US regulators are setting a dangerous precedent on Silicon Valley Bank

Former FDIC Chair and CFS senior fellow Sheila Bair penned “US regulators are setting a dangerous precedent on Silicon Valley Bank” in the Financial Times (FT).  The piece covers:

– Systemic risk determination,
– Use of FDIC insurance,
– Fed policy.

To view the piece:
https://www.ft.com/content/b860ebb6-f202-4ec6-a80c-8b1527c949f4

U.S. Government Announces Uninsured SVB/Signature Depositors to Be Made Whole

In a joint statement, the U.S. Treasury, the FDIC and the Federal Reserve Board announced that all depositors, both insured and uninsured, of Silicon Valley Bank and Signature Bank, would be made whole for their deposits. Each bank had been closed this past Friday, SVB by the FDIC and Signature Bank by the New York State banking authorities.

The regulators described the protection of the depositors as not requiring funding from taxpayers as the funding would come from a special assessment on banks that will be paid into the Deposit Insurance Fund.

The regulators had previously said that shareholders and other unsecured creditors of the bank would not be protected (and thus could be wiped out) and that management of the two banks had been removed.

President Joseph R. Biden issued a statement to assure depositors and call on Congress and the banking regulators to “strengthen the rules for banks to make it less likely that this kind of bank failure will happen again.” Numerous other statements have been issued (see primary sources below).

LOFCHIE COMMENTARY

First, the statement that none of the bailout will be borne by taxpayers is somewhat misleading. The bailout is not being financed by other banks buying a business that had positive going forward value. Rather, it is being financed by government-imposed regulatory fees that must be passed through and eaten by shareholders or paid by customers in higher fees or lower interest rates on deposits.  

Second, the statement raises many questions. Are all bank deposits from now on implicitly insured? Where will the no-bailout line be drawn in the future? What is the justification? That is not to say that the bailout was not reasonable under the circumstances. Had there not been one, we almost certainly would have seen additional runs on other banks and financial institutions. Depositors were very much poised to move their money from small banks to larger ones. But it will be interesting to see whether depositors begin assessing bank risk more closely going forward, just as institutional investors began to assess broker-dealer risk more carefully after 2008.

Third, the best explanation of the 2008 financial crisis was a 1986 book by Hyman Minsky called “Stabilizing an Unstable Economy.” (See The Future of Financial Regulation.) Minsky argued that periods of financial calm create a lack of focus on real risks, which in turn leads to speculation and thus to instability. The book came briefly into vogue during the 2008 financial crisis, in a period referred to as the “Minsky Moment.” 

One could reasonably argue that that the last few years have seen rampant speculation, but by the regulators, not market participants. Rather than focus on the ordinary risks inherent to our economy – money supply, inflation, price volatility – the financial regulators have become distracted by speculative risks that are of high political import, such as climate change, an issue as to which they have neither sufficient knowledge nor actionable data, nor any meaningful ability to influence events. 

The FSOC’s 2022 Annual Report (see related coverage) makes 16 references to inflation (many of them about global inflation and very little about the impact of inflation and the attempts to control it on bank risk). By contrast, there are 112 references to climate (not historically regarded as a threat to financial stability). The FSOC 2021 Annual Report managed 41 references to inflation versus 86 references to climate, a lack of attention to actual risk in 2021 that only became more pronounced in 2022. (It also is notable that SVB was particularly focused on ESG lending, not limited to climate.)  So while the regulators may have been right that climate risk is a material risk to the financial system, they were likely wrong about the reasons. The risk was that climate change distracted the financial regulators from the relative boring work of financial regulation.  

Financial regulators need to devote their attention to the ordinary and mundane matters of financial risk. Attending to mundane matters does not mean adopting a slew of new and burdensome regulations, imposing new weights on the markets to compensate for past regulatory distractions.  When the next FSOC Annual Report is published, there should be more references to ordinary risks such as inflation, interest rates, maturity mismatches and failures to diversify risk, than there are to references to climate.  

Primary Sources

  1. White House: Remarks by President Biden on Maintaining a Resilient Banking System and Protecting our Historic Economic Recovery
  2. Joint Statement by the Department of the Treasury, Federal Reserve, and FDIC
  3. House Financial Services Committee Press Release: McHenry Statement on Regulator Actions Regarding Silicon Valley Bank
  4. Senate Banking, Housing and Urban Affairs Committee Press Release: Scott Statement on Government Response to Failures of Silicon Valley Bank and Signature Bank
  5. NYS Department of Financial Services: Superintendent Adrienne A. Harris Announces New York Department of Financial Services Takes Possession of Signature Bank
  6. FRB Press Release: Federal Reserve Board announces it will make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors
  7. Press Release: Joint Statement by Treasury, Federal Reserve, and FDIC
  8. SEC Statement: Chair Gary Gensler on Current Market Events
  9. FDIC Establishes Signature Bridge Bank, N.A., as Successor to Signature Bank, New York, NY
  10. FDIC Acts to Protect All Depositors of the former Silicon Valley Bank, Santa Clara, California
  11. FDIC Creates a Deposit Insurance National Bank of Santa Clara to Protect Insured Depositors of Silicon Valley Bank, Santa Clara, California
  12. Financial Stability Oversight Council Meeting on March 12, 2023
  13. House Financial Services Committee: Ranking Member Waters’ Statement Following the Closure of Silicon Valley Bank

The Future of Risk Management

CFS special counselor David X Martin and David R. Koenig, founder of the Directors and Chief Risk Officers group (DCRO) opine on “The Future of Risk Management.”  Risk management and crisis prevention are longstanding core objectives and activities at CFS.

David and David offer perspective on how boards and organizations can foster a positive embrace of risk taking. Topics include:

– Translating the new risks
– Resiliency planning
– Risk any unanticipated impact of efficiency
– Forward facing techniques
– Professionalizing risk management
– The future of risk governance at the board level

To view the full article:
http://www.CenterforFinancialStability.org/research/Risk_Future_022221.pdf

New ETF Resource for Investors, Officials, and the Public

Exchange-Traded Funds (ETFs) are at the forefront of the shift from active to passive investment management styles.  Hence, ETFs now represent a large swath of the financial asset landscape. To be sure, ETFs provide outstanding vehicles to express views across a wide range of asset classes. Yet, the Federal Reserve Bank of New York created a special Secondary Market Corporate Credit Facility (SMCCF) to purchase ETFs and some fear underlying systemic risks.

CFS recently conducted a survey of highly knowledgeable participants in academia, investment management and banking.  The results were clear.  More knowledge of ETFs and their impact on the financial system is vital.

The Center for Financial Stability ETF library represents a first step to support and publicize the most thoughtful research and ideas regarding the market structure, risks, and policy.  The Library is divided into two sections 1) Analysis of Risks and Markets and 2) Policy and Regulation.

Access the ETF Library through the main menu on our homepage or www.centerforfinancialstability.org/ETFs.php

We invite you to submit original pieces or material to be considered for posting to Brigitte Rudman at brudman@the-cfs.org

Ranking Member of the House Financial Services Committee Offers Republican List of Hearing Priorities

Ranking Member of the House Financial Services Committee (“HFSC”) Patrick McHenry (R-NC) offered to cooperate with new Chair Maxine Waters on a list of priorities affecting the U.S. financial system.

According to Mr. McHenry, the list of hearing topics concern areas that are critical to ensuring the “strength and stability of the U.S. financial system and the global competitiveness of American job creators.” The list includes:

  • Britain’s withdrawal from the European Union and its effects on the U.S. economy and the international financial system;
  • the Export-Import Bank and “its impact on the global competitiveness of U.S. companies and U.S. job creation”;
  • cybersecurity within the financial space, to evaluate the “readiness” of the financial sector and the ability of the U.S. government to protect digital consumer accounts against fraud, misuse and improper access;
  • China’s “debt trap” and the implications of China’s lending decisions in relation to the IMF, the World Bank and global systemic risk;
  • foreign investment and venture capital in the global economy, to assess how the U.S. Treasury Department is implementing the Foreign Investment Risk Review Modernization Act of 2018;
  • scheduled reductions to the Federal Reserve’s balance sheet, specifically in relation to unwinding crisis-era asset purchases;
  • the National Flood Insurance Program (“NFIP”), to examine proposed reforms that could impact the “affordability, availability and long-term solvency of the NFIP”;
  • the modernization of the Bank Secrecy Act and Anti-Money Laundering regulatory regime to inspect the duplicative nature of the current rules;
  • the Terrorism Risk Insurance Act, to provide oversight of the program, better comprehend the private insurance market, and build consensus before the program expires;
  • the regulation of FinTech; and
  • the oversight of the Financial Accounting Standards Board and its Current Expected Credit Loss Accounting Standard.

Mr. McHenry noted that the list is not exclusive, but that it gives the HFSC an opportunity to better understand the “complex legislative landscape we will face this Congress.”

Lofchie Comment: The list contains a number of important big-picture concerns. It is not a list, however, likely to generate much political or press excitement. In this environment, it is an open question whether Chair Waters will take up any of the items on Representative McHenry’s list.

“Clean” Holding Company Requirements Now Fully Effective

The Federal Reserve Board’s (“FRB”) “clean holding company” requirements – which apply to the eight U.S. globally systemically important banks and the U.S. intermediate holding companies of the largest foreign banks operating in the United States – became effective on January 1, 2019. The requirements are applicable only to the legal entity that is the top-tier U.S. holding company and do not apply to its affiliates or subsidiaries.

According to the final rule adopted by the FRB, covered holding companies generally are barred from:

  • issuing guarantees of a subsidiary’s liabilities with cross-default rights regarding the covered holding company’s insolvency/resolution;
  • entering into qualified financial contracts with a third party;
  • providing short-term debt instruments to a third party; and
  • participating in upstream guarantees.

The prohibitions are applicable only to instruments or arrangements issued or entered into on or after January 1, 2019.

SEC Office of Investor Advocate Reviews FY 2018 Activities

The SEC Office of the Investor Advocate (“OIA”) identified “problematic products or practices” and summarized steps the agency and self-regulatory organizations took to respond to investor concerns during the past year.

In a “Report on Activities,” the OIA Investor Advocate identified “potentially problematic products or practices during Fiscal Year 2018” as reported by the SEC, NASAA, FINRA and the MSRB. These include, among others: (i) initial coin offerings, cryptocurrency and blockchain; (ii) a variety of scams and schemes (related to, e.g., regulator impersonations, Ponzi schemes, natural disasters and investments in “unicorns,” binary options, oil and gas, marijuana, microcap stocks and real estate, among others); (iii) cybersecurity; (iv) investment fees and expenses; (v) suitability of wrap fee programs; (vi) registrations of third-party providers, marketers and gatekeepers; (vii) a variety of risks (e.g., trading on margin, data aggregation, disclosure, and use of credit cards); and (vii) other practices (e.g., pennying and prearranged trading in connection with primary offerings).

In the report, the OIE focused on five key policy areas: public company disclosure, equity market structure, municipal market reform, accounting and auditing, and fiduciary duty.

On some of the broader policy questions, the OIA:

  • approved of the SEC’s current approach to ICOs, including its emphasis on the responsibilities of gatekeepers and others under securities laws;
  • encouraged FINRA to publicize the “data sets, models, and rankings” it uses to evaluate broker risk to help retail investors;
  • urged the SEC to prioritize reforming “outdated transfer agent regulations”; and
  • supported the continuing publication of investor education materials regarding the use of margin debt, although the OIA did not recommend any immediate regulatory changes.

Investor Advocate Rick A. Fleming recounted specific steps the OIA took to address investor concerns. The OIA:

  • requested additional research on the impact of proposed amendments to modernize public company reporting requirements;
  • collaborated with SEC staff and several SROs to “encourage equity market structure reforms designed to enhance market resilience, efficiency, transparency, and fairness”;
  • reviewed rulemaking proposals to reform the regulation of the fixed income markets and municipal securities markets;
  • supported the SEC’s proposed amendments concerning enhanced municipal securities disclosure under Exchange Act Rule 15c2-12;
  • provided feedback in response to MSRB’s draft amendments to rules on primary offering practices;
  • continued monitoring accounting and auditing standard setters:
  • urged the FASB to return to its earlier proposal for harmonizing its definition of materiality with “the courts, the SEC, and the PCAOB” due to investor concerns;
  • encouraged the SEC’s attention to problems regarding non-GAAP financial measures;
  • monitored developments with respect to auditor attention requirements;
  • sought internal and external feedback on accounting and auditing issues;
  • assisted the SEC in researching how proposed Regulation Best Interest would affect investors; and
  • submitted a comment supporting FINRA’s proposal to amend Rule 2111.

Mr. Fleming also stated that budgetary constraints affected some 2018 initiatives, including the agency’s failure to “build out” the Ombudsman role and certain research functions.

Crisis Detection and Prevention

I discuss crisis detection and prevention based on experiences chairing an inter-agency crisis prevention group (while at the U.S. Treasury), working as a strategist on Wall Street, and advising a global macro hedge fund. The paper was published as a chapter in “The 10 Years After” the financial crisis volume published by the Reinventing Bretton Woods Committee.

My views differ from many recently offered.

I conclude with eight actionable ideas to improve crisis detection for investors and officials.

For full remarks:
www.CenterforFinancialStability.org/research/10YearsAfter_Goodman_Chapter.pdf

CFTC Commissioner Quintenz Supports Revised Cross-Border Swaps Framework

CFTC Commissioner Brian Quintenz expressed support for an approach toward substituted compliance determinations that distinguishes between the rules designed to address systemic risk reforms and those designed to address market activities. The approach is consistent with an alternative cross-border swaps framework espoused by CFTC Chair J. Christopher Giancarlo in a recent white paper.

In remarks at FIA Asia 2018, Mr. Quintenz disagreed with recent criticism of the white paper by CFTC Commissioner Rostin Behnam. Mr. Behnam argued that Mr. Giancarlo should have expressed his views through formal, statutory procedures, as opposed to a white paper. Mr. Quintenz stated that the majority of CFTC Commissioners will “find a consensus on restructuring the agency’s cross-border approach in the coming months.”

Among other things, Mr. Quintenz supports:

  • an approach toward substituted compliance determinations that distinguishes between the rules designed to address systemic risk reforms and those designed to address market activities;
  • expanding the use of exemptive authority for non-U.S. central counterparties (“CCPs”) that do not pose risks to the U.S. financial system, while CCPs posing a risk to the U.S. financial system should continue to be registered with the CFTC;
  • the proposition that swaps trading venues subject to comparable regulation abroad should be exempt from swap execution facility (“SEF”) registration with the CFTC;
  • the proposition that U.S. persons should be permitted to access non-U.S. platforms in non-comparable jurisdictions without SEF registration “subject to materiality threshold”; and
  • Mr. Giancarlo’s approach to which transactions count for purposes of the swap dealer thresholds, noting in particular that “foreign consolidated subsidiaries” need only count their dealing activity with U.S. and U.S.-guaranteed persons (rather than all transactions).

Mr. Quintenz also considered “arranged, negotiated and executed” (“ANE”) transactions. Mr. Quintenz said that it is a “credible proposition” that involvement of U.S. personnel in a trade should implicate some U.S.-based regulations. He urged the CFTC to consider whether its supervisory interest in a trade outweighs that of a non-U.S. regulator who has oversight of the counterparties. Mr. Quintenz advocated an ANE standard that focuses on client-facing sales and trading activity, rather than “incidental activity by U.S. personnel.” He also said that any ANE standard must provide market participants with clarity with respect to which regulations will apply to swap transactions from the outset.

Lofchie Comment: While it would be a wonderful thing if the SEC and the CFTC could reach full agreement on a (sensible) cross-border regulatory approach, there are a few issues on which such agreement is particularly important to decreasing regulatory complexity: the definition of U.S. (non-U.S.) person; the situations in which the involvement of a U.S. agent in ANE for a foreign dealer results in the imposition of U.S. legal requirements; and just what U.S. legal requirements are imposed as a result of the U.S. agent’s involvement.

SEC to Examine Operations of Certain Mutual and Exchange-Traded Funds

In a Risk Alert, the SEC Office of Compliance Inspections and Examinations (“OCIE”) provided information on a series of examination initiatives being conducted on industry practices and regulatory compliance of mutual funds and exchange-traded funds (“ETFs”) (collectively, the “funds”). The OCIE is interested in how the operation of these funds may impact retail investors.

The OCIE said it is investigating the following funds and advisers:

  • index funds that track custom-built indexes;
  • smaller ETFs and/or ETFs with little secondary market trading volume;
  • mutual funds with higher allocations to certain securitized assets;
  • funds with aberrational underperformance relative to their peer groups;
  • advisers who are relatively new to managing mutual funds; and
  • advisers who provide advice both to mutual funds and to private funds that (i) have similar strategies or (ii) are managed by the same portfolio managers.

The OCIE stated that it is evaluating whether the advisers’ and funds’ policies and procedures are designed to address risk and conflicts. The OCIE said it will examine disclosures and how the funds assess portfolio management compliance, and fund governance.

Lofchie Comment: It should be expected that the SEC will look closely at any situation where a public fund underperformed a private fund or managed account with a generally similar strategy. Any adviser who is managing clients that fit that description should carefully consider the reasons for the difference in performance.