SEC Issues Report on Access to Capital and Market Liquidity

The SEC Division of Economic and Risk Analysis (“DERA”) issued a report on how Dodd-Frank and other financial regulations have impacted (i) access to capital and (ii) market liquidity.

The report contains analyses of recent academic work, as well as original DERA analyses of regulatory filings. The report is divided into two major parts: “Access to Capital – Primary Issuance” and “Market Liquidity.” Highlights of the DERA report include the following:

Access to Capital – Primary Issuance

  • Primary market security issuance has not decreased since the implementation of Dodd-Frank regulations.
  • Capital from initial public offerings has “ebb[ed] and flow[ed] over time,” and the post-crisis downturn is “broadly consistent with historical patterns of IPO waves.”
  • The introduction of the JOBS Act brought an increase in small-company IPOs, and “IPOs by [emerging growth companies] may be becoming the prevailing form of issuance in some sectors.”
  • Regulation A amendments, including an increase in the amount of capital allowed to be raised, resulted in an increase in Regulation A offerings.
  • JOBS Act crowdfunding provisions have allowed some firms to use crowdfunding to raise pre-revenue funds.
  • The private issuance of debt and equity increased significantly between 2012 and 2016, and amounts raised through exempt offerings were much higher than those raised through registered securities.

Market Liquidity

  • There is no evidence that the Volcker Rule has resulted in decreased liquidity, particularly with regard to U.S. Treasury Market liquidity.
  • Trading activity in the corporate bond trading markets has tended either to increase or to remain static.
  • The number of dealers participating in corporate bond markets has remained similar to pre-crisis numbers.
  • Dealers have reduced capital commitments, which is in line with regulatory changes, such as the Volcker Rule, that “potentially reduc[e] the liquidity position in corporate bonds.”
  • For small trades, transaction costs generally have decreased; DERA suggested that this might be due in part to the emergence of alternate trading systems as platforms for trading corporate bonds.
  • For certain larger or longer maturity corporate bonds, transaction costs have increased since post-crisis regulatory changes.

DERA noted that it is difficult to quantify the effects of particular regulatory reforms, and that a variety of factors may contribute to market conditions.

Lofchie Comment: The conclusion reached by the Division of Economic and Risk Analysis – that there is no clear link between the Volcker Rule and decreased liquidity – contrasts sharply with the recent U.S. Treasury Report, which concluded that the rule’s “implementation has hindered marketmaking functions necessary to ensure a healthy level of market liquidity.” Similarly, a September 2016 study by FRB staff found that the Volcker Rule has had a “deleterious effect” on corporate bond liquidity. According to that study, dealers that are subject to Volcker requirements become less likely to provide liquidity during times of market stress.

Notably, DERA found that intraday capital commitments by dealers have declined by 68%. It is difficult to understand how a reduction in dealer inventory of this scale has no effect on liquidity. If that is really the case, then DERA should do more to identify the countervailing reasons that would explain the constancy of liquidity.

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.

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.

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.

Federal Reserve Board Governor Powell Advocates Additional Regulatory Reform

At the Salzburg Global Seminar, Federal Reserve Board Governor Jerome H. Powell lauded the progress made by the U.S. financial system since the financial crises, particularly in the increased liquidity and improved loss-absorbing capacity of banks. Mr. Powell identified five “key areas” that would benefit from additional regulatory reform:

  • Small banks: Continue to improve regulations governing call reports and the frequency of examinations by simplifying the general capital framework for community banks.
  • Resolution plans: Extend the living will submission cycle from once a year to once every two years, and focus every other filing on key topics of interest and material changes from the previous year.
  • Volcker Rule: Work together with the other four Volcker Rule agencies to reevaluate the rule and ensure that it delivers policy objectives effectively.
  • Stress testing: Evaluate stress testing and comprehensive capital analysis and review, including through public feedback, in order to improve transparency of process.
  • Leverage ratio: Reexamine enhanced supplementary leverage ratio in order to adhere to the proper calibration of leverage ratio and risk-based capital requirements.

 

Federal Register: Treasury Asks Public to Help Reduce Regulatory Burdens

The U.S. Treasury Department (“Treasury”) requested recommendations and information from the public to identify Treasury regulations that can be “eliminated, modified, or streamlined in order to reduce burdens.”

The request was issued in response to Executive Order 13777 (“Enforcing the Regulatory Reform Agenda”), which requires regulatory agencies to form task forces that help to implement previous orders focused on regulatory reform. The Treasury asked that submissions (i) identify regulations by titles and citations to the Code of Federal Regulations, and (ii) explain how the regulations could be modified, if appropriate, or why they should be eliminated.

Comments must be submitted by July 31, 2017.

Lofchie Comment: The Treasury’s request for public input follows immediately on the heels of their real-world critique of problems with the current regulatory system (see Treasury Gets Specific, Recommends Significant Regulatory Reform). Market participants should take up the Treasury on this request for comment. The new regulators appear to be concerned with real, practical problems, such as duplicate or ambiguous regulatory requirements, regulatory costs, diminished liquidity and market fragmentation.

Treasury Gets Specific, Recommends Significant Regulatory Reform

The U.S. Treasury Department (“Treasury”) released a report pursuant to President Trump’s February Executive Order establishing core principles for improving the financial system (see previous coverage). Drafted under the direction of Treasury Secretary Steven T. Mnuchin, the report is the first of a four-part series on regulatory reform and covers the financial regulation of depository institutions. Subsequent reports will focus on areas including markets, liquidity, central clearing, financial products, asset management, insurance and innovation.

The report contained the following Treasury recommendations, among others:

  • Capital and Liquidity: (i) raise the threshold for participation in company-run stress tests to $50 billion in total assets (from the current threshold of more than $10 billion), (ii) tailor the application of the liquidity coverage ratio appropriately to include only global systemically important banks and internationally active bank holding companies, and (iii) remove U.S. Treasury securities, cash on deposit with central banks, and initial margin for centrally cleared derivatives, from the calculation of leverage exposure.
  • Volcker Rule: modify the Volcker Rule significantly, by (i) providing a full exemption for banks with $10 billion or less in total assets, and (ii) evaluating banks with greater than $10 billion in total assets based on the volume of their trading assets. Treasury also recommended a number of other measures to reduce regulatory burdens and simplify compliance, such as further clarifying the distinction between proprietary trading and market-making.
  • Stress Testing: increase the asset threshold from $10 billion to $50 billion, and allow regulatory agencies to make discretionary decisions for a bank with more than $50 billion in assets based on “business model, balance sheet, and organizational complexity.”
  • Consumer Financial Protection Bureau (“CFPB”): restructure the CFPB to provide for accountability and checks on the power of its director, or subject the agency’s funding to congressional appropriations. (Treasury criticized the “unaccountable structure and unduly broad regulatory powers” of the CFPB, and concluded that the structure and function of the agency has led to “regulatory abuses and excesses.”)
  • Residential Mortgage Lending: ease regulations on new mortgage originations to increase private-sector lending and decrease government-sponsored lending.

Treasury also outlined its support for the idea of creating an “off-ramp” from many regulatory requirements for highly capitalized banks. This approach would require an institution to elect to maintain a sufficiently high level of capital, such as a 10% non-risk weighted leverage ratio.

Lofchie Comment: At last, a regulatory discussion that says something more than “there was a financial crisis, so there must be more rules, and more rules will make us safer.” This report reads as if it was informed by real work experience. It is a recognition of both the costs and benefits of financial regulation.

The report is not an attack on government. While critical of Dodd-Frank, Treasury acknowledges the better aspects of it, particularly improvements in bank capital ratios. In sum, Treasury is making the point that Dodd-Frank is seven years old; hundreds of rules have been adopted under it, and the time has come to see what aspects of it are working or not. (If there is anyone out there who believes after seven years of Dodd-Frank that it’s all going swimmingly, that person is just not paying attention.)

The biggest question is whether those who have disagreements with the recommendations will argue why the particulars are wrong, or whether the debate will simply be about the evils of Wall Street and the Administration. After seven years of Dodd-Frank (did someone break a mirror?), it really is time to talk specifics.

FINRA Economists Report Mixed Progress in Securitized Asset Liquidity

FINRA’s Office of the Chief Economist published a research note authored by two staff members that examined the liquidity of securitized assets over the course of the last several years. The authors utilized FINRA Trade Reporting and Compliance Engine (“TRACE”) data to evaluate liquidity in (i) real estate securities (including MBSs, CMBSs, CMOs, and TBAs) and (ii) other categories of asset-backed securities, including credit cards, automobiles, and student loans. They found that bid-ask spreads are almost universally down and the price impact of trades has fallen in every security since 2012. However, the number and volume of new issues of securitized assets have not recovered to pre-crisis levels and trading volume is generally down for most categories of securitized assets.

FINRA also published a similar analysis dealing with corporate bond liquidity.

Lofchie Comment: Regulators tend to emphasize bid/offer spread as the key data point for assessing market liquidity. However, that is only one measure of liquidity, and arguably not a very important one. The metric that the regulators should focus on more is the amount of the available liquidity; i.e., the size of the bids and offers. In any case, the authors of this study concede that trading volume in certain products is materially down, which would obviously suggest that available liquidity is materially down, notwithstanding that the spreads between bids and offers have decreased.

New Study Shows Post-Crisis Regulations Hurt Bond Liquidity

In an article posted on the Liberty Street Economics blog of the Federal Reserve Bank of New York, authors Tobias Adrian, Nina Boyarchenko and Or Shachar (collectively, the “authors”) explained the results of a recent study, which indicated that corporate bond liquidity has been adversely affected by post-crisis regulation.

The authors analyzed FINRA Trade Reporting and Compliance (“TRACE”) data in order to evaluate trade activity and measure corporate bond market liquidity. By utilizing the information provided by TRACE reports, the authors were able to determine which parent bank holding company (“BHC”) corresponded to a dealer in a particular trade. The authors then calculated bond liquidity by using common corporate bond liquidity metrics and incorporating constraints based on the balance sheet of the relevant BHC.

The economists stated that the results demonstrate the negative impact on bond liquidity of post-crisis regulation. Further, the authors argue that actual trading behavior data supports this conclusion.

Lofchie Comment: The results of this study are welcome and expected. For quite some time, the regulators seemed to deny there was any proof that the Dodd-Frank regulations damaged liquidity, notwithstanding both evidence to the contrary and common sense (how could regulations that heavily burden trading not impact liquidity?). That said, the fact that the regulations impair liquidity does not mean that the regulations are bad. All it means is that the regulations create trade-offs; one can reasonably argue that the diminished liquidity is worthwhile. It is important, however, that the regulators admit that the trade-offs exist (“it’s all good” is not the way the world works: regulations have both costs and benefits).

FDIC Vice Chair Urges Partitioning of Nonbanking Activities

FDIC Vice Chair Thomas Hoenig discussed his recent proposal to require that banks partition certain nonbanking activities (see previous coverage for more detail).

At a Conference on Systemic Risk and Organization of the Financial System held at Chapman University, California, Mr. Hoenig described a shift in the banking industry towards consolidation among the largest banks. He noted some of the key factors that have led to this trend: (i) technological developments and financial engineering, (ii) 1990s legislation easing the strain of banking regulations, (iii) significant mergers of commercial and investment banks, and (iv) fallout from the 2008 financial crisis, including the introduction of the Dodd-Frank Act in 2010.

Mr. Hoenig noted that, while the Dodd-Frank Act included some structural changes (such as the Volcker Rule), Congress, in large part, chose “regulatory control over structural change.” Mr. Hoenig warned that such over-reliance on regulation potentially could slow down economic growth. He instead advocated for structural change, suggesting that:

“. . . universal banks would partition their nontraditional activities into separately managed and capitalized affiliates. The safety net would be confined to the commercial bank, protecting bank depositors and the payment system so essential to commerce. Simultaneously, these protected commercial banks would be required to increase tangible equity to levels more in line with historic norms, and which the market has long viewed as the best assurance of a bank’s resilience.”

Mr. Hoenig recommended implementing a variety of other safeguards to supplement the partition, such as setting limits on the amount of debt the ultimate parent companies could downstream to subsidiaries. He also mentioned the possibility that, by allowing for resolution through bankruptcy, his proposal could reduce regulatory burdens, including the elimination of risk-based capital and liquidity, the Comprehensive Capital Analysis and Review, Dodd-Frank Act Stress Testing, the Orderly Liquidation Authority, Living Wills, and parts of the Volcker Rule.

Lofchie Comment: One problem with the proposal is the distinction it makes between traditional and nontraditional activities. This distinction is based upon the time in which a particular type of financial activity was created and the substance of the activity. For example, entering into swap transactions (particularly as to rates and currencies) and clear swaps and futures should be viewed as core banking activities: they are activities that are completely about credit intermediation. To assert that they are not “traditional” banking activities because they were not done in the 1950s or the 1850s would be not so different from stating that email is not a traditional form of bank communication. It may not be traditional, but it is the modern version of the telephone, and it is core to what banks do.