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.

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.

FRB Governor Jerome Powell Applauds “Aggressive Response” to Financial Crisis, Calls for Some Adjustments

Federal Reserve System (“FRB”) Governor Jerome Powell reviewed the regulatory response to the global financial crisis and offered his perspective on the state of current financial market infrastructure and possible regulatory adjustments going forward.

In a speech before the Global Finance Forum, Mr. Powell praised those who aggressively responded to the financial crisis as having prevented another depression. At the time, he noted, the two primary tasks were to “get the economy growing again” and address the “many structural weaknesses” in the financial system. Mr. Powell noted that while job growth has been strong and the U.S. has not had another recession, there has been a labor productivity slowdown associated with “weak investment and a decline in output gains from technological innovation.” To address this, Mr. Powell called for a “national focus on increasing the sustainable growth rate of our economy.”

Mr. Powell stated that the financial system has improved and stabilized primarily because of (i) higher levels of quality capital held, (ii) higher levels of liquidity held, (iii) capital stress testing, (iv) resolution planning (i.e., living wills), and (v) the “greater transparency and more consistent risk management” that comes with the central clearing of interest rate and credit default swaps. He argued that these core reforms should be protected, but called for certain regulatory adjustment in instances where new regulations have been inappropriately difficult for smaller firms or otherwise inefficient, adding:

“Some aspects of the new regulatory program are proving unnecessarily burdensome and should be better tailored to meet our objectives. Some provisions may not be needed at all given the broad scope of what we have put in place. I support adjustments designed to enhance the efficiency and effectiveness of regulation without sacrificing safety and soundness . . .”

Lofchie Comment: Mr. Powell joins a steadily increasing number of regulators who are conceding that Dodd-Frank has had some material negative effects. These concessions lay the groundwork for a rational discussion of how financial regulation may be improved – a welcome change from eight years in which “improvement in regulation” and “more regulation” were purported to be synonymous concepts.

President Trump Directs Treasury Secretary to Reconsider Two Dodd-Frank Authorities

In two executive memoranda, President Donald J. Trump directed the U.S. Department of the Treasury to review key elements of the Dodd-Frank post-crisis regulation. The memoranda authorizes the Treasury Secretary to review (i) the processes of the Financial Stability Oversight Council (“FSOC”) for designating “systemically important” institutions, and (ii) the Orderly Liquidation Authority (“OLA”) including a review of potentially adverse consequences posed by the framework.

In a statement, Treasury Secretary Steven Mnuchin said that during the review process, the Treasury will not designate any new non-bank financial institutions as systemically important under the FSOC. The goal of the review, he said, is to “make this a smarter, more effective process that reduces the kinds of systemic risk that harmed so many Americans during the financial crisis of 2008.”

Secretary Mnuchin said that the review of the OLA will attempt to determine (i) whether the OLA is encouraging “inappropriate risk-taking,” (ii) “the extent of taxpayer liability,” and (iii) how the bankruptcy code “may be a more appropriate avenue of resolving financial distress.”

President Trump remarked:

“I’m . . . issuing two directives that instruct Secretary Mnuchin to review the damaging Dodd-Frank regulations that failed to hold Wall Street firms accountable. . . . These regulations enshrine ‘too big to fail’ and encourage risky behavior.”

 

Lofchie Comment: Politically, these executive actions are promoted as being for the purpose of holding Wall Street accountable. The larger benefit they provide is to put a check on the very broad discretionary powers afforded the government under Dodd-Frank. These executive actions move financial regulation back toward a system of rules governed by written procedures and not by grants of broad discretion.

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.

Federal Reserve Governor Daniel Tarullo Reconsiders the Volcker Rule

In his parting speech as a member of the Board of Governors of the Federal Reserve System (“FRB”), Governor Daniel K. Tarullo asserted “that strong capital requirements are central to a safe and stable financial system.” He described the post-crisis atmosphere in which regulatory capital requirements were first proposed, and evaluated the subsequent adoption of the Dodd-Frank Act. Noting that a statute as broad as Dodd-Frank could not possibly get everything right, Governor Tarullo cited the Volcker Rule as an area where the “case for change has become fairly strong”:

[T]he Volcker rule is too complicated. Achieving compliance under the current approach would consume too many supervisory, as well as bank, resources relative to the implementation and oversight of other prudential standards. And although the evidence is still more anecdotal than systematic, it may be having a deleterious effect on market making, particularly for some less liquid issues.”

Governor Tarullo identified the following flaws in the Volcker Rule: (i) it involves five regulatory agencies, (ii) it contemplates evaluating the mindset of a trader at the time a trade is made, and (iii) it applies to a much broader group of banks (including community banks) than necessary.

Governor Tarullo championed the “risk-based” capital approach as the best post-crisis capital buffer, noting that no single measure of capital would be appropriate. He advocated moving toward a simpler approach for community banks and rejected a recent proposal to implement a broad leverage ratio, increased to 10 percent, as a substitute for existing regulation. He argued that a higher leverage ratio would “make banks less profitable, and . . . they would be strongly incentivized to change the composition of their balance sheets dramatically, shedding safer and more liquid assets” if the new ratio became the predominant regulatory feature.

Governor Tarullo also evaluated the unfinished “transition of stress testing from crisis program to a permanent feature of prudential oversight.” He stated that for stress testing to succeed, it must evolve along with the financial system. He opposed removing capital distributions from the stress-test regime claiming that it would result in fewer protections for the financial system.

Lofchie Comment: When even Governor Tarullo admits that Dodd-Frank is not working as planned, it is time for the last holdouts to concede that the statute could use a re-think. His grudging acknowledgment that the evidence is “more anecdotal than systematic” is almost amusing given how available it has been for years. Seee.g.SEC Commissioner Gallagher Discusses SEC Supervision of Fixed Income Liquidity, Market Structure and Pension Accounting (with Lofchie Comment). His admission of (at least potential) error (if one can call it that) should make it obvious that no one (whether in the private sector or in government) can possibly get it right all of the time. For the last several years, it was Governor Tarullo who, more than any other regulator, argued that the Federal Reserve Board was capable of getting it right. As to this claim, the skeptics may consider themselves fully justified: Mercatus Scholar Hester Peirce Cautions against Macroprudential Regulation (with Lofchie Comment).

SEC Acting Chair Michael Piwowar Encourages “Special Study” of Securities Market Reform

A “Special Study” of the securities markets will offer recommendations for financial market regulatory reform. In a speech at the Program in the Law and Economics of Capital Markets at the Columbia University Law and Business Schools, SEC Acting Chair Michael Piwowar called the planned analysis “comprehensive” and “long overdue.”

Columbia University spokespersons disclosed that the Special Study will be conducted in three phases: (i) the commissioning of major papers to provide a “roadmap” for the implementation of the study, (ii) a plan of action for completion of the study, and (iii) the implementation itself, including a comprehensive final report directed at federal financial regulators and the U.S. Congress. The final report has a target completion date of December 2020.

SEC Acting Chair Michael Piwowar applauded the new Special Study, and noted that the 1963 study on which it is based remains “the most comprehensive review of our securities markets that has ever been undertaken.” He urged those who will conduct the new study to approach it with open minds, particularly when identifying entirely new issues and alternatives, and to avoid tethering the project to previous market reform proposals and approaches.

In his remarks, Acting Chair Piwowar questioned the very process of enacting Dodd-Frank:

“[Dodd-Frank] was enacted before any of the official regulatory inquiries into the cause of the financial crisis had been completed. Rather than respond to acute and identifiable causes of concern, Dodd-Frank foisted upon the SEC several special-interest driven mandates that were far outside the scope of our core mission. These overtly politicized obligations have served to distract the SEC from fundamental issues – not the least of which is evaluating how our rules are actually operating.”

He added that the current “pause” in Dodd-Frank-era rulemaking has allowed the SEC to refocus on equity market structure, and that the results of the Special Study will be an “invaluable contribution to potential market structure reforms.”

Lofchie Comment: While the announcement of a study is not necessarily exciting, it is potentially very significant. For the last eight years, the regulation of the securities industry has been, as Chair Piwowar observes, heavily politicized. Interested legislators have taken the view that more regulation is inherently good, and that less regulation is inherently bad, without considering the actual cost or benefits of any particular item of legislation. If the discussion of appropriate regulation can be made less partisan, then the economy will benefit, particularly if a calmer discussion allows for the presentation of a broader range of views.

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.”

Financial Services Committee Chair Prepares “Views and Estimates” Document for Markup

Financial Services Committee Chair Jeb Hensarling circulated to Members of the Committee on Financial Services a “Views and Estimates” document for markup. Once adopted by the full committee, the document will be transmitted to the Budget Committee “to be set forth in the concurrent resolution on the budget for fiscal year 2018.”

The document is required by section 301(d) of the Congressional Budget Act which requires “each standing committee to submit to the Committee on the Budget, not later than six weeks after the President submits his budget or upon the request of the Budget Committee: (i) its views and estimates with respect to all matters to be set forth in the concurrent resolution on the budget for the ensuing fiscal year that are within its jurisdiction or function; and (ii) an estimate of the total amounts of new budget authority and budget outlays to be provided or authorized in all bills and resolutions within its jurisdiction that it intends to be effective during that fiscal year.”

The document includes the following recommendations:

  • “replace the failed aspects of the Dodd-Frank Act with free-market alternatives”;
  • “place the non-monetary policy activities of the independent agencies within the Committee’s jurisdiction on the appropriations process”;
  • “replac[e] the Orderly Liquidation Authority with established bankruptcy procedures, wherein shareholder and creditor claims are resolved pursuant to the rule of law rather than the arbitrary discretion of regulator”;
  • eliminate the Office of Financial Research, as proposed by the Financial CHOICE Act;
  • “enhance accountability and lead to greater transparency” at the Consumer Financial Protection Bureau (“CFPB”) by reforming the CFPB’s “operations and unconstitutional structure, including by subjecting the CFPB to Congressional appropriations process, and by reforming the CFPB’s statutory mandate to ensure that it takes into account, and seeks to promote, robust market competition”;
  • “modernize the SEC’s operations and structure to eliminate inefficiencies”; and
  • “promote greater accountability at the Federal Reserve by advancing legislation to fund the non-monetary activities of the Federal Reserve’s Board of 33 Governors and 12 regional banks through the Congressional appropriations process.”

Lofchie Comment: If there is an overriding theme in the initiatives contained in the Visions and Estimates document, it is that Congress chooses to assert its authority over the so-called “regulatory state,” or the unofficial fourth branch of the government. Most significantly, Congress is exercising that authority by asserting its funding power over the various regulatory agencies – particularly, the CFPB. Undoubtedly, many of these measures will be seen as reasons for Democrats and Republicans to fight, but that should not be the case with the exercise of the funding powers. The issue raised by these measures is not whether elected Democrats or Republicans are in the right concerning any particular policy decision, but whether regulatory agencies should be able to operate free of the political control of whichever party is in power.

The Visions and Estimates document provides an example of this in a section that examines the funding of the CFPB. Assuming that current CFPB Director Richard Cordray serves out his term, Mr. Cordray will remain in power until some point in 2018; he will keep his position for a substantial part of President Trump’s four-year term. President Trump then will be able to appoint a new CFPB director who could undo much of the previous director’s work and will serve well into the term of the next elected President, who easily could be a Democrat. In short, we could have a situation in which the unelected head of the CFPB is not financially accountable to Congress and acts in opposition to whoever happens to be President at a given time, whether Republican or Democrat. This is no way to structure a regulatory agency. Both Democrats and Republicans ought to prefer the CFPB to be funded by Congress and held accountable by elected political officials.

House Votes to Nullify SEC Resource Extraction Rule

By a vote of 235 to 197, the House of Representatives passed a joint resolution (H.J. Res. 41) to nullify an SEC final rule regarding the disclosure of payments by resource extraction issuers, Exchange Act Rule 13q-1 (the “Resource Extraction Rule”). The Resource Extraction Rule was mandated under Section 13(q) of the Securities Exchange Act, which was added by Section 1504 of the Dodd-Frank Act. The rule requires issuers to disclose certain payments made to government entities for the commercial development of oil, natural gas or minerals.

Lofchie Comment: For a long time, the Resource Extraction Rule had been criticized by Republicans as inadequate to achieve its intended purpose and irrelevant to the mission of the SEC. Seee.g.SEC Commissioner Gallagher Speaks on the Priorities and Mispriorities of the SEC (with Lofchie Comment).