OCC Releases Semiannual Risk Report

The Office of the Comptroller of the Currency (“OCC”) described the principal risks facing national banks and federal savings associations in its Semiannual Risk Perspective for Spring 2017 (the “Report”).

In the Report, the OCC identified the following key risk themes:

  • strategic risk due to a changing regulatory climate, low interest rates and competition from nonfinancial firms, including fintech companies;
  • increased credit risk and relaxed underwriting standards due to strong risk appetite and competitive pressures;
  • elevated operational risk as a result of increased reliance on third-party service providers and attendant cybersecurity risks; and
  • high compliance risk as banks navigate money laundering risks and new consumer protection requirements.

OCC supervisory priorities for the next 12 months will remain broadly the same as in 2016 and will include the objective of identifying and assigning regulatory ratings and risk assessments. The OCC also pledged a continued commitment to monitoring and evaluating risks presented by third-party service providers.

In remarks on the Report, Acting Comptroller of the Currency Keith A. Noreika stated:

“The OCC employs a risk-focused approach to supervision, and tailors examination strategies to the individual risks of each of its supervised institutions and will pay close attention to these key risk areas over the next six months.”

 

Lofchie Comment: A material portion of the “risk” that banks face, according to the report, is regulatory risk. The Comptroller’s remark that “[m]ultiple new or amended regulations are posing challenges” to banks and the financial system also echoes the comment made by the SEC’s Investor Advocate in his recent report to Congress that he would “encourage Congress to consider giving the [SEC] a respite from statutory mandates” (at 3). It is clear that the very rate and extent of regulatory change has itself become a threat to the financial system.

FRB Governor Powell Examines Liquidity Risks in Central Clearing

At the Federal Reserve Bank of Chicago Symposium on Central Clearing, Board of Governors of the Federal Reserve System (“FRB”) Governor Jerome H. Powell detailed the risks faced by central counterparties (“CCPs”) and their members.

Because they advocated for central clearing, Mr. Powell noted, global authorities (i) have a responsibility to make sure that CCPs do not become a point of failure in the system and (ii) must ensure that bank capital rules do not discourage central clearing.

Regarding bank capital, Mr. Powell argued that the supplementary leverage ratio for U.S. global systemically important banks fails to account for the relatively low risk of central clearing, as compared to riskier activities, and could discourage central clearing. He explained that the Basel Committee on Banking Supervision is considering a “risk-sensitive” approach to evaluating counterparty credit risk for certain centrally cleared derivatives, which could help to encourage central clearing. He also noted that the FRB is considering implementing a “settlement-to-market” approach for some cleared derivatives that would treat daily variation margin as a settlement payment, which means that banks would not have to hold capital against it.

On the subject of liquidity, Mr. Powell outlined the risks associated with central clearing. He noted the challenges that CCPs face with regard to outgoing and incoming payment flows. In the event of a member default, for instance, CCPs would need to be able to convert large amounts of non-cash collateral into cash in order to make payments to non-defaulting parties. For that reason, they must have lines of credit and ready access to the repurchase market. Mr. Powell’s example of a payment flow challenge led him to consider where CCPs should store their available cash. He mentioned central bank deposits as a safe and flexible option.

Mr. Powell also described the risks associated with incoming payment flows. Market volatility can trigger events that lead to an abnormal number of margin calls, which, in the first instance, requires liquidity on the part of clearing members to meet the margin call. It also requires a series of payments to be made simultaneously, so that the CCPs can obtain funds from the settlement bank quickly to meet margin requirements for its members. (In most instances, clearing members have an hour to meet intraday margin calls.) By way of example, Mr. Powell noted that data from the CFTC suggests that the top five CCPs requested $27 billion in additional margin over the two days following the Brexit referendum, which is about five times the average amount. Fortunately, members and CCPs were prepared in that instance, and were able to make the necessary payments.

In order to manage liquidity risk, Mr. Powell suggested, regulators should conduct expanded stress tests for CCPs:

“Conducting supervisory stress tests on CCPs that take liquidity risks into account would help authorities better assess the resilience of the financial system. A stress test focused on cross-CCP liquidity risks could help to identify assumptions that are not mutually consistent; for example, if each CCP’s plans involve liquidating Treasuries, is it realistic to believe that every CCP could do so simultaneously?”

He also urged regulators to (i) facilitate innovations that help to reduce liquidity risks, such as exploring the utilization of distributed ledger technology, (ii) make Federal Reserve bank accounts available to major CCPs, and (iii) take global market implications into account when developing solutions for managing liquidity risk for CCPs.

Lofchie Comment: The CFTC and the banking industry have long argued that the Basel III capital rules that require banks to reserve against collateral posted to a central clearing agency are mistaken. Governor Powell is coming around belatedly to that view. The existence of central clearing parties does not decentralize risk; it concentrates it. Yet a further risk of clearing emphasized in Governor Powell’s remarks is the power that the clearing agencies have to suck tremendous amounts of liquidity out of the market: $27 billion of additional margin in the two days following Brexit. (What this means is that, in demanding more margin to protect their own liquidity in a financial crisis, clearing agencies may bring down everyone else.)

It is certainly time for a full review of the benefits and risks of central clearing. Many of the concerns raised by clearing skeptics are being proved valid.

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.

NASAA Warns Financial CHOICE Act Moves in “Wrong Direction”

In testimony submitted to the House Financial Services Committee (“Committee”), North American Securities Administrators Association (“NASAA”) President Mike Rothman argued that the updated Financial CHOICE Act should not be passed in its current form. Mr. Rothman objected to bill provisions related to enforcement and regulatory authority, capital formation, and investor protection.

At a hearing before the Committee, Chair Jeb Hensarling (R-TX) introduced the Financial CHOICE Act of 2017. As previously discussed, this bill is an update of the CHOICE Act of 2016 (see the Committee’s summary of changes) and represents a major overhaul of the current financial services regulatory regime including a partial repeal of Dodd-Frank.

Mr. Rothman testified that the proposed Financial CHOICE Act of 2017 would weaken important reforms and protections, undermine regulators’ ability to enforce financial laws, and “dramatically change regulatory policies in the wrong direction.” He argued that state securities regulators are concerned the bill would unnecessarily expose investors and markets to significant new risks, and replace efficient protections with ineffective measures:

“By attempting to eviscerate so many critically important reforms – weakened oversight of private securities markets and reforms; watered down provisions intended to expand fiduciary obligations to investment professionals; lowered standards for securities sold to the investing public; diluted rules that keep “bad actors” out of our securities markets, among many others – the legislation blithely aims to sweep away in one stroke scores of essential protections and modernizations to our financial regulatory architecture. . . .”

Specifically, Mr. Rothman noted objection to Section 391 of the proposed legislation. He argued that NASAA objects to a mandate governing the coordination of state and federal enforcement actions because it would hamper the voluntary state-federal collaborative framework that is in place already.

Lofchie Comment: CHOICE Act Section 391 requires that various federal agencies (which are enumerated in Section 311 of the bill, but essentially includes the major U.S. financial regulators) better coordinate among themselves which agency should be the lead in any regulatory action where numerous agencies are involved. It does not, by its terms, impose any obligations on state regulators; it merely requires that the federal government act as a unified entity (which would seem entirely sensible, would conserve the government’s resources, and would reduce the nightmare scenario of a business dealing with multiple regulators in regard to any one single issue). The Section does not require the states to coordinate either among themselves or with the federal government, although it would be good if they were to do so.

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).

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.

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.