Response to WSJ Comments…”What’s Money?”

Thank you for your interest in my letter highlighting how determinants of inflation can be better understood.  To clarify, two types of money exist ‘state money’ produced by the Fed and ‘bank money’ created by the private sector.  Bank money drives growth. Today, bank money includes the service value of traditional commercial bank products such as deposits as well as shadow banking services such as commercial paper, money market funds, and repurchase agreements. In fact, what constitutes money may change over time as new financial products are introduced.

So, it is essential that the Fed, economists, and market participants measure and monitor both state and bank money.  CFS Divisia accomplishes this feat by identifying assets that serve as money.  Importantly, not all of these monetary assets provide equal amounts of service as money to the economy.

Bill Barnett uses the example of measuring the service value of transportation.  Would a pair of roller skates and a locomotive provide equal value to the economy?  No.  So, CFS Divisia derives weights that vary over time.

For the theory, history and math behind CFS Divisia, please see Bill’s book Getting It Wrong

For a practical application of CFS Divisia see

Comptroller of the Currency Discusses Regulation of FinTech

In a speech at the LendIt USA 2017 conference, Comptroller of the Currency Thomas J. Curry (i) outlined the function of the Office of the Comptroller of the Currency (“OCC”), (ii) urged financial industry innovators to develop strong compliance programs early on, (iii) described the recently established Office of Innovation as a resource to support banks and financial technology (“FinTech”) companies, and (iv) defended the OCC initiative to grant federal charters for FinTech companies involved in banking activities.

FRB Governor Powell Describes Challenges to Real Time Payment Systems and Blockchain Technology

Federal Reserve System Governor (“FRB”) Jerome Powell described the challenges and policy objectives behind (i) the creation of a real-time retail payment system, (ii) the use of distributed ledger technology for clearing and settlement services, and (iii) the issuance of digital currencies by central banks.

In an address before the Yale Law School Center for the Study of Corporate Law, Governor Powell criticized the sluggishness of the U.S. payment system. He stated: “our traditional bank-centric payments system, sometimes operating on decades-old infrastructure, has adjusted slowly to the evolving demands for greater speed and safety. Innovators have built new systems and services that ride on top of the old rails but with mixed results, and over time, our system has grown more fragmented.” Arguing that “it will take coordinated action to make fundamental and successful nationwide improvements,” Mr. Powell said that efficiency and safety were the FRB’s primary objectives regarding the development of a faster payment system utilizing real-time payments (see FRB Policy on Payment System Risk). Mr. Powell highlighted some of the work being done by the FRB Faster Payments Task Force, which recently completed reviews of 19 faster payment proposals.

On the use of DLT and blockchain technology, Mr. Powell noted recent developments and collaborations between banks and market infrastructures, including plans to use DLT by a few major U.S. clearing organizations. However, Mr. Powell observed that:

  • the financial industry has focused on the development of systems that require permission for access to ledgers, functions or information, rather than the open access system contemplated by Bitcoin;
  • firms are still trying to determine the business case for upgrading and streamlining payment, clearing, settlement, and other functions related to DLT;
  • technical issues – including issues of reliability, scalability, and security – remain unresolved;
  • governance and risk management will be “critical” to the success of DLT; and
  • the legal foundations supporting DLT, including jurisdictional issues, need more attention.

Mr. Powell also discussed the prospect of central banks issuing digital currencies. He cautioned that major technical and privacy challenges, as well as competition with private-sector products, might “stifle innovation over the long run.”

Republican Staff Rips into “SIFI” Designation Process

Republican staff members of the House of Representatives Financial Services Committee issued a Report titled: The Arbitrary and Inconsistent FSOC Nonbank Designation Process. The Report sharply criticized the designation process by the Financial Stability Oversight Council (“FSOC”) for Systemically Important Financial Institutions (“SIFIs”), which are subject to enhanced regulatory standards.

Republican staff members analyzed nonpublic internal FSOC documents and concluded that FSOC does not adhere to its own rules and guidance in the following ways:

  • FSOC considers “non-systemic risks” when determining whether to make a “systemically important” designation.
  • FSOC “simply assumes” that financial distress at a company will cause the impairment of financial market functioning, and damage to the broader economy, without actually making such a determination, as required by FSOC’s own rules.
  • FSOC fails to follow its own requirement that the evaluation of the systemic risk posed by individual firms must be done “in the context of a period of overall stress in the financial services industry and in a weak macroeconomic environment.”
  • FSOC shows a particular lack of consistency when considering whether to factor the use of collateral in certain financial transactions into designation decisions.

Republican staff concluded that FSOC’s analysis of companies has been “inconsistent and arbitrary.”

Lofchie Comment: The legislation granting FSOC the authority to designate firms as SIFIs is open-ended and ambiguous. The legislation effectively allows the government to decide arbitrarily which companies it elects to designate as SIFIs. (Seee.g.ACLI Files Amicus Brief in MetLife v. FSOC.) The House Report found that the FSOC decision-making process was more open-ended than the provisions governing it. Patrick Pinschmidt, who was the Deputy Assistant Secretary for FSOC, makes the point more sharply in his testimony in the Appendix attached to the Report. According to Mr. Pinschmidt, “there are no bright-line thresholds in terms of what’s bad or what’s good. . . . [I]t’s a qualitative assessment based on significant qualitative analysis. . . . And it’s up to each voting member of the Council to decide . . . what constitutes a significant threshold. . . .”

There is no reason to believe that those who are in or out of government are especially good at making company-specific decisions based on qualitative factors. Picking winners and losers in the market is nearly impossible to do consistently. That is just one reason why the government should not make “qualitative” choices about which companies should be regulated.

Inevitably, the House Republicans’ report on FSOC will be criticized by Democrats as partisan. That said, Democrats should be pleased if the outcome is that the FSOC is stripped of its designation authority, since they should not want Republicans to hold this arbitrary authority and possibly use it against those who may support the Democrats. None of us should want the government to hold this arbitrary authority. Instead, let’s have clear and objective rules.

NY Financial Services Department Adopts Final Revisions to Cybersecurity Requirements

The New York Department of Financial Services (“DFS”) adopted final revisions to its new cybersecurity regulations, which apply to a wide range of insurance, banking and financial services companies (“Covered Entities”) under its supervision (see previous coverage of the proposed revisions). The regulations will take effect on March 1, 2017 and, starting in 2018, will require a Covered Entity to prepare and submit a Certification of Compliance annually by February 15 to the DFS concerning the firm’s cybersecurity compliance program.

Required elements of the program include (i) the means to prevent and detect cyber events, (ii) the development of a cybersecurity policy, (iii) the appointment of a “qualified” chief information security officer, (iv) testing programs, (v) audit trails and (vi) access controls.

New York Governor Andrew M. Cuomo praised the new regulations:

“These strong, first-in-the-nation protections will help ensure [the financial services] industry has the necessary safeguards in place in order to protect themselves and the New Yorkers they serve from the serious economic harm caused by these devastating cyber-crimes.”


Lofchie Comment: New York State has been very aggressive in regulating and sanctioning firms engaged in financial activities. In their original form, the rules proposed by New York State to regulate “money laundering” set impossible-to-meet compliance standards. (Ultimately, the rules adopted by New York State were less draconian than those that were proposed originally, but that is saying very little.) The adopted Cybersecurity regulations are open-ended, complex and burdensome and will result in creating many new ways for the government to collect fines when something goes wrong. The fact that New York State rushed to declare itself “first in the nation” to adopt such a detailed set of rules suggests that its local government is too eager to place onerous requirements on the financial sector and, as a consequence, expand opportunities to collect fines.

That said, firms must abide by the new compliance obligations and do their best not to give New York State an opportunity to collect.

Federal Reserve Governor Tarullo Resigns

Board of Governors of the Federal Reserve System (“Board”) Governor Daniel K. Tarullo submitted his resignation letter to President Trump. The resignation is effective April 5, 2017. Governor Tarullo’s departure will leave the Board with three vacancies.

Governor Tarullo served as Chair of the Board’s Committee on Supervision and Regulation and Chair of the Financial Stability Board’s Standing Committee on Supervisory and Regulatory Cooperation. He also served as the informal “Vice Chairman of Supervision,” a Dodd-Frank created position that was never filled by President Obama. In that capacity, Governor Tarullo has been recognized as the architect of much of the Board’s post-crisis policy and regulatory decision-making.

The four current Governors are: Stanley Fischer (term expires January 31, 2020); Janet Yellen (term expires January 31, 2024); Lael Brainard (term expires January 31, 2026); and Jerome H. Powell (term expires January 31, 2028). The term of current Chair Janet Yellen expires February 3, 2018. President Trump will have the opportunity to influence the direction of the Board by filling the three vacant seats, naming a new Chair, and filling key leadership positions.

Lofchie Comment: Governor Tarullo pursued an expansionary regulatory philosophy. He believed that financial market participants fell into two categories: banks that were at least indirectly regulated by the Federal Reserve Board, and shadow banks that were improperly avoiding regulation by the Board. (See Fed Governor Examines Post-Crisis Financial RegulationGovernor Tarullo Delivers Speech Regarding Shadow Banking and Systemic Risk Regulation.) Throughout his tenure, Governor Tarullo seemed to be oddly hostile to the securities financing markets and largely indifferent to declines in liquidity in the financial markets. (See Federal Reserve Board Governor Tarullo Calls for Regulatory Approach to “Runnable Funding”.)

Governor Tarullo could have remained to complete his full term set to expire on January 31, 2022. It is clear, however that the Governor’s expansionary regulatory philosophy would have come into direct conflict with the views of the new administration. Governor Tarullo’s resignation is significant given the influence that he held over the regulatory direction at the Board.

Treasury Secretary Nominee Clarifies Positions on Volcker Rule, Carried Interest

In written responses to the Senate Finance Committee, Treasury Secretary nominee Steven Mnuchin provided his views on a number of topics, including the carried interest on hedge funds and the Volcker Rule. Mr. Mnuchin stated that the administration’s tax plan would “recommend repealing carried interest on hedge funds.”

As to the Volcker Rule, Mr. Mnuchin suggested that the “proprietary trading” restrictions could be narrowed and the Volcker Rule applied only to FDIC-insured banks, not necessarily their affiliates. If confirmed as Chair of the Financial Stability Oversight Council, Mr. Mnuchin said he would “address the issue of the definition of the Volcker Rule to make sure that banks can provide the necessary liquidity for customer markets and address the issues” contained in a recent Fed working paper. Mr. Mnuchin stated that:

“I am supportive of the Volcker Rule to mitigate the impact that proprietary risk taking may have on a bank that benefits from federal deposit insurance. However, …we need to provide a proper definition of proprietary trading, such that we do not limit liquidity in needed markets….”

Senator Sherrod Brown Criticizes President-Elect Trump’s Pick for SEC Chair

In response to the selection of Jay Clayton as nominee for SEC Chair, U.S. Senator Sherrod Brown (D-OH) opined that “[i]t’s hard to see how an attorney who’s spent his career helping Wall Street beat the rap will keep President-elect Trump’s promise to stop big banks and hedge funds from ‘getting away with murder.'”

Lofchie Comment: Football Outsiders (a statistics site for football fans) includes a generic complaint form for readers to use when they disagree with the results of a given analysis but do not wish to engage in substantive discussion. Similarly, the Trump administration might find it useful to provide a generic form for those who wish to complain about a given individual from the private sector who is tasked with serving in the government:

[Mr./Ms.] [Name] is [completely/wholly/totally/horrendously/shockingly/
fabulously/absolutely] [unqualified/unfit/unsuited] to serve as [name of post] for the [name of agency] because that person previously worked in the private sector where the individual’s job included [ [helping a corporation make money] / [defending a person against a governmental or regulatory action] / [interaction with governments of countries other than the United States] ].

Notwithstanding Senator Brown’s remarks, many of President Obama’s appointees also had significant Wall Street careers prior to their government service, including CFTC Chair Gensler and Secretary of the Treasury Lew. Having had a career in the private sector ought not to generate a generic salvo.


Study Finds Volcker Rule Has “Deleterious Effect” on Corporate Bond Liquidity

The Board of Governors of the Federal Reserve System staff members and a Cornell University finance professor examined the impact of the Volcker Rule on corporate bond illiquidity and dealer behavior during times of market stress. In a recent working paper, the authors concluded that the rule creates a less liquid market for corporate bonds because the dealers that are covered by it become “less willing” to offer liquidity during such times.

The economists focused on the downgrading of investment-grade corporate bonds due to the increased risk of “forced selling.” They reported that:

  • when compared to a control group of BB-rated bonds, downgraded bonds exhibited a “larger price impact of trading”;
  • the larger price impact grew after the implementation of the Volcker Rule;
  • bond market illiquidity during “stress periods is now approaching levels see[n] during the financial crisis”; and
  • dealers covered by the Volcker Rule have decreased their involvement in dealer-customer trades and are “less willing to commit capital.”

The authors concluded that the effect of the rule on dealers has been pronounced:

Overall, our results show that the Volcker Rule has had a real effect on dealer behavior, with significant effects only on those dealers affected by the Volcker Rule and not all bond dealers.

The working paper is an academic study drafted as part of the Finance and Economics Discussion Series, Division of Research & Statistics and Monetary Affairs of the Federal Reserve Board in Washington.

Lofchie Comment: The consensus among both buy- and sell-side market participants is that there has been a decline in liquidity. One would expect liquidity to decline as a result of the Volcker Rule for a number of reasons. For one thing, it is difficult for a bank to demonstrate to regulators that its trading activities are permissible market-making and not impermissible proprietary trading. As a result, banking organizations are likelier to withdraw from the market than to risk regulatory repercussions. It would be surprising if the Volcker Rule did not diminish liquidity.

For the past several years, banking regulators refused to acknowledge the likelihood of the Volcker Rule’s negative effect on liquidity. To bolster their refusal, regulators have reiterated that the bid-ask spread in highly rated bonds has stayed the same or declined, even as they pointedly ignored the fact that the size of trades has decreased and disregarded the impact of diminished liquidity on bonds that are less highly rated. (See FDIC Chair Gruenberg Asserts That Post-Crisis Reforms Strengthen the Financial System.)

As the authors of the paper observed, the fact that the Volcker Rule resulted in diminished liquidity does not mean that the Volcker Rule is a failure, per se, or that its consequences are negative overall. What it does mean is that the rule has demonstrably and materially negative consequences. The important question is this: do the benefits of the Volcker Rule outweigh its disadvantages?

Unfortunately, that question is not answered by this study, nor has it been debated by the regulators. Those who have an interest in defending the rule cannot be trusted to address the issue fairly and have refused to admit any downside thus far. (Comparee.g.Comptroller Curry Asserts That Post-Crisis Financial System Is Stronger and Regulators Examine Current Developments in U.S. Treasury Markets (with Delta Strategy Group Summary) with CFTC Commissioner Giancarlo Calls for “Clear-Eyed Attention” to Market Challenges.)

The failure of regulators to concede potential issues with various rulemaking decisions would be problematic enough if it were confined to the Volcker Rule. Sadly, it is not. That same failure derails regulators’ discussions of mandatory central clearing. What could make the problem even worse is the possibility that the downsides of the new rules may compound each other; i.e., both the Volcker Rule and mandatory central clearing requirements have material negative effects on liquidity (albeit for different reasons: Volcker, because it discourages market-making; central clearing, because it drains cash and liquid assets from the system, as Houston University Finance Professor Craig Pirrong argues in a recent Streetwise Professor blog entry), thus making the markets far more prone to share downward breaks.

This is not to say that the new rules are all bad; it is to say that they may be bad in toto or in part, and that their negative consequences must be acknowledged.

May the new year allow these issues to be seen with new eyes.

GAO Issues Report on Agency Coordination and Financial Market Impact of Latest Dodd-Frank Rules

The Government Accountability Office (“GAO”) issued a report on efforts by regulatory agencies to analyze and coordinate Dodd-Frank Act rules that became effective between July 2015 and July 2016. The GAO also examined the impact of select Dodd-Frank Act rules on financial market stability.

The GAO concluded that the CFTC and prudential regulators “coordinated domestically and internationally” and “largely harmonized their respective rules” to develop regulations on margin requirements for over-the-counter swaps. The GAO found that the CFPB “followed its internal guidance for coordinating with relevant agencies throughout the rulemaking process” in adopting the integrated mortgage disclosure rule.

The GAO determined that regulators issued final rules for approximately 75% of the 236 provisions of the Dodd-Frank Act that the GAO is monitoring. GAO noted that delayed implementation of Dodd-Frank Act requirements by the financial services industry, as well as factors outside of its provisions like monetary policy, can make it difficult to isolate the effect of the Dodd-Frank Act on the financial marketplace. That said, the GAO found that, among other actions, Dodd-Frank Act implementation has had the following effects on the financial services industry:

  • large bank systemically important financial institutions have increased in size but have become less vulnerable to financial distress;
  • designated nonbanks are more resilient and less interconnected than in prior years; and
  • increased percentages of collateral for swaps by banks may help protect against credit loss.

However, the GAO stated that:

“The full impact of the Dodd-Frank Act remains uncertain because some of its rules have not been finalized and insufficient time has passed to evaluate others.”

The GAO will continue to monitor the implementation of “prior recommendations intended to improve, among other things, financial regulators’ cost-benefit analysis, interagency coordination, and impact analysis associated with Dodd-Frank regulations.”

Lofchie Comment:  There is not much in this report to get excited about. That the regulators are cooperating with respect to rulemaking is generally a good thing, but it does not necessarily say anything about the quality of the rules being adopted. The numbers demonstrating that banks have become more “resilient” are so high-level that they are of no particular value.