NY Fed Bank President Says It’s Time to Evaluate Post-Crisis Regulatory Regime, Questions Effectiveness of Volcker Rule

Federal Reserve Bank of New York (“NY Fed”) President and CEO William C. Dudley articulated several principles to consider when evaluating the post-financial crisis regulatory regime and raised questions about the effectiveness of the Volcker Rule.

Mr. Dudley stated that the financial crisis exposed flaws in the regulatory framework – in particular, capital and liquidity inadequacies at large financial institutions. He cited “a number of important structural weaknesses that made it vulnerable to stress” including: (i) systemically important firms operating without sufficient capital and liquidity buffers, (ii) risk monitoring, measuring and controlling failures, (iii) significant problems in funding and derivatives markets, and (iv) fundamental defects in the securitization markets. These weaknesses, he noted, were “magnified by the lack of a good resolution process for large, complex financial firms that got into trouble.”

Mr. Dudley argued that while the industry “must resolve to never allow a return to [pre-crisis] conditions,” now is an appropriate time to begin evaluating the changes that were made to the regulatory regime. He articulated three principles to keep in mind for an effective regulatory regime:

  1. “Ensure that all financial institutions that are systemically important have enough capital and liquidity so that their risk of failure is very low, regardless of the economic environment.”
  2. “Have an effective resolution regime that allows such firms to fail without threatening to take down the rest of the nation’s financial system, and without requiring taxpayer support.”
  3. Ensure that the financial system remains resilient to shocks by preserving “the centralized clearing of over-the-counter (OTC) derivatives, better supervision and oversight of key financial market utilities, and the reforms of the money market mutual fund industry and the tri-party repurchase funding (“repo”) system.”

Mr. Dudley suggested that regulatory and compliance burdens could be made “considerably lighter” on smaller and medium-sized banking institutions because “the failure of such a firm will not impose large costs or stress on the broader financial system.”

Mr. Dudley also questioned whether the implementation of the Volcker Rule was achieving its policy objectives. Regulating entities under the Volcker Rule is difficult, he argued, because most market-making activity has “an element of proprietary trading” and the division between market-making and proprietary trading is “not always clear-cut.” Mr. Dudley said that while the evidence may be inconclusive, the Volcker Rule could be responsible for a decline in market liquidity of corporate bonds. Mr. Dudley strongly recommended Volcker exemptions for community banks.

Lofchie Comment: Mr. Dudley notes that the profitability of banks has dropped in light of their reduced leverage, but he asserts that they remain “profitable enough to cover their cost of capital.” What makes this remark particularly notable is the contrasting recent assertion of FDIC Vice-Chair Thomas Hoenig who claimed that (i) banks’ return on equity was low because they were too highly leveraged (a completely counterintuitive assertion that Mr. Hoenig did not fully explain) and (ii) that banks were less profitable than essentially every other industry (which would seem to suggest that banks were not profitable enough to cover their costs of capital, or at least that investors’ capital was better deployed elsewhere). Whatever is causing the decline in bank profitability (leverage too high or leverage too low), bank regulators should worry that the firms that they regulate are not making enough money to sustain themselves for the long term.

House Republicans Release Revised CHOICE Act

House Republicans released the Financial CHOICE Act of 2017. The bill is an update of the CHOICE Act of 2016. The new version represents a major overhaul of the current financial services regulatory regime including a partial repeal of Dodd-Frank.

In September 2016, the House Financial Services Committee approved the initial version of the CHOICE Act by a vote of 30 to 26. At a hearing scheduled for April 26, 2017, the Committee will discuss the updated version of the bill. Proposed changes to the current financial regulatory regime include, among other things:

  1. an opt-out of many regulatory requirements for banks and other financial institutions if they maintain a 10% leverage ratio (among other conditions);
  2. subjecting the federal banking agencies to greater congressional oversight and tighter budgetary control;
  3. materially reducing the authority of the Financial Stability Oversight Council and the establishment of a new process of identifying financial institutions as “systemically important”;
  4. a repeal of the Orderly Liquidation Authority and the creation of a new bankruptcy process for banks;
  5. reforms in bank stress tests;
  6. a restructuring of the CFPB, FHFA, OCC, and FDIC into bipartisan commissions appointed by the President;
  7. the elimination of the CFPB supervisory and examination authority;
  8. a repeal of the Volcker Rule; and
  9. facilitated capital raising by small companies, including through crowd-funding.

The Committee released a summary of changes.

Regarding derivatives, the new legislation exempts certain inter-affiliate swaps from nearly all Title VII requirements (except reporting), and otherwise removes a number of changes to Title VII that were previously included (it is suggested that this is because such provisions would be addressed in CFTC reauthorization legislation).

Chairman Jeb Hensarling (R-TX) called the bill a solution that “grows our economy from Main Street up.” He asserted that the CHOICE Act is premised on the principles that all banks need to be well-capitalized and that community banks and credit unions deserve relief from the “crushing burden of over-regulation.”

Lofchie Comment: Changes that the bill would make in the regulatory process are genuinely significant. These are largely in Title III of the proposal (see page 104).

Under the terms of the bill, the various financial regulators (including the banking regulators, the CFTC and the SEC) would be prohibited from issuing a “regulation” (which term would be broadly defined) unless the regulator first issued a statement (i) stating the need for the regulation, (ii) explaining why the private market could not address the problem, (iii) analyzing the adverse impacts of the regulation, and (iv) attempting to quantify the costs and benefits of the regulation, including its effects on economic activity, the basis for its determinations, and, most significantly, “an explanation of predicted changes” that will be brought about by the regulation.  A final rulemaking would be required to include “regulatory impact metrics selected by the [regulator’s] chief economist.”

Adherence to this process would make the tasks of the regulator materially more difficult, or at least it would make it more difficult for the regulators to pass rules. Of course, there is a significant amount of good in that. Regulators should be subject to a reasonably high burden of consideration in adopting rules that may cost market participants, in the aggregate, millions of dollars in compliance costs or that have negative effects on the economy generally.

One of the most interesting provisions of the bill is the requirement that regulators should provide an explanation of predicted changes that will result from the rule. Doubtless, in many cases, the predictions will turn out to be wrong. But that is ok. It is unreasonable to expect that regulators will be always, or even that consistently, correct in their predictions. The new standard may be hard to assess, but the attempt is still worthwhile.

CFTC Names First-Ever Chief Market Intelligence Officer

CFTC Acting Chair J. Christopher Giancarlo appointed Andrew B. Busch Chief Market Intelligence Officer. Mr. Busch will lead the new Market Intelligence Unit which is designed “to understand, analyze and communicate current and emerging derivatives market dynamics, developments and trends – such as the impact of new technologies and trading methodologies.” The position is a first for the agency. Mr. Bush will start on April 10, 2017. Acting Chair Giancarlo explained that:

“[t]he new Chief Market Intelligence Officer . . . will help activate the CFTC’s latent capability for market intelligence, giving us better insight into the needs of participants in the futures and swaps we oversee.”

Previously, Mr. Busch founded and served as CEO of the boutique economic research company, Bering Productions, Inc.

Acting Chair Giancarlo Asserts “New Direction Forward” for CFTC

CFTC Acting Chair J. Christopher Giancarlo called for the CFTC to “reinterpret its regulatory mission” by (i) fostering economic growth, (ii) enhancing U.S. financial markets, and (iii) “right-sizing its regulatory footprint.” Acting Chair Giancarlo delivered his remarks before the 42nd Annual International Futures Industry Conference, on the day after President Donald J. Trump announced his intention to nominate Mr. Giancarlo as CFTC Chair (see previous coverage).

In his speech, Mr. Giancarlo called for an end to the “overly prescriptive regulation of the American derivatives markets,” which he asserted are now “more fragmented, more concentrated, less liquid, and less supportive of economic growth and renewal than in the past.” Mr. Giancarlo noted that he is not opposed to Title VII of Dodd-Frank (in which, he maintained, “Congress got much right”), but rather with the CFTC’s implementation of the market reforms.

Acting Chair Giancarlo stated that the CFTC should foster economic growth by:

  • reducing regulatory burdens through initiatives like “Project KISS” (“Keep It Simple, Stupid”), designating his chief of staff as the CFTC Regulatory Reform Officer, and reviewing all CFTC rules in order to reduce regulatory burdens and costs for participants in markets under CFTC oversight;
  • becoming a “smarter regulator” by restructuring agency surveillance organizations and appointing a Chief Market Intelligence Officer who will report directly to the CFTC Chair; and
  • embracing financial technology (“fintech”) by adopting a “do-no-harm” approach and reviewing agency treatment of fintech innovation.

Acting Chair Giancarlo also asserted that the CFTC should enhance financial markets by:

  • “calibrating bank capital charges for economic growth” as a voting member of the Financial Stability Oversight Committee;
  • reforming the CFTC’s “flawed swaps trading implementation” with a “better regulatory framework for swaps trading” that allows market participants to select the manner of trade execution best suited to their needs, rather than having specific types “chosen for them by the federal government”; and
  • improving coordination with global regulators through measures while “fully embrac[ing] the Trump Administration’s Executive Order to advance American interests in international financial regulatory negotiations and meetings.”

Lastly, Mr. Giancarlo suggested that the CFTC should obtain a “right-size regulatory footprint” by:

  • “normaliz[ing] CFTC operations” after the “era of Dodd-Frank implementation” by decreasing regulatory burdens and attending to “longer range goals,” such as leveraging diversity;
  • “eschew[ing] empire building” at the CFTC by “resetting its focus on its core mission” and streamlining the work of various divisions; and
  • “run[ning] a tighter ship” in the wake of recent reductions in the agency budget and appropriations.

Acting Chair Giancarlo concluded:

“The time has come to reduce regulatory barriers to economic growth. The American people have elected President Trump to turn the tide of over-regulation. Financial market regulators, like the CFTC, must pursue their missions to foster open, transparent, competitive and financially sound markets in ways that best foster American prosperity.”

CFTC Chair Timothy Massad Resigns

CFTC Chair Timothy G. Massad tendered his resignation to President Obama. He will leave the CFTC on January 20, 2017. In a statement, which was accompanied by a 16-page summary of the CFTC’s accomplishments during his two-and-a-half-year tenure, Chair Massad asserted that the Commission had realized his agenda:

“I came to the CFTC with a number of priorities, and I am proud we have made significant progress in every area.”

Chair Massad highlighted accomplishments during his tenure. The CFTC:

  • ensured that “commercial businesses [could] continue using the derivatives markets efficiently and effectively to hedge routine commercial risk and engage in price discovery”;
  • “worked to ensure clearinghouses are stronger and more resilient through enhanced risk surveillance, new supervisory stress testing, and the development and completion of recovery and wind down plans and rules”;
  • “largely finished implementing the regulatory framework for swaps”;
  • “improved international coordination”;
  • “engaged in robust enforcement efforts”; and
  • took action to “address the new challenges and opportunities in the derivatives markets, particularly cyber threats, clearinghouse resilience, and the increased use of automated trading.”

Chair Massad emphasized that he “worked to make sure the rules focus on where the greatest risk exists, in transactions between large financial institutions,” and to ensure they were “largely harmonized with other domestic and international requirements.” He also noted that the clearinghouses are “stronger and more resilient,” through enhanced risk surveillance, new supervisory stress testing, and the development and completion of recovery wind down plans and rules.

SEC Chair White Presses Ahead with New Regulations

SEC Chair Mary Jo White issued a response to the Senate Banking Committee’s November 30 letter cautioning federal agencies not to finalize pending rules during the departing administration’s last days. According to Chair White, many of the SEC’s planned initiatives are “ready for Commission consideration.” She stated her intention to move forward with them before the change in administrations.

Chair White referred to comparable post-election periods in the past. She noted that the SEC enacted a number of substantive rules during transition periods after the 2000 and 2008 elections. The SEC should not “deviate from its historical practice of independently carrying out its duties,” she said.

Chair White listed several items that were ready for an SEC vote, including the following:

  • the adoption of rules to establish capital, margin and segregation requirements for security-based swap dealers and major security-based swap participants;
  • the adoption of rules regarding recordkeeping, reporting and notification requirements for security-based swap dealers and major security-based swap participants;
  • the adoption of rules regarding the orderly liquidation of certain broker dealers; and
  • the adoption of Investment Company Act Rule 30e-3, which concerns an optional method for investment companies to use to transmit shareholder reports by web posting.

Lofchie Comment: How much of the letter is devoted to formalities and how much concerns important issues is difficult to say, since some of the proposed rules are not significant to market participants; e.g. the rules on orderly liquidation and shareholder reports. At least three new Commissioners will be joining the SEC in the next few months. Surely, it is appropriate to allow those Commissioners to decide for themselves whether to proceed with the swap dealer rules as proposed or to amend them. In other words, given that these rules have been years in the making, is there an urgent reason to adopt them before the new Commissioners are seated?

Chair Massad Describes the CFTC’s Efforts on Behalf of Commercial End-Users

CFTC Chair Timothy Massad detailed the agency’s past efforts and his remaining agenda on behalf of commercial end-users. In an address at the American Gas Association 9th Annual Energy Market Regulation Conference, Chair Massad outlined actions the CFTC undertook in support of commercial end-users:

  • the exemption of commercial end-users from the CFTC’s rule on margin for uncleared swaps;
  • clarifying when commonly used agreements that include volumetric optionality provisions are forward contracts, and not subject to swaps rules;
  • eliminating certain reporting and recordkeeping obligations and announcing that trade options would not be subject to position limits;
  • customer protection improvements regarding collection of margin;
  • simplifying recordkeeping requirements;
  • granting delayed reporting for contracts in illiquid markets;
  • amending CFTC swap dealer rules so that “local, publicly-owned utility companies can continue to effectively hedge their risks in the energy swaps market”;
  • the exemption of certain transactions in the regional transmission organization and independent system operator markets from most provisions of CFTC rules other than the authority to pursue fraud and manipulations in these markets;
  • clarifying that community development financial institutions and small banks may choose not to clear a swap subject to the CFTC’s clearing requirement; and
  • ensuring that end-users can use the Congressional exemptions given to them regarding clearing and swap trading even if they enter into swaps through a treasury affiliate.

He then described several pending actions (position limits, capital requirements for swaps dealers and major swap participants, the de minimis threshold, and the modernization of recordkeeping requirements), as well as new challenges (cybersecurity, automated trading and the changing nature of liquidity and clearinghouse resilience).

On the issue of recently reproposed rules for limiting speculative futures and swaps positions, Chair Massad stated that the CFTC has a responsibility to “implement a balanced rule that achieves the objectives Congress has established,” and that he hopes the reproposal can be finalized in the near future.

Chair Massad asserted that end-users were “not the cause of the crisis.” He stated that there is a need to make sure that implementing reforms do not create undue burdens on these businesses. In a look back on his legacy at the CFTC, Chair Massad stated:

“We worked to keep the focus of regulation on those who create the most risk, and made rules less prescriptive in some areas. And we have worked to strengthen relationships with international regulators and harmonize regulations across borders.”

 

Lofchie Comment: In his remarks, Chair Massad stated:

“When I and my fellow Commissioners, Sharon Bowen and Chris Giancarlo, joined the CFTC together in June of 2014, it already had written most of the rules required by the Dodd-Frank Act. However, there were many criticisms and concerns. We inherited the task of finishing and improving this framework.” [Emphasis supplied.]

In many ways, Chair Massad’s freedom to re-examine and re-think the regulations adopted under former Chair Gensler was limited. That is, Chair Massad was limited to working at the edges, always declaring that any amendments made under his stewardship were merely “fine-tuning,” finishing a “framework” that he had inherited. See, e.g.Chair Massad Updates CFTC Priorities (need to fine-tune swap regulations); CFTC Chair Massad Discusses CFTC Rulemaking in an International Context (with Lofchie Comment) (fine tuning of cross-border regulations); Chair Massad Discusses CFTC’s Market Risk Strategy and Priorities for “Fine-Tuning” Flawed Rules (with Zwirb Comment). It is quite clear, however, that the CFTC’s rules were (and are) in need of an entirely fresh eye. This requires more of a Zen mindset than the one he brought to the task. See, e.g.Zen Mind, Beginner’s Mind by Shunryu Suzuki. The next CFTC administration should be better positioned in this regard.

CFTC Proposes Capital, Liquidity and Related Requirements for Swap Dealers

The CFTC approved proposed rules establishing minimum capital, liquidity, financial reporting and related requirements for CFTC-registered swap dealers (“SDs”) and major swap participants (“MSPs”). The proposed rules are a reproposal of rules previously proposed in 2011.

The proposed rules cover the follow areas related to SDs and MSPs:

  • capital requirements;
  • liquidity requirements;
  • financial recordkeeping and financial reporting;
  • obligation to notify regulators if a firm’s capital drops below certain levels; and
  • limitations on the withdrawal of capital and liquid assets.

The CFTC identified three approaches to allow firms to meet capital requirements:

  • an approach based on bank capital requirements that would be available to SDs that are subsidiaries of a bank holding company and thus subject to BHC capital requirements;
  • an approach modeled after the SEC’s capital requirements; and
  • a “tangible” net capital approach intended for a commercial enterprise, but that is also required to register as a swap dealer with the CFTC.

The proposal would establish certain liquidity, reporting and notification requirements, and would obligate entities covered by the proposal to keep current books and records in accordance with U.S. Generally Accepted Accounting Principles. Firms would be able to use models, although the models would have to be approved by the regulators. In addition, the rules provide for a “comparability” determination that will allow non-U.S. swap dealers that are not subject to regulation by the Federal Reserve Board to be subject to their home country capital rules.

There are currently 104 provisionally-registered swaps dealers (no registered major swap participants). Of those, 51 are not subject to the CFTC’s capital requirements because they are subject to U.S. bank requirements (including 36 which are non-U.S. banks having branches in the United States). Eight of the remaining swap dealers are already capital-regulated by the CFTC because they are FCMs, some of which are also SEC-registered broker-dealers. Of the remaining firms, some are subsidiaries of U.S. or non-U.S. bank holding companies or other entities subject to Basel-capital requirements that have sufficient capital to sustain their activities. Currently, there are no registered major swap participant and there is only one primarily commercial firm (Cargill) provisionally registered as a swap dealer with the CFTC.

In statements issued in connection with the reproposal, Chair Timothy Massad emphasized that the proposed requirements should avoid requiring all such firms to follow one approach. “Requiring all firms to follow one approach could favor one business model over another, and cause even greater concentration in the industry,” he said.

Commissioner J. Christopher Giancarlo expressed concerns regarding (i) the rule’s effect on smaller swap dealers and how much additional capital they may have to raise; (ii) the especially broad scope of the proposal; and (iii) the proposed capital model review and approval process.

Lofchie Comment: In terms of the substance of the rule requirements, the CFTC largely punted responsibility (and appropriately so) either to the banking regulators or to the SEC, both of which have significantly more expertise and staff to deal with these matters. It would have been messy for the CFTC and the SEC to take different approaches to capital requirements. Firms subject to regulation by both regulators would have been forced to comply with the more conservative set of rules in any case. In terms of process, the CFTC will wait and see what capital rules are eventually adopted by the SEC and then piggyback on them. For the CFTC, this is an entirely sensible way to go.  For firms that have an interest in the CFTC Rules, and will be subject to the “SEC version of the SEC rules, this means that they should concentrate on commenting on the actual SEC Rules, as the CFTC will likely follow along with whatever the SEC does.

In the Appendix, the CFTC reports the number of registered swap dealers and major swap participants. The numbers are revealing.

  • The CFTC stated that it had expected 300 swap dealers to register. Only 104 firms have done so. The costs associated with registration have likely caused numerous firms either to abandon dealing in swaps or to reduce their level of business below the de minimis level so as to not become subject to registration. Put differently, the regulations have led to a significant increase in the concentration of the swaps-dealing business. If the CFTC determines to reduce the level of business at which swap dealers are required to register, virtually all of the small unregistered swap dealers will further reduce their level of business or drop out of swaps dealing entirely. In short, Dodd-Frank has led to a significant accelerated concentration of swaps exposure.
  • There are no firms registered as a major swap participant. Not one. The registration requirements, applicable to large users of swaps that are not dealers, are absurd; it would be impossible for any non-dealer to comply with them. These provisions should be dropped from Dodd-Frank and the regulators should no longer waste time coming up with rules for registration categories that will apply to no one.
  • Congress gave no instruction as to how capital requirements could possibly be applied to a commercial entity that is a swap dealer. It simply does not work to have regulatory capital requirements (which largely require that a firm hold liquid financial assets) for commercial enterprises that own oil wells, related buildings and refineries. After years of struggling with how to make this round peg fit into a square hole, the CFTC essentially gave up (which was the rational thing to do). It set a low tangible capital requirement, which serves as an irrelevant fig leaf: a rule that the CFTC proposed merely because Congress required it to do so.

Currently, the CFTC does not have the expertise to supervise a models-based capital regime. Greater consideration should be given as to how this will work in practice.

SEC Explains Methodology for Analyzing Comments on Proposal to Restrict Derivatives Use

The SEC Division of Economic and Risk Analysis (“DERA”) set forth the methodology it used to analyze comments received on a proposal for the use of derivatives by registered funds and business development companies.

According to DERA, most commenters proposed that Investment Company Act Rule 18f-4 should measure a fund’s derivatives exposure using notional amounts adjusted to reflect the risks of the underlying reference assets. These SEC-adopted risk-based adjustments would be derived from standardized schedules used for other regulatory purposes.

DERA evaluated aspects of the proposal that included (i) the internal consistency of using risk-adjustment and haircut schedules across asset classes, and (ii) categories created for the purposes of risk adjustment and risk weighting with respect to the rule.

Lofchie Comment: In its analysis, DERA seemed not to differentiate between the use of derivatives for speculation and for hedging. Apparently, DERA assumed that the derivatives would be used only for speculation.

 

IOSCO Reports on Implementation of Post-Crisis Recommendations for Securities Markets

The IOSCO Board reported on the implementation of the G20/Financial Stability Board’s (“FSB”) post-crisis recommendations to strengthen securities markets. The Board report includes insight and analysis on the implementation of recent reforms and is based on self-reporting by national authorities in FSB jurisdictions. The report focused on (i) hedge funds; (ii) structured products and securitization; (iii) oversight of credit rating agencies; (iv) measures to safeguard the efficiency and integrity of markets; and (v) supervision and regulation of commodity derivative markets.

Highlights of the report:

  • hedge funds – all responding jurisdictions which permit or have hedge funds reported implementation of the G20 and IOSCO recommendations relating to registration, disclosure and oversight of hedge funds. Almost all reported implementation of recommendations in relation to international information and enhancing counterparty risk management;
  • structured products and securitization – most responding jurisdictions reported the introduction of measures to strengthen supervisory requirements or best practices for investment in structured products, and to enhance disclosure of securitized products as recommended by the Financial Stability Forum (now the FSB) in 2008 and IOSCO in a number of reports from 2009 onwards; and
  • oversight of credit rating agencies – all responding jurisdictions implemented G20/FSB recommendations to require registration and provide appropriate oversight of FSB jurisdictions in line with IOSCO’s Code of Conduct Fundamentals for Credit Ratings Agencies.

In addition, the report stated that the implementation of G20/FSB recommendations “is still progressing” in the areas of (i) measures to safeguard the integrity and efficiency of financial markets, and (ii) the supervision and regulation of commodity derivatives markets.