could be wiped out) and that management of the two banks had been removed.

President Joseph R. Biden issued a statement to assure depositors and call on Congress and the banking regulators to “strengthen the rules for banks to make it less likely that this kind of bank failure will happen again.” Numerous other statements have been issued (see primary sources below).

LOFCHIE COMMENTARY

First, the statement that none of the bailout will be borne by taxpayers is somewhat misleading. The bailout is not being financed by other banks buying a business that had positive going forward value. Rather, it is being financed by government-imposed regulatory fees that must be passed through and eaten by shareholders or paid by customers in higher fees or lower interest rates on deposits.  

Second, the statement raises many questions. Are all bank deposits from now on implicitly insured? Where will the no-bailout line be drawn in the future? What is the justification? That is not to say that the bailout was not reasonable under the circumstances. Had there not been one, we almost certainly would have seen additional runs on other banks and financial institutions. Depositors were very much poised to move their money from small banks to larger ones. But it will be interesting to see whether depositors begin assessing bank risk more closely going forward, just as institutional investors began to assess broker-dealer risk more carefully after 2008.

Third, the best explanation of the 2008 financial crisis was a 1986 book by Hyman Minsky called “Stabilizing an Unstable Economy.” (See The Future of Financial Regulation.) Minsky argued that periods of financial calm create a lack of focus on real risks, which in turn leads to speculation and thus to instability. The book came briefly into vogue during the 2008 financial crisis, in a period referred to as the “Minsky Moment.” 

One could reasonably argue that that the last few years have seen rampant speculation, but by the regulators, not market participants. Rather than focus on the ordinary risks inherent to our economy – money supply, inflation, price volatility – the financial regulators have become distracted by speculative risks that are of high political import, such as climate change, an issue as to which they have neither sufficient knowledge nor actionable data, nor any meaningful ability to influence events. 

The FSOC’s 2022 Annual Report (see related coverage) makes 16 references to inflation (many of them about global inflation and very little about the impact of inflation and the attempts to control it on bank risk). By contrast, there are 112 references to climate (not historically regarded as a threat to financial stability). The FSOC 2021 Annual Report managed 41 references to inflation versus 86 references to climate, a lack of attention to actual risk in 2021 that only became more pronounced in 2022. (It also is notable that SVB was particularly focused on ESG lending, not limited to climate.)  So while the regulators may have been right that climate risk is a material risk to the financial system, they were likely wrong about the reasons. The risk was that climate change distracted the financial regulators from the relative boring work of financial regulation.  

Financial regulators need to devote their attention to the ordinary and mundane matters of financial risk. Attending to mundane matters does not mean adopting a slew of new and burdensome regulations, imposing new weights on the markets to compensate for past regulatory distractions.  When the next FSOC Annual Report is published, there should be more references to ordinary risks such as inflation, interest rates, maturity mismatches and failures to diversify risk, than there are to references to climate.  

Primary Sources

  1. White House: Remarks by President Biden on Maintaining a Resilient Banking System and Protecting our Historic Economic Recovery
  2. Joint Statement by the Department of the Treasury, Federal Reserve, and FDIC
  3. House Financial Services Committee Press Release: McHenry Statement on Regulator Actions Regarding Silicon Valley Bank
  4. Senate Banking, Housing and Urban Affairs Committee Press Release: Scott Statement on Government Response to Failures of Silicon Valley Bank and Signature Bank
  5. NYS Department of Financial Services: Superintendent Adrienne A. Harris Announces New York Department of Financial Services Takes Possession of Signature Bank
  6. FRB Press Release: Federal Reserve Board announces it will make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors
  7. Press Release: Joint Statement by Treasury, Federal Reserve, and FDIC
  8. SEC Statement: Chair Gary Gensler on Current Market Events
  9. FDIC Establishes Signature Bridge Bank, N.A., as Successor to Signature Bank, New York, NY
  10. FDIC Acts to Protect All Depositors of the former Silicon Valley Bank, Santa Clara, California
  11. FDIC Creates a Deposit Insurance National Bank of Santa Clara to Protect Insured Depositors of Silicon Valley Bank, Santa Clara, California
  12. Financial Stability Oversight Council Meeting on March 12, 2023
  13. House Financial Services Committee: Ranking Member Waters’ Statement Following the Closure of Silicon Valley Bank

Robinhood and GameStop: Essential issues and next steps for regulators and investors

The hullabaloo surrounding the run up in the price of GameStop (GME) and the activities of Robinhood have generated front page news, calls for action, and allegations of wrongdoing.

However, lost in the headlines and struggles between good and bad or big and little is the issue of greatest concern to all – financial stability.

A group of Center for Financial Stability (CFS) experts
1) examine essential issues as well as
2) propose next steps.

As these are complex and multipronged challenges, we look forward to any comments you might have.

To view the full article:
www.CenterforFinancialStability.org/research/GME_Robinhood_020421.pdf

ECB presentation by Philipp Hartmann

The Center for Financial Stability (CFS) recently hosted a roundtable discussion on European Central Bank (ECB) monetary policy with Philipp Hartmann. Philipp is Deputy Director General for research at the ECB and one of the founders of its research department.

Philipp’s presentation – covered the first 20 years of ECB policy, the relatively wide range of monetary instruments, defining new ones, and the strategic underpinning of its policy framework – available at http://www.CenterforFinancialStability.org/research/20190717_ECB_Monetary_Policy_Hartmann.pdf

CFTC Chair Giancarlo Seeks to Extend SEF Comment Period, Move Forward on Cross-Border Framework

CFTC Chair J. Christopher Giancarlo will seek an extension (to March 15) of the comment period for a proposal to amend various aspects of the rules governing the trading of swaps (the “SEF Proposal”). He also intends to move forward with amendments to the CFTC cross-border framework.

In a keynote address at the ABA Business Law Section Derivative & Futures Law Committee Meeting, Mr. Giancarlo highlighted aspects of the SEF Proposal and his approach to cross-border regulation.

On cross-border matters, Mr. Giancarlo reiterated points he raised in a 2018 white paper, “Cross-Border Swaps Regulation Version 2.0.” He recommended changes to the rules to avoid the fragmentation of liquidity across borders, which, he argued, results in smaller liquidity pools with less efficient and more volatile pricing. Mr. Giancarlo said he remains open to refinements of his approach, particularly as it relates to “arranged, negotiated or executed” transactions. Mr. Giancarlo said he would direct the CFTC staff to prepare “as soon as possible . . . various new cross-border rule proposals.” He said these proposals will address a range of issues, including the registration and regulation of swap dealers, swaps central counterparties and swaps-trading venues.

On the SEF Proposal, Mr. Giancarlo said that recent deliberations with market participants showed widespread agreement that “the current framework is flawed, clunky and would benefit from substantial revision.” He noted general support for (i) replacing existing guidance and no-action letters with final rules, (ii) more flexible methods of execution, (iii) easing the burdens of swap execution facility (“SEF”) compliance and (iv) broker proficiency exams.

Mr. Giancarlo said that market participants expressed their concerns with (i) the process and timing of any new rules, (ii) proposed restrictions on pre-trade communications and (iii) “overly simplified” changes to the standard for “impartial access.”

He welcomed comments on, among other things:

  • certain minimum conditions with adequate timing for connectivity and onboarding that could be imposed before swaps became subject to mandatory trading;
  • the pre-trade communications rule, which, he said, was not intended to “disintermediate essential client relationships;”
  • whether encouraging liquidity and price formation on SEFs is sufficiently furthered without a need to ban pre-trade communications off SEFs; and
  • whether the imposition of minimum membership standards (to the extent consistent with an SEF statutory right to establish such criteria) would improve the proposed standards.

In light of the interest in the proposal, Mr. Giancarlo will seek to extend the comment period to March 15. (The comment deadline for the SEF proposal is currently February 13, 2019.)

Finance Professor Says New Technology Not to Blame for Market Volatility

University of Houston Finance Professor Craig Pirrong rejected current conjecture that recent market sell-offs are due to technology, such as automated, algorithmic or high-frequency trading.

In a recent blog post, Professor Pirrong addressed concerns that increasing automation is responsible for a lack of liquidity during downturns, stating “by virtually every measure, the increasing automation in markets has led to greater liquidity.” Moreover, he asserted that the fact that market makers pull back from supplying liquidity during downturns is not unique to HFT; according to Professor Pirrong, this occurred in similar downturns “long before markets went electronic.” The same is true for so-called “momentum trading,” which Professor Pirrong said “is something else that long predates the rise of the machines.”

Because stock market movements are often unexplainable, large moves of an adverse nature often result in a “search for villains and scapegoats,” an exercise that, according to Professor Pirrong, is fruitless. He further noted that:

“[t]he bottom line is that the stock market sometimes decline substantially, without any obvious cause. Indeed, the cause(s) of some of the biggest, fastest drops remain elusive decades after they occurred. This is true across virtually every institutional and technological trading environment, making it less likely that any particular selloff is uniquely attributable to a change in technology. Furthermore, large market moves in the absence of any decisive event or piece of news is not inconsistent with market “rationality”, or due to some behavioral anomaly (which is inherently human, by the way).”

Novick on Financial Industry Transitions

Barbara Novick (BlackRock Vice Chairman and CFS Advisory Board Member) discussed financial industry transitions at the recent CFS Global Markets Workshop.

Presentation highlights include:

– Indexed equity strategies remain relatively small,
– Challenges of applying macroprudential tools to market finance,
– Potential risks to the US financial system from the future of Libor to bondholder rights to pension underfunding, among others.

For accompanying slides:
www.CenterforFinancialStability.org/research/BNovick-slides11-29-18.pdf

FRB Vice Chair Considers Proposed Amendments to Stress Testing Program

Federal Reserve Board (“FRB”) Vice Chair for Supervision Randal K. Quarles considered proposed changes to the FRB’s large bank stress testing regime that would increase transparency and efficiency.

In a speech at the Brookings Institution, Mr. Quarles said that the FRB is seeking to improve the measurement of trading book-related risks, and that a “single market shock” approach in existing stress testing practice does not adequately capture risks in firms’ trading books. He said that the proposed changes “are not intended to alter materially the overall level of capital in the system or the stringency of the regime.”

Mr. Quarles discussed changes to the Comprehensive Capital Analysis Review (“CCAR”) indicating that the FRB will reconsider whether any part of the regulatory capital rule (the stress capital buffer or “SCB”) proposal will remain for the 2019 CCAR. He said that he intends to request that the FRB exempt firms with less than $250 billion in assets from the 2019 CCAR quantitative assessment and supervisory stress testing in light of the FRB’s recent tailoring proposal. In addition, Mr. Quarles expressed his support for “normaliz[ing] the CCAR qualitative assessment” by (i) removing the public objection tool and (ii) evaluating firms’ stress testing practices through “normal supervision.”

Mr. Quarles stated that elements of the proposal to integrate stress testing with the stress capital buffer will be amended after receiving public comment. As a result, the SCB, which was scheduled for the 2019 stress test cycle, will be delayed. Mr. Quarles said that the first SCB may go into effect after 2020.

From China / Central Banking East and West since the Crisis…

I had the pleasure of presenting “Central Banking East and West since the Crisis,” at a discussion hosted by the Shanghai Development Research Foundation (SDRF) and Friedrich Ebert Stiftung.

Key takeaways include:

  • Much has changed in China and central banking in the last decade.
  • Most analysis of central bank balance sheets fails to incorporate the impact of the People’s Bank of China (PBOC) on the provision of global liquidity. This is a critical error – especially as the Chinese yuan (CNY) moves toward reserve currency status.
  • The Federal Reserve, PBOC, Bank of Japan, and Bank of England were early providers of global liquidity in the aftermath of the crisis. Yet, after 2011, central bank liquidity created distortions.
  • Extraordinary monetary policies were far from costless.
  • Analysis of speculative activity in futures markets after large injections of central bank liquidity reveals that:
    1. Speculative activity skyrockets.
    2. Net speculative long positions increase and push valuations upward.
    3. The volatility of investor positioning or investor switching behavior also increases.
  • Removal of excess central bank liquidity remains one of the most formidable challenges for markets today.

For slides accompanying the presentation: www.CenterforFinancialStability.org/speeches/ShanghaiDRF_101518.pdf

On a parenthetical note, after over two decades of travel to China, this was one of my most extraordinary visits.