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.

CFTC Acting Chair Giancarlo to Move Past Dodd-Frank and Focus on How CFTC “Applies Reforms”

In the June 23, 2017 issue of The Risk Desk, editor John Sodergreen offered his take on CFTC Acting Chair J. Christopher Giancarlo’s efforts to work on regulatory reform.

Mr. Sodergreen noted a sharp distinction between the friendly reception Mr. Giancarlo received at recent congressional hearings with that of his predecessors, who, he said, “often managed to draw fire from Republicans and Democrats alike.” Mr. Sodergreen emphasized how little controversy was generated at Mr. Giancarlo’s budget hearing, stating:

“[U]p and down the line, Republican and Democrat alike seemed to praise the acting chairman for submitting a budget request that exceeds the president’s number by over $30 million. We sensed no pushback at all, which had to be some sort of first.”

Mr. Sodergreen was also taken by how Mr. Giancarlo was endorsed at his nomination hearing before the Senate Agriculture Committee. Mr. Sodergreen called it “a slam-dunk, a fan-fest almost,” and added: “[i]t was the fastest confirmation hearing we had ever seen and we covered them all since Jim Newsome’s hearing.”

Mr. Sodergreen highlighted Mr. Giancarlo’s non-confrontational approach to regulatory reform, as reflected in these congressional appearances. Concerning Dodd-Frank, Mr. Sodergreen (i) stated that Mr. Giancarlo “didn’t see the value in debating whether Dodd-Frank is good or bad” and (ii) explained that Mr. Giancarlo chose to focus on high-frequency trading and cyberattacks, which are two “massive” areas of concern for the CFTC. In this regard, Mr. Sodergreen pointed out that Mr. Giancarlo is calling for a forward-looking agenda. Mr. Sodergreen further highlighted Mr. Giancarlo’s explanation of the Project KISS (“Keep It Simple, Stupid”) initiative, which Giancarlo described as focused on how reforms are applied rather than repeal or rollback (see previous coverage).

Based on these hearings, Mr. Sodergreen predicted an easy confirmation. “[We]’d bet the farm Giancarlo sails through,” he said.

Lofchie Comment: On the one hand, there is a good amount of Dodd-Frank that should be repealed or rolled back, particularly in the commodities world. On the other hand, there is something to be said for avoiding partisan disputes.

Banking Regulators Recommend Volcker Reassessment and Other Reforms

In a hearing on “Regulation and Economic Growth” held by the Senate Committee on Banking, Housing, and Urban Affairs, bank regulators testified on the current banking environment and outlined principles, recommendations, and objectives to promote future efficiency.

Board of Governors of the Federal Reserve System (“FRB”) Governor Jerome Powell focused on regulatory developments including (i) capital requirements for banks, including common equity tier 1 capital requirements and an additional surcharge for global systematically important banks, (ii) mandatory stress testing for large banks, (iii) the liquid coverage ratio requirement, and (iv) resolvability planning obligations. He testified that the FRB will explore the measures aimed at reducing regulatory burdens including a reassessment of Volcker Rule requirements that do not directly relate to its main policy goals, and an examination of the leverage ratio to ensure that it is properly calibrated to prevent market distortions. Mr. Powell also stated that the FRB is not in favor of reducing risk-based capital requirements, as recommended by a recent Treasury report.

Acting Comptroller of the Currency Keith A. Noreika also advocated for a fresh look at the Volcker Rule, and argued that a better approach may be to entirely exempt community banks from the rule’s requirements. Additionally, he expressed support for considering “off-ramp” provisions for institutions that clearly do not present risks that the Volcker Rule was implemented to mitigate. Mr. Noreika echoed Treasury suggestions for raising stress test thresholds, and asserted a commitment to streamlining reporting requirements for smaller banks.

FDIC Chair Martin Gruenberg explained that a recent review (conducted pursuant to the Economic Growth and Regulatory Paperwork Reduction Act of 1996) has resulted in several interagency actions aimed at reducing reporting requirements, simplifying certain capital rules, and moving towards a more individualized approach to bank examinations. Mr. Gruenberg argued against Treasury report recommendations to (i) remove the FDIC from the living wills process, and (ii) remove central bank deposits, Treasury securities, and initial margin on derivatives from the denominator of the supplementary leverage ratio and enhanced supplementary leverage ratio.

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.

House of Representatives Passes Financial CHOICE Act

On June 8, 2017, the House of Representatives passed the “Financial CHOICE Act of 2017” (H.R. 10) (the “CHOICE Act”). The vote was 233 to 186, largely along partisan lines. The CHOICE Act had been approved by the House Financial Services Committee on May 4, 2017. The bill is a major overhaul of the current financial services regulatory regime including a partial repeal of Dodd-Frank. (For previous Cabinet coverage of general provisions of the bill, see House Republicans Release Revised CHOICE Act.)

Financial Services Committee Chair Jeb Hensarling (R-TX) stated that the CHOICE Act would have a significant impact on the economic wellbeing of the United States:

“[The CHOICE Act] stands for economic growth for all, but bank bailouts for none. We will end bank bailouts once and for all. We will replace bailouts with bankruptcy. We will replace economic stagnation with a growing, healthy economy.”

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.

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.