Category Archives: Emerging Risks

G20 Describes Path to Global Economic Recovery

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The Group of 20 Finance Ministers and Central Bank Governors (“G20”) reviewed efforts to respond to “key economic challenges, as well as the progress . . . made since the beginning of this year.” The meeting was held over two days in Chengdu, China.

In a Communiqué issued at the end of the conference, the G20 members conveyed the following:

  • “The global recovery continues but remains weaker than desirable.” This is due in part to high financial market volatility and geopolitical conflicts, and to fluctuating commodity prices and low inflation, both of which could be prevented by sharing the benefits of growth within and among countries in order to promote inclusiveness.
  • The G20 will use “all policy tools – monetary, fiscal and structural – individually and collectively to achieve . . . strong, sustainable, balanced and inclusive growth.” Achieving that goal will involve making tax policy and public expenditure more “growth-friendly” by prioritizing high-quality investments.
  • Structural issues, such as excess capacity in certain industries, are “exacerbated by a weak global economic recovery and depressed market demand” and have affected trade and workers negatively.
  • Multilateral development banks (“MDBs”) have a “unique role in supporting infrastructure investment.” G20 has asked MDBs to undertake joint actions that support “quality infrastructure development, which aims to ensure economic efficiency in view of life-cycle cost, safety and resilience.”
  • The G20 supports the “continued effort to incorporate enhanced contractual clauses into sovereign bonds.”
  • The G20 prioritizes “building an open and resilient financial system,” by implementing the total-loss-absorbing-capacity standard and effective cross-border resolution regimes. Members will “continue to address systemic risk within the insurance sector,” along with “emerging risks and vulnerabilities in the financial system, including those associated with shadow banking, asset management and other market-based finance.”
  • The G20 recognizes “recent progress made on effective and widespread implementation of the internationally agreed standards on tax transparency.” The G20 recognizes the effectiveness of “tax policy tools in supply-side structural reform for promoting innovation-driven, inclusive growth, as well as the benefits of tax certainty to promote investment and trade.” The G20 will continue working on issues surrounding pro-growth tax policies and tax certainty.
  • G20 countries should participate in a “voluntary peer review of inefficient fossil fuel subsidies that encourage wasteful consumption.” Further, green financing must be increased if environmentally sustainable growth on a global scale is to be supported.

Lofchie Comment: Although the G20 Communiqué has no actual legal effect, the intellectual bent is clear: it supports globalism and government intervention while remaining either indifferent or hostile to private enterprise. The Communiqué begins with a recognition that the global economy is weak. It then pivots toward questions of infrastructure spending which inherently means either government spending or spending through international government agencies and “multilateral development banks.” The G20 seems to view private financing sources with suspicion and perhaps even hostility in its assessment of “vulnerabilities . . . associated with shadow banking, asset management and other market-based finance.”

The G20 stance on energy is that “green financing must be increased,” presumably, through additional government financing. At the same time, the G20 advocates for the reduction of “fossil fuel subsidies that encourage wasteful consumption.” It is difficult to understand the policy implications of these statements. Wouldn’t governmental subsidies of green financing also encourage wasteful energy consumption? If, for example, you wanted to reduce energy consumption, wouldn’t you have to raise the cost of energy, instead of subsidizing its production?

According to the G20, tax collection must be improved while “pro-growth tax policies” are implemented. Again, it is difficult to understand what is being advocated here. Is this an argument for reduced taxes? The G20 says that it favors the use of “tax policy tools in supply-side structural reform for promoting innovation-driven, inclusive growth, as well as the benefits of tax certainty to promote investment and trade.” What does this mean? Who possibly could be against “innovation-driven, inclusive growth”? Or better yet, how about this incomprehensible line: “We launch the Global Infrastructure Connectivity Alliance to enhance the synergy and cooperation among various infrastructure connectivity programs in a holistic way.”

In a passage from the Communiqué that seems particularly problematic, the G20 observes that “fluctuating commodity prices and low inflation . . . could be prevented by sharing benefits of growth within and among countries to promote inclusiveness.” Perhaps this is true, but since the Democratic and Republican parties both seem to oppose further trade agreements, and likely are in favor of reevaluating established ones, it is unclear what part or political faction of the U.S. government would endorse the G20’s position.

The Ongoing Battle of Cybersecurity

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Cybersecurity is not a technical issue. It’s a managerial problem that requires a new approach to risk management.

Imagine going down a river in a rowboat. Water seeps in, and you cannot see below the waterline — or, as it’s called in cyberese, the attack surface. While on the river, you bail the water out, and upon arriving back onshore you patch the most obvious holes. The very next day, you purchase a new product that ensures the bottom of your boat is absolutely water resistant. Now, feeling highly confident that you solved yesterday’s problem, you take the rowboat out on the river again. This time, you go over a waterfall and wreck the boat.

To read the rest of the article, click here:

SEC Chair White Outlines SEC Disclosure Developments

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SEC Chair Mary Jo White reviewed the development of SEC disclosure in corporate governance. She focused on board diversity, non-Generally Accepted Accounting Principles and sustainability reporting.

Chair White reported that the SEC staff is preparing recommendations to the Commission to amend the rule requiring companies’ proxy statements to include “more meaningful board diversity disclosures on their board members and nominees where that information is voluntarily self-reported by directors.” She emphasized that the SEC’s “lens on board diversity disclosure needs to be refocused in order to better serve and inform investors.”

Chair White discussed the reporting of non-GAAP financial measures, voicing “significant concern” over companies that take the flexibility of non-GAAP information “far and beyond what is intended and allowed.” She cautioned that “the non-GAAP information, which is meant to supplement the GAAP information, has become the key message to investors, crowding out and effectively supplanting the GAAP presentation.” Chair White urged companies to review SEC guidance on non-GAAP disclosures carefully.

Chair White reported that the SEC is addressing disclosure of sustainability information through a “materiality-based approach to disclosure, guidance on certain issues,” and through “shareholder engagement on a range of sustainability topics.” She noted that the disclosure of sustainability matters has increased, but affirmed that the SEC is taking a “more focused look at such disclosures, particularly [those that are] related to climate change, in [its] annual filings reviews.”

Chair White delivered her remarks at the International Corporate Governance Network Annual Conference in San Francisco, California.

Lofchie Comment: How much of the SEC’s focus on “disclosure” is driven by the interests of investors? Is it really true that corporations would better serve their investors if their disclosures spotlighted the risks of climate change, or does that proposed requirement reflect a political preference? If it is the latter, wouldn’t most investors be more concerned about the risks that might arise from Brexit, Zika and other pandemics, governmental defaults on both national and municipal levels, aging populations, regulatory burdens, and so on? How can the need for disclosure on global warming possibly take precedence over disclosure concerning other kinds of risks?

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.

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

Members of Congress Call on GAO to Analyze Effect of Regulatory Overlap on FinTech

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Twelve U.S. members of Congress requested that the Government Accountability Office (“GAO”) address how the “fragmentation and overlap” described in its previous report affected the evolution of the “convergence of the financial and technological industries” (“FinTech”).

In a letter to the Comptroller General, the members of Congress urged GAO to “provide information” on the following questions:

  • How has fragmentation and overlap in financial regulation slowed innovation or restricted the ability of financial firms from pursuing new technological ventures?
  • How has collaboration between financial firms and FinTech innovators helped firms to streamline processes and increase their own efficiency in delivering products and services?
  • What kinds of challenges do financial institutions and FinTech companies experience within the existing regulatory framework?
  • How can regulators streamline partnership and collaboration processes in FinTech ventures for financial firms or technology entrepreneurs in order to help them obtain necessary resources?
  • What kinds of best practices can U.S. regulators employ in order to emulate the culture of collaboration that is fostered by the work of regulators in other countries?
Lofchie Comment: This request by members of Congress seems to be a response to the Office of the Comptroller of the Currency’s recent report, which took what may be described as a regulator’s view of innovation: if it works, then it’s great, but if it doesn’t, then it’s potentially careless and in violation of the law. (See OCC Summarizes Latest Developments of Its Innovation Initiative (March 31, 2016).)

Financial Industry Associations Recommend Adoption of Global and Preventative Cybersecurity Policy

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ISDA, SIFMA, Asia SIFMA (“ASIFMA”) and the European Banking Association (“EBA”) (collectively, “the Associations”) outlined a set of principles that they deemed “essential” to the formation of effective cybersecurity, data and technology policies. The Associations submitted these principles to the Financial Stability Board and IOSCO for review.

The Associations identified “two crucial issues that must be recognized before effective policymaking can be established”: (i) cybersecurity, data protection and technological advancement are international issues that require global solutions, and (ii) cybersecurity threats, risks and technological advances shift faster than regulations and standards can respond.

The Associations asserted that the purpose of effective regulation is to ensure that enough people, processes and technologies are in place to manage risks. They concluded that effective prudential frameworks and policies must permit companies to conduct their own risk assessments and determine which kinds of technology are best at meeting their respective security needs.

Lofchie Comment: The Associations recognized that (i) the regulators tend to know less materially than the industry about cybersecurity, and (ii) industry participants have every incentive to improve their cybersecurity defenses. The philosophical question presented is whether the regulators can resist the temptation to adopt prescriptive rules. Such rules are more likely to impede the work that firms do than they are to be useful.

To find examples of overly prescriptive rules, one only has to review Dodd-Frank’s rules on risk management, which require completely unrelated types of risk to be reported to the same manager, even though doing so runs contrary to the operations of any rationally managed  business. The end result is that firms are burdened with two types of reporting lines: one for the real and reasonable world, and one that must meet prescriptive regulatory requirements.

SEC Commissioner Talks Disclosure in the Digital Age

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Commissioner Kara M. Stein called on the SEC to create a “Digital Disclosure Task Force” – which would include investors, companies and technology experts – to “envision what disclosure should look like in the Digital Age.”

At the 48th Annual Rocky Mountain Securities Conference, the Commissioner asserted that the electronic data gathering and reporting (“EDGAR”) system, serving as the SEC’s central data repository, “has not changed much” since it was rolled out in 1995, and needs a redesign to “catch up to the new digital world.”

Commissioner Stein noted that as part of a second ongoing SEC initiative, the “Disclosure Effectiveness” project, a recent SEC Concept Release on Business and Financial Disclosures failed to ask important questions relating to: (i) corporate governance disclosures; and (ii) how to best measure corporate performance (i.e., whether non-GAAP measures present a true and fair view of company performance).

To achieve effective disclosure, Commissioner Stein recommended that regulators not only solicit written comments, but also conduct investor testing to “truly understand what investors and our markets need.” She also commented on sustainability disclosure to differentiate companies and to foster investor confidence, trust and employee loyalty.

Commissioner Stein argued that in providing information, disclosure must be digitalized for investors to “effortlessly and electronically get what they need, when they need it, nothing more and nothing less.” With the advent of structured data, machine readable data can facilitate more real-time or on-demand data availability for investors.

Lofchie Comment: Commissioner Stein’s suggestion that the SEC should attempt to find out what disclosures investors really want makes sense. Both the SEC and Congress should embrace it. Recent “social” disclosure requirements (e.g., conflict minerals, compensation ratios, and diversity and contributions to come) are political rather than financial in nature.

Commissioner Stein is correct that the best way to find out what investors want is to ask them. Accordingly, it would make sense to require issuers to ask their investors (in their proxy statements, perhaps) whether they actually desire such disclosure and at what cost. Perhaps investors in some companies/industries will want “social” disclosures of the sustainability type noted by Commissioner Stein. Others may not. The Commissioner’s suggestion that what investors want may change over time is also noteworthy. Today, investors may want (or not want) conflict mineral/compensation/diversity/contribution disclosures. Next year, investors may decide that they do not (or do) want them. Let the market decide.

NY Federal Reserve V.P. Discusses the Role of Bank Supervision

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Executive Vice President of the Federal Reserve Bank of New York (“FRBNY”) Kevin Stiroh discussed the necessity of governmental supervision of the financial industry (oversight of firms’ governance, internal controls and financial condition) as opposed to mere regulation (rulemaking).

Mr. Stiroh, who is head of the FRBNY’s Supervision Group, discussed the theory and practice of bank supervision – considering the need for supervision, the FRBNY’s role in supervising banks, and some of the practical realities of conducting such supervision.

Mr. Stiroh stressed three developments which will be relevant to the FRBNY in executing its supervisory responsibilities.

  • Cybersecurity. Because the state of cybersecurity readiness varies across firms, Mr. Stiroh explained, supervisors must develop common principles for addressing cybersecurity risks and defending operations that are critical to the financial services sector.
  • FinTech. Mr. Stiroh questioned whether FinTech will “enhance or fundamentally disrupt” the financial service and payment industries. In that regard, he noted, investment in FinTech companies rose 10% between 2010 and 2015. Mr. Stiroh noted that firms and supervisors should be mindful of how technological change impacts bank risk and the supervisory framework.
  • Reputational Risk. Mr. Stiroh encouraged financial institutions to “consider the many factors that have contributed to recent, widespread misconduct and the perceived lack of trust in the financial sector.” He argued that firms should have strong incentives to manage their reputations, and that supervisors should support that goal.

Mr. Stiroh also cited two recent Federal Reserve Supervisory letters on capital planning (see Premium Content links on the right) as “specific examples” of how regulators approach firms that are more or less complex.

Mr. Stiroh delivered his remarks at the SIFMA Internal Auditors Society Education Luncheon at the Harvard Club in New York City.

Lofchie Comment: One of the reasons that the financial services industry is under pressure is because the government attacks its reputation constantly, and not always for good reasons. (To be fair, Mr. Stiroh noted both actual misconduct and a perception of a lack of trust.) With that in mind, consider the following observations: (i) most persons (including the government) tend to be less critical of themselves than of others, (ii) misconduct by government officials and a perceived lack of trust seems at least as common in government as in the financial services, and (iii) mistakes by those in government seem as frequent as mistakes by those in the financial sector. It is not true that the only so-called mistake made by government is insufficient regulation; many regulations are either unnecessary or spur conduct that undermines monetary growth. When the government becomes as critical of itself as it is of the financial industry, then both will improve together.

SEC Chair White Calls for Vigilance of the “Unicorns”

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SEC Chair Mary Jo White outlined the opportunities, challenges and risks of “Silicon Valley” technology in the financial markets and urged entrepreneurs and issuers of private companies – particularly of “unicorns” (private start-up firms with valuations that exceed $1 billion) – to focus on investor interests.

Chair White examined the following challenges for new and evolving markets:

  • Pre-IPO Financing: Chair White asserted that despite broad sophisticated investor awareness that the majority of pre-IPO companies fail, venture capital firms, private equity funds, smaller retail investors and the “next . . . student whose great idea needs funding” all equally lose when “participants choose – with eyes wide open – to invest in private companies at valuations that may be ethereal or over-inflated.” She called for vigilance of so called unicorns, by establishing robust internal controls and governance procedures to provide accurate disclosures of financial results.
  • New Models of Capital Formation: Chair White declared that the SEC will hold brokers and funding portals responsible to be “bulwarks of investor protection” in securities-based crowdfunding that was recently introduced by Regulation Crowdfunding. She also emphasized that the SEC is counting on advisers as “gatekeepers” presenting information on the significant risks involved to make secondary market trading work fairly for investors. Although Chair White recognized that many secondary market participants may be “buy and hold” investors seeking exposure to late round pre-IPOs to profit from an eventual IPO or acquisition, she asked for regulators to scrutinize these emerging platforms to ensure they provide a functioning market that operates within the disclosed parameters.
  • Financial Controls and Corporate Governance: Chair White noted a “current slow-down” in IPOs and that unicorns are staying private longer. She called on entrepreneurs and their advisers, venture capital and private equity investors as well as general industry leaders to request that private startups develop enhanced governance structures and internal control environments to match their respective size and impact.
  • Fintech: Chair White highlighted that the SEC is exploring whether: (i) blockchain technology applications require registration under existing SEC regulatory regimes, such as those for transfer agents or clearing agencies; (ii) “robo-advisors” meet Investment Advisers Act obligations and their fiduciary duties when they solely provide automated advice; and (iii) online marketplace lending platforms provide adequate information to investors on offered securities and whether these offerings are registered or made using an exemption.

Chair White concluded by encouraging cooperation between the SEC and Silicon Valley.

Chair White delivered her remarks at the SEC-Rock Center for Corporate Governance speaker series, “The Silicon Valley Initiative: Protecting Investments in Pre-IPO Issuers.”

Lofchie Comment: While it is certainly appropriate for the SEC to concern itself with investment in private issuers, the SEC should also be concerned that the costs of the regulation that it imposes might discourage companies from going public. Put differently, the SEC should consider whether it is selling a “product” (access to the public capital markets and exchange liquidity) that is unattractive in light of its subsequent costs.

Congress should also be concerned about the deterrent costs of needless regulation. When issuers and investors see that the costs of going public include regulatory requirements such as those relating to “conflict minerals” or “compensation ratios” that have no reasonable benefit to either party, they may forsake liquidity for the sake of rationality.