Category Archives: Bank Capital & Liquidity Rules

Bank Capital & Liquidity Rules

Professor Warns That Central Clearing Creates Unacceptable Liquidity Risks

Posted on by

In a blog post titled “Creeping Recognition That Regulation Has Created a Liquidity Death Star,” University of Houston finance professor Craig Pirrong argued that clearing and collateral mandates transform credit risk into liquidity risk, which increases systemic risk. According to Professor Pirrong, (i) variation margining causes spikes in the demand for liquidity, “exacerbating the liquidity squeeze” in stressed market conditions, and (ii) clearing “creates tight coupling because failures – or even delays – in making variation margin payments can put the clearinghouse into default or force it to liquidate collateral in an illiquid market.”

In spite of this, Professor Pirrong said, awareness of the danger of spikes in liquidity demand right when liquidity supply evaporates remains “sadly insufficiently widespread” among regulators.

Professor Pirrong expressed astonishment that regulators persist in thinking they are solving systemic risk problems “by imposing a mechanism that will sharply increase liquidity demand and restrict liquidity supply during periods of market stress . . . even though every major financial crisis in history has been at root a liquidity crisis.”

Lofchie Comment: Numerous pieces posted in the Cabinet have highlighted concern about the liquidity risks caused by central clearing organizations that use their ability to demand more margin, which can precipitate a spiraling sell-off as customers and clearing firms liquidate assets and positions to raise margin, which causes prices to decrease, which requires further sell-offs. See, e.g., FRB Governor Powell Discusses Expanding the Central Clearing of OTC Derivatives (with Lofchie Comment) (Nov. 6, 2014). Though Professor Pirrong’s views on central clearing are pessimistic, his blog post does not deal with another issue that should cause him to be even more pessimistic: not only will the clearinghouses call for more variation margin on positions (which in theory should merely reflect the movement of capital from one party to another); they also will demand more initial margin from both parties, which could suck liquidity out of the financial system. That is because one of the biggest differences between bilateral derivatives contracts and central clearing systems is that in the bilateral world, large institutions generally do not have the ability to demand more initial margin from each other. In a centrally cleared world, the central clearing party has the unlimited ability to keep itself safe by raising initial margin requirements.

Although it is good that regulators finally are paying attention to the risks created by central clearing, the problem is that they are focusing on the wrong risk. The biggest risk is not that a central clearing corporation might fail. It is, as we said in the 2014 story cited above, “the ability of a major [central clearing party] to survive by dragging down everyone else.”

SEC White Paper Examines Liquidity and Flows of U.S. Mutual Funds

Posted on by

In a white paper titled “Liquidity and Flows of U.S. Mutual Funds,” the SEC Division of Economic and Risk Analysis examined the U.S. mutual fund industry with particular attention paid to: (i) fund flows; (ii) the liquidity of fund portfolios; and (iii) the interaction of these characteristics.

The white paper emphasized that liquidity risk management is a primary concern for mutual funds due to: (i) the possibility of so-called asset “fire sales;” (ii) the exacerbation of these sales by how a fund’s net asset value is determined for redeeming investors; and (iii) the significant growth in emerging market, fixed income and alternative strategy mutual funds.

The white paper documented the following general trends in U.S. mutual funds:

  • the amount of assets held by U.S. mutual funds (excluding money market mutual funds and exchange traded funds) is increasing rapidly;
  • potentially less liquid mutual fund categories have grown substantially over the same period, with alternative strategy funds growing faster than any other category;
  • the cash and cash equivalent holdings of mutual funds vary significantly, and the variation in cash holdings within each investment category is larger than the variation between investment categories;
  • the volatility of net asset flows exhibits considerable variation between investment categories, and alternative strategy funds face more volatile flows compared to more traditional funds;
  • portfolio liquidity levels vary significantly between funds and over time;
  • among U.S. equity funds, those that invest in large cap equities and those with greater assets hold more liquid equity portfolios; and
  • equity portfolio liquidity decreased for U.S. equity funds during the financial crisis, particularly among those funds that already had relatively low equity portfolio liquidity.

Lofchie Comment: It seems inevitable that the final recommendation of the SEC’s study is that mutual funds should hold a greater share of their assets in “liquid” investments. In response, a quotation and a question.

The quotation is from John Maynard Keynes, The General Theory of Employment, Interest and Money, Chapter 12: “Of the maxims of orthodox finance liquidity, none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.” The second sentence of this quotation is the one that poses a particular challenge to the regulators. It is clear that the regulators disfavor regulated banks, broker-dealers and insurance companies taking speculative or illiquid positions. Perhaps this makes sense if one views those institutions as primarily serving a custodial function as holders of the assets of others. However, the regulators also clearly disfavor either private funds or public funds holding illiquid positions. (See, e.g., FSOC Seeks Comment on Notice about Risk to U.S. Financial Stability Caused by Asset Management Products and Activities (with Lofchie Comment) Dec. 18, 2014)).

So who will hold such positions? It’s not going to be individuals in their personal accounts, as individual holdings are a very small share of national assets. Pension plans? Foreign sovereign wealth funds? The bottom line is, society as a whole cannot be liquid: someone has to be willing to bear risk for the long term. It is all very well, but a little too easy, for the regulators to assert that a person or type of entity should not bear liquidity risk. But tell us who should bear it? That is the hard question. Unless it is addressed, it is a bit of a fool’s errand to demand the impossible: that everyone become liquid.

FRB Governor Tarullo Advocates for Broader Capital and Liquidity Regulations

Posted on by

Federal Reserve Governor Daniel Tarullo suggested that the U.S. central bank may have plans to “reshape” capital regulation for some large insurance firms, as well as for other financial market participants, including asset managers. As to insurance companies, due to a state-by-state implementation of the current U.S. rules for the insurance sector, Mr. Tarullo argued that the rules fail to make distinctions between traditional insurance firms and those that could pose risks to the broader economy. In light of the weaknesses exposed during the financial crisis, Mr. Tarullo stated that it is important to recognize that while some insurance products are not likely to play a role in a financial meltdown, other firm activities, such as derivatives, are more entangled with the financial system.

Further, Mr. Tarullo claimed that differences in the liability side of the balance sheet provide a good policy justification for having varying capital requirements even among the same types of financial intermediaries (that is, that different insurance companies might be subject to differing capital rules). He argued that “traditional capital regulation, with an implicit aim of protecting only conventional policyholders over time . . . does not reflect the balance risk sheets” of more complex insurance firms. He suggested that implementation of stricter rules would likely target big wealth-management or annuities businesses, rather than property insurers.

Mr. Tarullo then discussed the possible adoption of an integrated capital and liquidity regulatory regime, emphasizing his belief that insufficient regulatory attention has been paid to liquidity requirements, particularly to dependence on short-term wholesale funding.

Additionally, Mr. Tarullo discussed entities other than banks and insurance companies that would be appropriate targets of capital/liquidity regulation. In his view, broker-dealers present the “clearest case” for becoming subject to additional liquidity requirements.

Near the beginning of his speech, Mr. Tarullo conceded that “we should remind ourselves that the capital regulation of private corporations is unusual.” However, by the end of his speech, Mr. Tarullo indicated his support for the imposition of “prudential market regulation” on asset managers and rules about liquidity requirements and redemption limits on funds.

Lofchie Comment: Ultimately, Mr. Tarullo argues for a degree of governmental control over both public and private capital that is unprecedented both in its scope, but also in its subjectivity; i.e., government regulators creating rules that might be applicable to a single institution. Even if one were to believe that the government is capable of exercising as much wisdom as Mr. Tarullo seems to believe (on what basis?), one should be uncomfortable with conceding to the government as much power as Mr. Tarullo would have it take. In fact, it is not clear that there is any limit to the power that Mr. Tarullo would have the government assert over private investment and asset allocation decisions so long as he could argue that the government was acting in the public interest.

In this regard, it is somewhat telling that Mr. Tarullo feels it necessary that “we should remind ourselves that the capital regulation of private corporations is unusual.” Perhaps it is a such a good reminder that he ought to repeat it to himself several times a day.

OFR Publishes Working Paper on Liquidity Dynamics During Crises

Posted on by

The Office of Financial Research (“OFR”) published a working paper, “An Agent-based Model for Crisis Liquidity Dynamics,” that examines the effect of financial crises on (i) the balance sheets of market makers and their ability to take on inventory; and (ii) the difference in time frames between liquidity demanders and liquidity suppliers.

In order to “successfully model the dynamics of liquidity during market crises,” the authors of the working paper claim that it is important to understand demander and supplier (i) decision cycles, (ii) market dislocation; and (iii) stress to their portfolio adjustments. As to market makers, the authors state it is important to understand: (i) their capacity for taking on inventory; (ii) how long are they willing to hold these positions; (iii) the cycle of feedback for how these are affected by the market dislocations; and (iv) how they in turn further affect funding, leverage, and balance sheets.

The authors recommended that policymakers combat illiquidity by:

  • reducing the speed and size of liquidity demand, which has “taken the form of circuit breakers or a slowing of the cycle of margin calls”;
  • increasing the capacity and holding period of the market makers through infusions of funding, which (i) allows the broker-dealers to apply a larger balance sheet in their marketing activities; (ii) reduces the pressure on leveraged investors, which is “possibly stemming mushrooming liquidity demand;” and (iii) adds more funding for liquidity suppliers to enter and take larger positions; and
  • increasing the speed and size of the liquidity suppliers, which “has taken the form of government policy to step in as a liquidity supplier of last resort buying up assets when ready liquidity supply from the marketplace is flagging.”

The authors concluded that liquidity is “intricately linked” to the funding and capital structure of the markets. The authors cautioned that projecting the course of liquidity during a crisis without taking into account the real-time specifics of leverage, balance sheet, portfolio construction and decision process is “likely to fail”.

Lofchie Comment: Increased capital requirements on dealers, combined with the prohibition on bank dealers taking material positions, should significantly increase market volatility because market makers are much less likely, and are less able, to dampen such volatility. In fact, with a system of strict capital regulation, one should expect to see market makers very quickly being forced to liquidate into declining markets.

To counter the possibility of a market crash, the report suggests increasing the speed and size of liquidity suppliers – but actually, it is apparent that government policy is largely going in the opposite direction.

Shadow Casting

Posted on by

We are delighted that Center for Financial Stability (CFS) metrics are providing a standard to measure “shadow banking” or more aptly “market finance.”

Our analytics were featured in The “CFA Institute Magazine” July/August cover story, “Shadow Casting” by Maha Khan Phillips.

In the article, Ms. Khan Phillips questions if the financial industry should be worried about the potential growth in shadow banking.  She also investigates if regulators are being overzealous, or not zealous enough.

At CFS, we know market finance is undoubtedly compromising liquidity in international financial markets. According to CFS data, shadow banking is down a stunning 46% in real terms since it’s peak in 2008.

CFS believes that regulation has gone too far. There are very significant liquidity concerns in the market and regulation will make it worse.

To view the full article:
http://www.cfapubs.org/doi/pdf/10.2469/cfm.v26.n4.8

Today’s WSJ: ‘Fixing the Fed’s Liquidity Mess’

Posted on by

Today, on the fifth anniversary of Dodd-Frank, The Wall Street Journal published a CFS op-ed titled “Fixing the Fed’s Liquidity Mess.”

CFS special counselor Stephen Dizard and I note how:

Every Treasury Secretary since the late 1930s could proclaim with confidence that the U.S. bond market is the deepest and most liquid in the world. Today’s illiquid debt markets threaten the potency of this pledge. And it puts the global economy at risk for another financial crisis.

We offer three solutions:

– Lift the federal-funds rate to neutral levels.

– Ease restrictions on market finance.

– Arrange new private-sector liquidity facilities. Severe liquidity risks will not heal themselves—and waiting for the next crisis will be too late.

View the full article.

CFTC Commissioner Giancarlo Discusses the Perils of Low Liquidity, Rips into FSOC

Posted on by

CFTC Commissioner J. Christopher Giancarlo delivered the keynote address before the Cato Summit on Financial Regulation, focusing on the importance of liquidity to reduce risks in financial markets.

Commissioner Giancarlo stated that liquidity is the “life blood” of successful financial markets. He explained that the risk involved in hedging instruments helps “moderate price, supply and other commercial risks,” which in turn frees up capital to boost economic growth. According to Commissioner Giancarlo, an “inferno of complex derivative products used for unfettered risk taking overseen by feckless regulators” contributed to the financial crisis. He noted, however, that the focus of regulation in the post-financial crisis environment has centered around an “incomplete narrative” of deregulated banks that engaged in excessive trading leverage through derivatives, rather than focusing on mortgages that the Federal government encouraged.

According to Commissioner Giancarlo, after the financial crisis, international regulators focused on rulemakings that sought to control borrowing and to leverage the financial system by prioritizing “capital reserves over investment capital, balance sheet surplus over market making and systemic safety over investment opportunity.” He noted that the CFTC has contributed to decreasing liquidity in the form of its “flawed” swap trading rules, and the “double charging of margin” on certain types of derivatives.

Furthermore, he said that regulators are creating a “piecemeal” international framework that is increasing fragmentation and decreasing liquidity in global markets. Commissioner Giancarlo argued that liquidity acts as a “shock absorber” that creates volatile pricing in markets, suggesting that the regulation that contributes to reduced trading liquidity in markets is contributing to the risk of the next financial crisis (citing to a “veteran” industry commentator at fn. 49).

Commissioner Giancarlo went on to discuss the Financial Stability Oversight Council’s (“FSOC”) “unmitigated failure” as a coordinator of regulatory reform. He stated that FSOC has unwisely spent its time designating financial and insurance firms as “too big to fail,” rather than focusing on the systemic risk posed by “liquidity draining regulations.” Commissioner Giancarlo recommended that FSOC “step up to its statutory duty” to analyze U.S. and cross-border regulations.

Lofchie Comment: This seems a good opportunity to link to the Cabinet’s three most recent stories regarding FSOC: (i) ICI Submits Comment Letters to Regulators and FSB Critical of Potential for G-SIFI Designation (with Lofchie Comment); (ii) SIFMA AMG Urges Regulators to Stop Efforts to Create Systemic Risk Methodology for Asset Managers and Funds (with Lofchie Comment); and (iii) Professors Submit Brief Supporting FSOC’s Authority (with Lofchie Comment and YouTube Selection).

See: Commissioner Giancarlo’s Remarks.

OFR Issues Working Paper on Systemwide Commonalities in Market Liquidity

Posted on by

The Office of Financial Research (“OFR”) published a working paper which explores statistical commonalities among granular measures of market liquidity with the goal of illuminating systemwide patterns in aggregate liquidity. 

Lofchie Comment: While the bulk of this paper is too mathematical to be comprehensible to lawyers, there are still bits of it that can be understood by those without mathematical training. Some of the key conclusions are: (i) liquidity is hard to measure; (ii) disappearances of liquidity are sufficiently unusual that they are particularly hard to study; and (iii) when liquidity dries up, it tends to dry up broadly. These conclusions emphasize the continuing importance of the Federal Reserve as a lender of last resort; in fact, the importance of this role is probably increased (rather than decreased) by both Dodd-Frank, and the rules adopted subsequently to Dodd-Frank, as these rules are very likely to discourage private market participants from taking risks in periods of market decline.

Oddly, the power of the Federal Reserve to act as a lender of last resort is attacked by a broad swath of the political culture, both left and right – even by those who agree that the actions of the Federal Reserve as a liquidity provider saved the most recent financial crisis from being much worse.  It is even odder that some of those who attack the Federal Reserve’s authority to act as lender of last resort (isn’t that a central bank is supposed to do?), somehow support the authority of the Federal Reserve and FSOC to dictate permissible investments for private parties (which is a very odd role for a central bank).

See: “Systemwide Commonalities in Market Liquidity,” by Mark D. Flood, John C. Liechty, and Thomas Piontek.

Unintended Consequences of LOLR Facilities: The Case of Illiquid Leverage

Posted on by

Although the direct effect of lender-of-last-resort (LOLR) facilities is to forestall the default of financial firms that lose funding liquidity, an indirect effect is to allow these firms to minimize deleveraging sales of illiquid assets. This unintended consequence of LOLR facilities manifests itself as excess illiquid leverage in the financial sector, can make future liquidity shortfalls more likely, and can lead to an increase in default risks. Furthermore, this increase in default risk can occur despite the fact that the combination of LOLR facilities and reduced asset sales raises the prices of illiquid assets.

The behavior of U.S. broker-dealers during the crisis of 2007–09 is consistent with this unintended consequence. In particular, given the Federal Reserve’s LOLR facilities, broker-dealers could afford to try to wait out the crisis. Although they did reduce traditional measures of leverage to varying degrees, they failed to reduce sufficiently their illiquid leverage, which contributed to their failures or near failures.

Several mechanisms to address this unintended consequence of LOLR facilities are proposed in the attached article that appeared in the IMF Economic Review.

See:http://econpapers.repec.org/article/palimfecr/v_3a62_3ay_3a2014_3ai_3a4_3ap_3a606-655.htm