Category Archives: Bank Capital & Liquidity Rules

Bank Capital & Liquidity Rules

OFR Says “Brexit” Could Pose Risk to U.S. Financial Stability

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The Office of Financial Research (“OFR”) asserted that “severe adverse outcomes in the U.K. from ‘Brexit’ could pose a risk to U.S. financial stability.”

In its biannual report, titled the Financial Stability Monitor, OFR provided the results of an assessment that focused on “vulnerabilities – weaknesses in the financial system that can originate, amplify or transmit shocks, potentially destabilizing the system.” The report was organized into five risk categories: macroeconomic, market, credit, funding and liquidity, and contagion.

The report found that risks to financial stability have stayed within the medium range, but also have risen as a result of the U.K. withdrawal referendum. The report specified that “Brexit” could pose moderate risks to the financial stability of the United States:

  • Trade: Although a recession in the United Kingdom or countries in the European Union would reduce the demand for U.S. exports, it is unlikely that the reduction would threaten U.S. financial stability due to the low percentage of U.S. exports to the European Union and vice versa. However, a reduction in exports could slow U.S. growth moderately.
  • Financial Exposures: The financial claims of the United States on the United Kingdom and, more broadly, the European Union could be vulnerable to losses due to (i) currency depreciations and volatility, (ii) declines in asset market prices, and (iii) increased defaults on debt claims.
  • Confidence and Indirect Effects: Financial instability in the United Kingdom or, more broadly, the European Union could do lasting damage to the confidence of global investors, and that damage could become “self-perpetuating.” Additionally, “U.S. long-term interest rates reached historic lows in the week after the [“Brexit”] referendum,” which in turn “underpin[ned] excesses in investor risk-taking.”
  • Funding and Liquidity Risks: Although “[k]ey funding risks are much lower than before the financial crisis due to major changes in short-term funding markets,” several vulnerabilities still persist. These include risks in certain money market funds and short-term investment vehicles, and sharp falls in market liquidity during certain moderate stress events.
  • Contagion Risks: “[C]ontagion risk is greater than available metrics indicate. . . . It is unlikely that the contagion risks disappeared as stress receded. It is more plausible that underlying factors – such as risky assets’ tendency to become more correlated during market stress – pose enduring contagion risks.”

The report stated:

Because the U.K. economy and especially the U.K. financial system are highly connected with the rest of Europe and the United States, severe adverse outcomes in the U.K. could pose a risk to U.S. financial stability.

 

Lofchie Comment: The value of these government reports is questionable. Statements in the OFR report like: “severe adverse outcomes in the U.K. could pose a risk to U.S. financial stability,” are trivial given the current economic environment, and they offer no useful insight for market participants. More remarkable, however, was the failure of the Financial Stability Oversight Council (“FSOC”) to identify “Brexit” as a risk in its own annual report, produced just before the “Brexit” vote. The OFR’s biannual report and FSOC’s annual report raise necessary but basic questions: (1) are these agencies particularly skilled at identifying risks before the fact, and (2) do they have anything useful to say about risks after the fact?

ICI Calls on FSOC to Reconsider Position on Financial Stability Risk and Mutual Funds

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The Investment Company Institute (“ICI”), a global association of regulated funds, urged the Financial Stability Oversight Committee (“FSOC”) to reconsider the conclusion that liquidity and redemptions in mutual funds carry significant financial stability risks. The ICI was responding to an FSOC public update of a two-year review of asset management products and activities.

The ICI contended that although it recognizes the need for enhanced liquidity management for mutual funds, the FSOC provided “no basis . . . for its conclusion that there are financial stability concerns that may arise from liquidity and redemption risks in mutual funds, particularly funds investing in less liquid asset classes.” The ICI made the following assertions:

  • the FSOC’s concern that a “first mover” advantage in pooled investment vehicles may be attributed to either the mutualization of trading costs or funds selling their most liquid assets first to meet redemptions is unfounded and ignores data gathered in response to this very question by the ICI in December 2014;
  • the FSOC failed to substantiate concerns about destabilizing redemptions from mutual funds, which ignore the “modest net outflows from mutual funds in the aggregate, even during times of severe market stress”; and
  • the FSOC misconstrued the lessons to be learned from funds investing in less liquid assets (i.e., the Third Avenue Focused Credit Fund) despite the New York Federal Reserve’s economic modeling that suggests that “even extremely large outflows from high-yield bond funds – which assumed outflows far greater than ever seen in history – are simply too small to pose systemic risks.”

Lofchie Comment: The FSOC has shown a continuing interest in risks that relate to mutual funds and investment advisers, two areas that are not under the control of the banking regulators who dominate the FSOC. Meanwhile, the FSOC largely has ignored risks that seem far greater than, for example, the risks associated with government pension plans. Would it not be more prudent for the FSOC to address the unrealistically high levels of projected returns that these plans promise, along with the billions of dollars of long-term obligations they add, particularly given that governmental pension plans typically underestimate the life span of plan recipients? The FSOC should focus on risks that, despite being politically more difficult to confront, are greater in significance and certainty.

Why CFS Divisia Money Matters, Now!

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My remarks at the Society for Economic Measurement illustrate how the world may have been different had CFS Divisia money been on the Fed’s dashboard.

Even today, CFS Divisia M4 suggests that growth may be better than expected.

Takeaways for investors and officials from our experience producing monetary aggregates and measuring money in the U.S. since 2012 include: 1) private sector versus state money, 2) deflation and inflation scares, 3) a damaged monetary transmission mechanism, 4) collapse in shadow banking, 5) shortage of financial market liquidity, and 6) ideas for the future.

Whether you are a Keynesian, Monetarist, or simply agnostic, monetary and financial measurement and its integration into policy is essential for the future.

For full remarks:
http://centerforfinancialstability.org/research/why_cfs_divisia_071316.pdf

MRAC Reviews Agency Coordination in a CCP or Bank Resolution

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The CFTC Market Risk Advisory Committee (“MRAC”) examined (i) the Central Counterparty (“CCP”) Risk Management Subcommittee’s draft recommendations for the ways in which CCPs can coordinate their efforts when preparing for the default of a significant clearing member, and (ii) the roles the FDIC and the CFTC play in the resolution of banks and central counterparties.

At an open hearing, FDIC and CFTC staff presented a number of topics including: (i) the Title II Process under the Dodd-Frank Act, (ii) special accountability for the company management of global systemically important banks, (iii) access to the orderly liquidation fund, (iv) international engagement, and (v) derivatives clearing organization (“DCO”) resolution.

CFTC Commissioner Sharon Bowen expressed support for CCP coordination in general terms, “since it is highly likely that the default of a significant clearing member would occur in an environment where multiple CCPs and clearing members are affected.” She encouraged the FDIC, as the resolution authority for CCPs, and the CFTC, as the primary regulator for CCPs, to communicate and coordinate efforts.

CFTC Chair Timothy Massad emphasized the CFTC’s leadership in promoting cooperation and coordination.

It has been a priority of mine since taking office, and it is also a priority of regulators around the world, as evidenced by the agreement between U.S. and international regulators last year, to implement a four-part workplan to examine clearinghouse resiliency standards, recovery and resolution planning, and interdependencies among clearinghouses and clearing members. I am pleased that the CFTC is leading much of this work.

 

Lofchie Comment: The need for so-called coordination between CCPs evidences one of the negative consequences of both Dodd-Frank and mandatory clearing: materially increased interconnected risk through clearing members. Dodd-Frank (and similar legislation throughout the world) has resulted in fewer clearing counterparties, and these remaining counterparties, which now are smaller in number and larger in size, are each more connected with the other counterparties through the increased mandatory use of clearing corporations. Even as regulators talk about reducing interconnectedness, the implementation of burdensome regulatory policies drives mid-sized firms away from certain activities. That, combined with government-mandated linkages through clearing corporations, likely increases interconnectedness, perhaps to a material extent.

Questions about interconnected risk are worth considering. Answers might demonstrate that the results of coordination are themselves questionable. Even assuming that the regulations are moving markets in the right direction (and that is an assumption), the specifics of coordination demonstrate that not all of the results are good. At best, they’re mixed.

FRB Reviews the 2016 Dodd-Frank Act Supervisory Stress Test Results

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The Board of Governors of the Federal Reserve System (“FRB”) reviewed the results of their 2016 supervisory stress tests and determined that “the nation’s largest bank holding companies continue to build their capital levels and improve their credit quality, strengthening their ability to lend to households and businesses during a severe recession.” The supervisory stress tests are one component of the Comprehensive Capital Analysis and Review (“CCAR”), an annual exercise to evaluate the capital planning processes and capital adequacy of large bank holding companies (“BHCs”).

The 2016 Dodd-Frank Act stress test cycle (“DFAST 2016”) began January 1, 2016, and projected the performance of 33 BHCs in three scenarios over nine quarters (baseline, adverse, and severely adverse). The FRB stated that the results of the DFAST 2016 projections “suggest that, in the aggregate, the 33 BHCs would experience substantial losses under both the adverse and the severely adverse scenarios.” Through nine quarters of the planning horizon, the aggregate losses under the “severely adverse scenario are projected to be $526 billion.” These projected losses include:

  • $385 billion in accrual loan portfolio losses;
  • $11 billion in OTTI and other realized securities losses;
  • $113 billion in trading and/or counterparty losses at the eight BHCs with substantial trading, processing, or custodial operations; and
  • $17 billion in additional losses from items such as loans booked under the fair-value option.

Compared to last year’s severely adverse test scenario, firms that are active in trading and market activities saw smaller losses in net income as a result of less severe stress in the equity markets, but firms more focused on traditional lending activities were more affected by negative short-term interest rates and greater stress in the real economy. The FRB explained that the year-over-year changes in supervisory stress test results reflect several factors: (i) changes in BHCs’ starting capital positions; (ii) portfolio composition and risk characteristics; (iii) changing hypothetical scenarios; and (iv) model changes.

The FRB noted that the 2015 severely adverse scenario “assumed that corporate credit quality worsened even more than what would be expected in a severe recession,” which “amplified the widening of corporate bond spreads, decline in equity prices, and increase in equity price volatility.” By comparison, the 2016 severely adverse scenario “includes a more severe recession than last year’s scenario and also features negative short-term interest rates, which moderates the decline in equity prices and increases in market volatility relative to last year.”

The FRB highlighted that the Federal Reserve made “notable changes” in three models used for this year’s supervisory stress tests, namely: (i) the operational risk model; (ii) the market risk-weighted assets model; and (iii) the capital calculation model. The FRB observed that these changes had “moderate effects on the aggregate results but had varied effects on individual firms.”

FSOC Approves 2016 Annual Report

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The Financial Stability Oversight Council (“FSOC”) approved unanimously its 2016 Annual Report containing recommendations on central counterparties (“CCPs”), cybersecurity and market structure. In open and executive sessions, the FSOC reviewed (i) updates on market developments, (ii) the Federal Reserve’s proposed rulemaking applying to certain insurance companies, and (iii) the annual reevaluation of the designation of non-bank financial companies.

The 2016 Annual Report offered the following recommendations:

  • Cybersecurity. Financial regulators should “strongly support” efforts to implement the Cybersecurity Act of 2015 in order to establish a “robust legal framework for sharing cyber-related information.” Regulators must maintain a “common risk-based approach to assess cybersecurity and resilience,” and develop “robust sector-wide plans” for responding to significant cybersecurity incidents.
  • Liquidity and Redemption Risks. Regulators should consider implementing the following measures:
    • robust liquidity risk management practices for mutual funds, particularly with regard to preparations for stressed conditions by funds that invest in less liquid assets;
    • clear regulatory guidelines that address limits on a mutual fund’s ability to hold assets with very limited liquidity in order to prevent holdings of potentially illiquid assets from interfering with a fund’s ability to make orderly redemptions;
    • enhanced reporting and disclosures by mutual funds of their liquidity profiles and liquidity risk management practices;
    • taking steps that would allow and facilitate mutual funds’ use of tools to allocate redemption costs more directly to investors who redeem shares;
    • additional public disclosure and analysis of the external sources of financing, such as lines of credit and interfund lending, as well as events that trigger the use of external financing; and
    • measures to mitigate liquidity and redemption risks that are applicable to collective investment funds and similar pooled investment vehicles offering daily redemptions.
  • Capital Liquidity and Resolution. Regulatory agencies should review the resolution plans of large, complex bank holding companies closely in order to promote resolvability under the U.S. Bankruptcy Code and ISDA’s 2015 Universal Resolution Stay Protocol.
  • Central Counterparties. The Federal Reserve, the CFTC and the SEC should continue to coordinate and examine ways to improve the supervision of all CCPs that are designated as systemically important financial market utilities.
  • Wholesale Funding Market Reforms. Regulators must monitor general collateral finance repo transactions and assess the risks that could be posed by cash management vehicles that are not money market funds.
  • Data Quality, Collection and Sharing. Regulators should (i) develop permanent data collection programs, (ii) adopt the legal entity identifier, where appropriate, and (iii) harmonize the reporting of derivatives data.
  • Financial Stability. Regulators should expand a recent Treasury Request for Information by examining the regulatory treatment of products that have “highly correlated underlying risk drivers.” In addition, they should utilize coordinated tools, such as “trading halts,” and enhance data and information sharing among member agencies.
  • Financial Innovation. Regulators should actively monitor and evaluate the risks posed by technological advances in practices and products, such as marketplace lending and distributed ledger systems, both of which “appear poised for substantial near-term growth.”

FSOC also noted that a federal court rescinded its designation of a non-bank financial company for Federal Reserve supervision and prudential standards. The government is appealing the court’s decision and stated:

[FSOC]’s authority to designate nonbank financial companies remains a critical tool to address potential threats to financial stability, and [FSOC] will continue to defend vigorously the nonbank designations process.

 

Lofchie Comment: While the FSOC Report provides good general background on the state of various types of financial institutions; e.g., broker-dealers, credit companies and banks, as well as an overview of regulatory developments, it seems to be at least as much a political document as an analytic one. Very little is said regarding the reasons why FSOC’s designation of an insurance company as “systemically important” was rejected by the court, or of the criticisms of the SEC’s proposed rules with respect to leverage at investment companies or even the reasons why the economic data regarding hedge funds is poor (Form PF is useless). Likewise, to the extent that risks seemingly have been created by regulatory policy, those risks are glossed over; e.g., discussions of clearing house risks are focused on claimed improvements, rather than questioning the limits of the concept. It is clear that FSOC is concerned with the risk of securities lending activities, but risks that seem far greater, such as the low funding of municipal pension plans, are given relatively short shrift. With respect to the pension plans, FSOC did note that the levels of underfunding are significantly greater than the official numbers because the plans are allowed to use extremely optimistic projections of their future revenues. FSOC made no attempt to further describe or quantify the extent of the underfunding or of the over-optimism. In short, it is not unreasonable to conclude that the political nature of the annual report is influenced by the FSOC’s political and structural makeup.

FDIC Chair Gruenberg Asserts that Post-Crisis Reforms Strengthen the Financial System

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FDIC Chair Martin J. Gruenberg asserted that despite the challenging economic environment for U.S. banks, relevant data suggests that post-crisis reforms have made the financial system more resilient and stable while strengthening the ability of banking organizations to serve the U.S. economy. Mr. Gruenberg discussed four broad areas that reflect the ability of banking organizations to serve the U.S. economy effectively:

Credit Availability

Mr. Gruenberg argued that despite post-crises reform, U.S. banks remain willing to lend. He noted growth in the mortgage and commercial loan sectors, stronger capital and better and more resilient lending practices.

Bank Profitability

Mr. Gruenberg emphasized that “despite significant headwinds” – particularly reductions in net interest margin – bank earnings have demonstrated a favorable trajectory generally. He asserted that this improvement reflects a return to profitable banking, but with improved capital levels that are better equipped to absorb losses compared to the levels in pre-crisis years.

Market Liquidity

Mr. Gruenberg stated that post-crisis market liquidity for bonds has improved according to “recent research.” He emphasized that:

  • effective prudential regulation should help promote sustainable liquidity conditions through time;
  • the reduction in the size of broker-dealer balance sheets in recent years might be the result of factors such as (i) the consolidated capital and liquidity of their parent banking organizations, (ii) the effective elimination of their access to intra-day credit from the clearing banks in the tri-party repo market, (iii) the risks of holding bonds, and (iv) lower bid-offer spreads, which make buying and selling bonds less profitable; and
  • “market-making” may not be retreating, but instead may be changing through “lower transaction costs, more frequent and smaller trades, and more trades conducted as agent or on order rather than as principal.”

Migration of Financial Activities to Nonbanks

Mr. Gruenberg expressed “the idea that the post-crisis reforms may be changing the distribution of financial activity between banks and nonbanks, in some way making banks less important financial players than before.”

Mr. Gruenberg delivered his remarks before the Exchequer Club.

Lofchie Comment: For other apparent “good news” from FDIC Chair Gruenberg, see, e.g., FDIC Chair Gruenberg Says Financial Industry Better Prepared to Address Economic Challenges; Regulators Tout Progress in Bank Regulation; FDIC Chair Cites Progress in Development of Orderly Liquidation Framework.

Mr. Gruenberg states accurately that some measures of liquidity have in fact steadied or improved. He is, no doubt, aware that some measures of liquidity look materially worse. The question of which measures of liquidity are “better” might be the subject of some debate, but what should not be debated is the reality that the numbers are mixed. Anyone who is interested in a more balanced discussion of issues such as liquidity might wish to consider this report, which presents an alternative view even though it was produced by a governmental entity: IOSCO Staff Report Examines Potential Risks and Key Trends in Global Financial Markets.

The more serious issue to consider is this: nearly all regulation, even good regulation, is a double-edged sword. Even if the thrust of the net effect is good, the back-slash of increased regulation can impose costs and may prevent even more transactions. Devising economic regulations should be like determining speed limits: good regulators should weigh the benefits of road safety against the cost of taking too long to get home. There is no perfect speed, nor is there any speed with benefits and no costs. Ideally, regulators should pay constant attention to this cost/benefit balance; ideally, they should elucidate this balancing process for regulated persons and observers. Any message that leaves the impression that regulation is all good all the time will leave the regulated feeling doubtful as they pedal their way to profit.

Future and History of Global Capital Markets

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CFS partner, Jack Malvey from BNY Mellon, created a wonderful guide to financial market history and factors driving change into the 21st Century.

We are grateful to Jack for allowing us to share his presentation with CFS friends.

Although we rarely distribute outside research, today, markets confront challenges of epic proportion. Simply put, a glance back at the last thirty years is insufficient.

Analytics, data, and an appreciation of history are in our DNA. Hence, CFS hosted “Bretton Woods: The Founders and the Future” with long-term takeaways for markets and economies. Similarly, Senior Fellow Kurt Schuler’s Historical Financial Statistics (HFS) database – with contributions from over 80 academics – is a treasure trove of information and a popular part of our website.

Most importantly, thanks again to Jack for sharing his outstanding work integrating the past with the future. It is no wonder that a recent Bloomberg story referenced him as “one of the most-respected figures in the bond market.”

Given the enormous scope of coverage, Jack would be grateful for any thoughtful commentary.

The full presentation is:
www.CenterforFinancialStability.org/research/Global_Capital_Market_History.pdf

Federal Reserve Solicits Comments on Capital Requirements for Insurance Companies

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The Board of Governors of the Federal Reserve System (“FRB”) solicited comments on an advanced notice of proposed rulemaking regarding regulatory capital requirements for insurance companies.

The FRB suggested using two frameworks for these requirements: the “consolidated” approach and the “building block” approach. The consolidated approach applies to nonbank financial companies that will be supervised by the FRB and cover significant insurance activities (“systemically important insurance companies”). The building block approach applies to depository institution holding companies that are engaged in insurance activities (“insurance depository institution holding companies”) but that also own banks or thrifts.

Governor Daniel K. Tarullo stated: “the dual approach proposed today is another example of our efforts to tailor capital regulation to the different risks posed by financial intermediaries of varying types and complexity.”

Comments on the proposal must be submitted by August 2, 2016.

Lofchie Comment: How will state insurance regulators respond to the federalization of insurance regulation – especially as to its effect on insurance companies that are not affiliated with banks?

Bank for International Settlements Examines Data on Liquidity Supply

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The Bank for International Settlements (“BIS”) examined data showing that proprietary traders tend to place marketable buy orders after price drops, and marketable sell orders after price increases. This behavior helps the market absorb liquidity shocks – even during a crisis – and results in profits for the traders. The findings, contained in a working paper, highlight several consequences to recent regulatory reforms.

The BIS determined that while adverse selection costs for non-immediately executed limit orders are lower for fast traders (relying on advanced technology) than they are for slow traders, only proprietary traders can afford to leave limit orders in the book without bearing losses. According to the BIS paper, this finding suggests that technology alone is inadequate to overcome adverse selection costs; proper monitoring incentives are also necessary.

The paper highlighted other consequences:

  • Markets in Financial Instruments Directive (“MiFID II”): The requirement that trading venues cap the ratio of the number of messages with the number of trades given by any participant “might be counterproductive” because fast proprietary traders rely on numerous cancellations and updates to reduce the adverse selection cost incurred by their limit orders. The adverse selection costs incurred by limit orders left in the book could be increased by capping the percentage of cancellations and updates and thus deter the provision of liquidity by these orders.
  • Numerous New Banking Regulations: By increasing the difficulty and expense for banks to engage in proprietary trading, these regulations also might reduce market liquidity.

The paper’s findings are based on the results of unique data from Euronext and the Autorité des Marchés Financiers (French “Financial Markets Regulator”).

Lofchie Comment: “By increasing the difficulty and expense for banks to engage in proprietary trading, these regulations might also reduce market liquidity.” In other words, through their well-intentioned attempts to make banks “safer,” the banking regulators very well may be causing the markets to become far more fragile; i.e., vulnerable to a sudden crash as soon as markets turn in a negative direction because no one will be willing to buy, and consequently banks will become even less “safe.”

The analogy that Craig Pirrong makes of building up a dike in one spot without regard to the strength of the system as a whole is very appropriate. The bank regulators have focused on demonstrating the safety of the central clearing corporations and on the capital levels of banks, but, arguably, they are doing so at the cost of the overall safety of the system as a whole. The very high capital charges imposed on banks are likely to motivate banks to sell off assets very quickly in a market downturn; and the ability of central clearing corporations to demand unlimited collateral from clearing intermediaries will allow them to quickly drain liquidity out of the system when markets become volatile.