Category Archives: Bank Capital & Liquidity Rules

Bank Capital & Liquidity Rules

SEC Chair White Highlights Regulatory Initiatives for Investment Companies

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SEC Chair Mary Jo White outlined new agency initiatives in investment company regulation. She delivered her remarks before the 2016 General Membership of the Investment Company Institute.

As to contemporary asset management initiatives, Chair White identified the following as the most significant areas for regulation: conflicts of interest, registration, reporting and disclosure, portfolio composition and operational risks. Chair White highlighted the recent rulemakings on liquidity and derivatives as examples of the SEC’s new focus.

Chair White stated that the Division of Investment Management is reviewing fund disclosure effectiveness, and the SEC staff is undertaking further review of exchange-traded funds. While emphasizing technology risks, the use of service providers and the importance of accurate portfolio pricing, Chair White encouraged funds to focus on valuation, performance advertising and issues that may arise when funds make payments to intermediaries for the distribution of fund shares.

Lofchie Comment: The SEC’s proposals regarding liquidity and derivatives have been subject to significant negative reaction. The common theme from both industry and academic critics is that these proposals are economically simplistic and only appear to reduce risk. This may work for the economically unsophisticated (e.g., those who believe that all derivatives are inherently risk-creating), but in reality, those fearful of derivatives would increase risk by discouraging the use of hedging techniques that employ derivatives.

Chair White acknowledged that the SEC received critical feedback on both proposals. Regarding the derivatives proposal, she stated: “many commenters, however, are not in favor of the proposal’s portfolio limitations and some have provided a range of suggested modifications and alternatives.” Concerning the liquidity proposal, she noted: “many [commenters] expressed concerns about the liquidity classification framework and operational challenges for swing pricing.” It remains to be seen how, or even whether, the SEC will respond to these important criticisms.

 

OCC Provides Guidance on Revised SEC Money Market Fund Rules

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The Office of the Comptroller of the Currency (“OCC”) provided guidance to national banks and federal savings associations on the 2014 SEC revised money market fund (“MMF”) rules. The guidance (i) describes how the SEC’s MMF rules will likely affect banks, (ii) addresses product and process changes that affected banks should consider, and (iii) highlights potential compliance, liquidity, operational and strategic risks. The guidance emphasized that while the SEC’s MMF rules do not directly apply to banks, they do have many implications for the way banks conduct their business. For example, some banks will now need to be able to report and process transactions to four decimal places due to the possibility that an MMF’s NAV will float.

Lofchie Comment: Just like banks, broker-dealers should also review their treatment of MMFs that have a floating share value or that otherwise do not behave in the same manner as “traditional” MMFs. For example, one question that firms must consider is whether or not a share in a floating value MMF should be treated as a cash-equivalent for margin purposes.

Treasury and SEC Collaborate on Tracking of Cash Market Transactions

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The U.S. Department of the Treasury (“Treasury”) and the SEC announced a joint collaboration to build an efficient and effective structure that will track transactions in the Treasury cash market. As part of this effort, the agencies “requested that [FINRA] consider a proposal” to require member firms to report Treasury cash market transactions to a centralized repository.

Treasury asserted that public responses to previous requests for information on the most effective means for obtaining official sector access to cash market data demonstrated “broad support” for more comprehensive reporting to regulators.

Lofchie Comment: Assuming that FINRA “considers a proposal,” one wonders whether the Treasury and SEC will be able to make use of the information collected. After all, it is increasingly evident that part of the reason for increased volatility in the market is not the result of “bad” behavior, but rather from diminished liquidity resulting in part from increased regulatory and capital costs. Anyone attempting to argue that the costs exceed the benefits of such a central information collecting scheme should understand the intellectual bias at the regulatory agencies against concluding that increased regulation may have negative results.

NY Federal Reserve Bank President Cites Progress in Cross-Border Regulation

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Federal Reserve Bank of New York President and CEO William C. Dudley voiced optimism about the “substantial progress” made in “strengthening the global banking system.” He cited the establishment of capital and liquidity standards for internationally active banks as an example. In addition, he noted that “steps have been taken” to respond to the failure of systemically important financial firms on a cross-border basis.

Even so, Mr. Dudley asserted, “more needs to be done.” His recommendations include: (i) identifying and dismantling the impediments to orderly cross-border resolutions, and (ii) enhancing cross-border regulatory cooperation through the “greater exchange of confidential supervisory information so that national regulators can be fully informed about the conditions of the banks that operate within their borders.”

Mr. Dudley asked the following questions, which he said were raised by the idea of a convergent transcontinental economy:

  • Can policy strategies ensure that the global economy will escape from this long period of low inflation and real interest rates? If so, what are those strategies?
  • Does fiscal policy have sufficient scope to assume part of the burden of ending this period of persistently low inflation and interest rates?
  • Is the economy going through a period of secular stagnation or is it simply at the midpoint of a deleveraging process that will dissipate gradually?
  • Why hasn’t investment spending reflected the low level of interest rates?
  • What underlying factors have contributed to the recent slowdown in the growth of global productivity?
  • Is it possible for Europe to realize a banking union with a common deposit guarantee scheme?
  • Are there practical opportunities for furthering additional regulatory and supervisory convergence between the United States and Europe?

Mr. Dudley delivered his remarks at a conference hosted by the European Commission, the Federal Reserve Bank of New York and the Centre for Economic Policy Research: “Transatlantic Economy: Convergence or Divergence?”

Lofchie Comment: Since Mr. Dudley is pondering the lack of growth in investment spending and whether the economy is going through a period of secular stagnation, the ideal question for him to ask might be this: are there regulations that are materially damaging to economic growth? New rules have imposed billions of dollars’ worth of compliance and transactional costs. Many of those rules are not particularly sensible and a fair number are actually destructive. The time for regulators to exercise self-criticism is long past due. Unfortunately, too many seem to believe that economic growth can be achieved only by adding more regulations, without first conducting a meaningful analysis of which rules might work, which rules might fail, and which are not worth the costs their implementation would demand.

House Financial Services Committee Splits along Party Lines, Approves Amendments to Dodd-Frank

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The House Financial Services Committee approved two amendments to the Dodd-Frank Act that would (i) bring the CFPB within the ordinary Congressional appropriations process and (ii) eliminate the “orderly liquidation authority.” The vote was partisan with all Republicans voting in favor of the amendments and all Democrats voting against.

The amendments were as follows:

  • H.R. 1486, The Taking Account of Bureaucrats’ Spending Act (33-20). The bill would repeal the current independent funding of the CFPB and instead subject it to the annual Congressional appropriations process.
  • H.R. 4894, To Repeal Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (34-22). The bill would repeal the Orderly Liquidation Authority (“OLA”) in Title II of the Dodd-Frank Act, which authorizes the resolution of a financial institution the failure of which otherwise would threaten the financial stability of the U.S. economy.

Lofchie Comment: There is no justification for setting the CFPB’s budget outside of congressional processes. As the Republican’s press release notes, the Pentagon and the Justice Department have their budgets approved by Congress. Is the CFPB more important than those agencies? Even if one believes that protecting consumers from banks is more important morally than protecting citizens from enemies, what does that say about the Environmental Protection Agency and the Department of Health and Human Services? Why are they subject to a budget process from which the CFPB is exempt?

Conversely, while there are reasons to disapprove of the Orderly Liquidation Authority, the notion that the Federal Reserve should allow every major financial institution to fail during some future liquidity squeeze is not one of them. During the kind of real-life liquidity squeeze that we’ve endured in the past, it is not merely the “big banks” that collapse; it is also the entire financial system. Had the Federal Reserve Board not supplied liquidity to the system during the last crisis, numerous banks and money market funds would have failed, which in turn would have wiped out the savings of millions of investors.

Federal Reserve Bank President Evaluates Federal Reserve Board Actions Post-Crisis

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President of the Federal Reserve Bank of New York William Dudley praised the Federal Reserve Board for providing support to firms during the financial crisis and criticized efforts either to make the Board’s monetary policy more formulaic or to subject the Board to greater political control. At the Annual Meeting of the Virginia Association of Economists, President Dudley emphasized historical lessons and that the United States should maintain a strong central bank “insulated from short-term political pressures in [its] conduct of monetary policy.”

Drawing conclusions from the 2008 crisis, President Dudley asserted that:

  • The regulatory community did not fully grasp the vulnerability of the financial system. Accordingly, the Federal Reserve took actions to: (i) raise capital and liquidity requirements, (ii) put banks through annual stress tests, (iii) establish the Large Institution Supervision Coordination Committee to evaluate large firms, and (iv) set up the Office of Financial Stability.
  • The financial system needs to explain its actions with greater transparency. To increase transparency, Mr. Dudley stated, the Federal Reserve now (i) issues statements after each Federal Open Market Committee meeting, and (ii) holds a press conference four times per year to explain the Committee’s releases and its economic projections.
  • Some large financial institutions had become too-big-to-fail. Title II of the Dodd-Frank Act presently establishes a process to ensure that any financial firm can be resolved without threatening the viability of the financial system and without putting taxpayer funds at risk.

Lofchie Comment: President Dudley asserts that when the Board extended credit in the financial crisis, “it intervened to prevent the failure of several systemically important institutions, including firms it did not supervise – namely Bear Stearns and AIG.” The gist of Mr. Dudley’s remarks seems to be: if the Board made any mistakes leading to the crisis, it was not realizing that others would screw up. Wouldn’t it have been fairer to say that if the Board had not existed as a lender of last resort, the entire financial system might have collapsed, including institutions that were supervised by the Board? Isn’t it the case that a large number of banks would have failed without access to the Fed’s Discount Window?

There is no disagreement with the fact that the Board did step in as a lender of last resort. But there is an inconsistency between simultaneously claiming the need to learn from mistakes and the claim to have succeeded brilliantly. According to Mr. Dudley, whatever mistakes the Board might have made leading up to the financial crisis, without the Board’s wise conduct since that event, “the recovery would have been slower, the unemployment rate would have been higher, and there would have been a greater risk of deflation.” To those who worry that the Board’s policies have unduly distorted market forces, Mr. Dudley “simply responds” that “monetary policy always affects financial markets.” Shouldn’t a response be a little less simple? Like by how much and for how long

Today’s WSJ: ‘Focusing on Bank Size, Missing the Real Problem’…

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Today, The Wall Street Journal published an op-ed titled “Focusing on Bank Size, Missing the Real Problem.”

CFS Board Member and former Treasury Under Secretary Randal Quarles and I note how:

The new president of the Minneapolis Federal Reserve Bank, Neel Kashkari, along with Bernie Sanders, Elizabeth Warren, and Sherrod Brown believe that breaking up “too big to fail” institutions or turning them into regulated utilities is the only way the country can be confident that the 2008 bailouts won’t be repeated.

This proposal is misguided.

We offer three solutions:

– Facilitate orderly liquidation of failing or failed banks.
– Adopt a monetary policy rule to reduce the incentive for banks to take dangerous risks.
– Fully measure and evaluate the impact of Dodd-Frank before arbitrarily taking an ax to big banks and irreparably damaging the economy.

View the full article.

Crisis Detection: Implications for Investors and Officials…

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At the Boston Economic Club, I discussed crisis detection and prevention based on experiences chairing an inter-agency crisis prevention group — while at the U.S. Treasury — and working as a strategist on Wall Street.

I concluded with eight actionable ideas to improve crises detection for investors and officials.

For full remarks:
http://centerforfinancialstability.org/speeches/Boston_032316.pdf

NY Fed President Highlights Supervisory Objectives for Complex Financial Institutions

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New York Federal Reserve Bank President William Dudley described the current state of supervision over large, complex financial institutions. At a conference of regulators on the subject, President Dudley stated that supervision of large financial institutions is guided by two key objectives: (1) enhancing the resiliency of a firm to lower the probability of its failure and (2) reducing the impact on the financial system in the event of failure or material weakness. He asserted that because “[t]he activities and practices at large, complex financial organizations are simply too intricate and evolve too quickly to be fully described ex ante in regulation,” banking supervisors collect information through examinations and analysis, and “the ultimate responsibility for risk identification and risk management remains with the supervised institution.”

President Dudley stated that the Federal Reserve instituted three major horizontal evaluations which are a key part of the new enhanced supervisory framework for large banking companies: (i) the Comprehensive Capital Analysis and Review, which applies to firms with at least $50 billion in total assets and assesses capital adequacy, (ii) the Comprehensive Liquidity Analysis and Review, which examines the liquidity positions and liquidity risk management of large, complex banking organizations, including internal stress-testing practices, and (iii) the Supervisory Assessment of Recovery and Resolution Preparedness which provides an annual evaluation of the firms’ options to support recovery and progress in removing impediments to orderly resolution. President Dudley posed the following question regarding the supervision effectiveness: “If a bank fails, is this evidence of poor supervision, or instead evidence that even good supervision can’t prevent all bank failures? Improving our ability to do this diagnosis is critical.”

In a panel discussion on defining the objectives of supervision, FDIC Vice Chair Thomas Hoenig asserted that (i) big banks should be subject to a more detailed examination process, (ii) banks should provide a fuller disclosure of any financial difficulties that they may be having to the public “at an earlier stage,” (iii) bank capital requirements should be higher, and (iv) capital adequacy should be based on tangible equity rather than on risk-based capital.  He also stressed the importance of bank regulators not backing down to industry pressures, citing the example of when regulators questioned the viability of commercial real estate leading up to the 2008 crisis, but succumbed to industry pressures.

Lofchie Comment: Taken together, these speeches seem to be calling for regulatory supervisors to have greater authority with less responsibility. It is a call for greater power yet an attempt to pre-avoid blame in the event of market failure since “the ultimate responsibility for risk identification and risk management remains with the supervised institution.” It is easy to be left with the impression that the regulators are not inclined toward self-criticism. In this regard, the worst that Mr. Hoenig can find to say about the bank regulators is that they were insufficiently confident of their own correctness as to the state of the commercial real estate market in 2006 and 2007. Perhaps, then, a good challenge for Mr. Hoenig would be to go back and look at the predictions of bank regulators over the last twenty or thirty years, and to see how well they have fared. Maybe it will turn out that the bank regulators are routinely smarter than the markets, but maybe it won’t. To be cynical, predicting that many things may go badly, and, sometimes, being correct, does not require any remarkable skills (lawyers are in fact quite good at that).

SEC Chair White Embraces Regulatory Initiatives beyond Disclosure

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Chair Mary Jo White reviewed SEC progress on a number of prominent initiatives relating to: (i) asset management, (ii) equity markets structure, and (iii) SEC disclosure regimes. In remarks made at the annual “SEC Speaks” conference, Chair White stated that the SEC is “not only” a disclosure agency, and that SEC proposals reflect “careful consideration” of tools beyond disclosure. She said that complexity of products, changes in market participant behavior, pervasive network technology and systemic risks “call for additional protections.”

Regarding asset management, Chair White pointed to (i) a proposal to enhance reporting for investment advisers and mutual funds to improve the quality of information for investors; (ii) a proposal requiring that funds monitor and manage derivatives-related risks and provide limits on their use; and (iii) proposed reforms designed to promote stronger and more effective liquidity risk management across open-end funds and limit the adverse effects that liquidity risk can have on investors and potentially the broader markets. She stated that finalizing these rules will be 2016 priorities.

Regarding equity market structure, the Chair commented that the SEC proposed two rules to enhance the SEC supervision of markets: (i) a proposal to broaden the oversight of active proprietary trades, including high-frequency traders; and (ii) the first-ever major update to the regulations for alternative trading systems. Chair White noted that the SEC issued an advance notice of proposed rulemaking on transfer agents. She said that the SEC will look to finalize these proposals this year, as well as to advance order routing disclosures and trading algorithm risk controls.

Concerning disclosure effectiveness, Chair White said that the SEC will address the form and content of financial statements by entities other than Regulation S-X registrants.

Beyond the three core areas, Chair White discussed: (i) shortening the settlement cycle from T+3 to T+2 to reduce potential systemic risk; (ii) enhancing filings through the expanded use of structured data; (iii) finalizing rules updating the intrastate offering exemption; (iv) considering recommendations for a universal proxy; and (v) examining final rules for resource extraction.

Lofchie Comment: Chair White recognizes that the SEC imposes requirements that go beyond disclosure and makes a fair point that the SEC needs more tools. That said, it is important to question both the work that the SEC has done with the tools that it has, and who actually benefits from use of these tools. As to the SEC’s proposed requirements regarding risk management, these proposals have been sharply criticized by the Investment Company Institute as increasing risk for investors. As to the rules regarding resource extraction, it would be hard to make any serious argument that they can, in any way, really benefit investors.