Category Archives: Too-Big-to-Fail

Trump Nominee for Treasury Secretary Wants to “Strip Back” Dodd-Frank and Cut Corporate Taxes

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President-Elect Trump’s nominee for Treasury Secretary, Steven Mnuchin, stated that the “number-one problem with Dodd-Frank is it’s way too complicated and cuts back lending.” He stated that he intends to “strip back parts of Dodd-Frank that prevent banks from lending,” which will be the “number-one priority on the regulatory side.” In an exclusive CNBC “Squawk Box” interview, he described the Volcker Rule as “too complicated,” and complained that “people don’t know how to interpret it.”

In the interview, Mr. Mnuchin and Trump-appointed Commerce Secretary Wilbur Ross emphasized that tax reform is also a “number one priority.” Mr. Mnuchin stated that he would effect the “largest tax change since Reagan,” and would cut corporate taxes in order to create “huge economic growth.” Mr. Mnuchin added that this change was designed to be a “middle-income tax cut and the childcare credit is a big aspect of this.”

Lofchie Comment: Maintaining a sensible financial regulatory system, in which businesses can operate freely without fearing regulatory attacks, becomes impossible when the rules are too complex to interpret. It is refreshing to hear the simple statement from the new nominee for Treasury Secretary that some of the rules we have now are just “too complicated”!

Minneapolis Fed Requests Comments on Plan to End “Too Big to Fail”

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The Federal Reserve Bank of Minneapolis (“Minneapolis Fed”) requested comments on its proposed “Minneapolis Plan to End Too Big to Fail” (the “Plan”).

In the Plan, the Minneapolis Fed proposed:

  • requiring covered banks to issue common equity equal to 23.5 percent of risk-weighted assets, with a corresponding leverage ratio of 15 percent, in order to “dramatically increase common equity capital” and “substantially reduce the chance of bailouts”;
  • calling on the U.S. Treasury Secretary to either certify that covered banks are no longer systemically important or subject those banks to an additional 5 percent of risk-weighted assets per year until (i) the Treasury certifies them as no longer systemically important, or (ii) the banks’ capital reaches 38 percent, which the Minneapolis Fed reports is the “level of capital that reduces the 100-year chance of a crisis below 10 percent”;
  • levying a shadow bank tax in order to discourage banking activity from moving to the shadow banking sector, which would equalize funding costs between the two sectors; and
  • allowing the government to reform the current supervision and regulation of community banks by adopting a system that is “simpler and less burdensome while maintaining [the government’s] ability to identify and address bank risk-taking that threatens solvency.”

Because the Plan’s approach could result in “the migration of risky activity from the banking sector to nonbank financial firms, where capital requirements are lower, if they exist at all,” it explained, the Minneapolis Fed proposed to “address this unequal treatment across sectors by taxing the borrowings of large nonbank financial firms – also known as shadow banks.” Effectively, this tax would “make the cost of funds roughly equivalent between large banks and nonbanks.”

The Minneapolis Fed requested feedback on all aspects of the Plan by January 17, 2017.

Lofchie Comment: The Minneapolis Fed’s Plan would attempt to end the problem of too-big-to-fail by driving every large bank out of business through the imposition of massive capital charges. Since putting large banks out of business would cause borrowing activity to move from banks to non-banks, the plan would then impose a tax on large non-bank lenders that effectively would force every large non-bank lender to either become a bank (presumably a small bank, since large banks would be compelled to close) or cease operations.

Since the likely effect of the Plan on the economy of the United States would be significant, the Minnesota Fed might find it useful to project what it believes the Plan’s effects would be and why. It also might be useful for the Minnesota Fed to ask itself (i) if there would be any large banks left, (ii) if there would be any large non-bank lenders left, (iii) how many banks would remain overall, (iv) what effect the Plan would have on the U.S. economy, and (v) whether it is troubling that the Plan effectively would force all large moneylenders to become banks.

Streetwise Professor Claims “Brexit Horror Story” Highlights Dangers of Clearing Mandates

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In his latest post on the Streetwise Professor blog, University of Houston Finance Professor Craig Pirrong described the “horror story” of systemic clearing mandates, and explained why he remains skeptical that regulators will “take heed of the lessons of Brexit and take measures to ensure that the next time it isn’t a head shot.”

Professor Pirrong argued that “clearing mandates have supersized the clearing system, and commensurately increased the amount of liquidity needed to meet margin calls.” He highlighted Brexit as a “harrowing example” of “how tightly coupled the system is,” and listed other risk factors that clearing corporations’ response to Brexit have demonstrated. Those risk factors include the following:

  • “[m]uch of the additional margin was to top up initial margin, meaning that the cash was sucked into the [central clearing parties] and kept there, rather than paid out to the net gainers, where it could have been recirculated”; and
  • “each [central clearing party] acted independently and called margin to protect its own interests” – which is “ironic, because one of the alleged justifications for clearing mandates was the externalities present in the [over-the-counter] derivatives markets.”

Professor Pirrong observed that Brexit might prove to be as instructive as it is “horrific”:

Horror stories are sometimes harmless ways to communicate real risks. Perhaps the Brexit event will be educational.

Nevertheless, he concluded, the “clearing mandate is a reality, and is almost certain to remain one.” Given that reality, he maintained, it is doubtful that “whatever is done will make the system able to survive The Big One.”

Lofchie Comment: With respect to central clearing, the systemic risk on which regulators have focused is that clearinghouses will fail. However, the greatest risk created by central clearing as mandated by Dodd-Frank is this: in an attempt to save themselves from the risk of failure, clearinghouses could use their ability to demand an unlimited amount of initial margin from clearing member participants and so drain needed liquidity from the financial system. In other words, clearinghouses likely would save themselves from going under by sucking all of the liquidity out of the financial system. This, in turn, could trigger the failure of clearing members, or their customers who are required to post additional margin. It also could cause a downward spiral of pricing, forcing market participants to liquidate positions in order to eliminate margin calls.

Senator Urges President to Replace SEC Chair

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Senator Elizabeth Warren (D-MA) “strongly urge[d]” President Obama to “immediately designate another SEC Commissioner as Chair of the agency.”

In her letter to the President, Senator Warren explained that “Chair White’s refusal to move forward on a political spending disclosure rule serves the narrow interests of powerful executives who would prefer to hide their expenditures of company money to advance their own personal ideologies.” Senator Warren highlighted Chair Mary Jo White’s “Disclosure Effectiveness Initiative” as part of her “anti-disclosure agenda” and charged that the SEC never has produced data to support Chair White’s presumption that investors experience “information overload.” She further noted that Chair White “has also refused to say how much time and agency resources have been spent on this voluntary initiative,” which Senator Warren had previously requested in a letter to Chair White. Senator Warren continued:

Giant public companies have every right to advocate for less transparency in public markets, whatever the broader economic consequences. But the SEC was not created to work for them. Under a new Chair, the agency can re-direct its limited discretionary resources away from actively undermining the interests of investors and back toward its core purposes.

Senator Warren also pointed out that, “[a]s of October 2016, the SEC has yet to finalize nineteen mandatory rules under the Dodd-Frank Act.”

Lofchie Comment: Senator Warren appears to take the view that financial regulation is but the continuation of politics by other means (paraphrasing Prussian strategist von Clausewitz). The attack on the SEC Chair is not the first shot fired by the Senator. She has launched a number of attacks on regulators and academics who have not aligned their views with hers. See, e.g., Senator Warren Asks CFTC to Withdraw EEMAC Report on Position Limits; Senator Warren Questions “Good Intentions” behind Study Challenging DOL’s Fiduciary Proposal.

The Senator’s latest missive follows closely upon the D.C. Circuit Court decision that the CFPB structure, which is commonly viewed as the Senator’s creation, is unconstitutional because the Director of the CFPB was immune from dismissal by the President. Yet now, the Senator calls for the SEC Chair to be fired because she has failed to follow “Congressional mandates.” To be consistent, the Senator should acknowledge that the CFPB’s original structure was inherently flawed in that it inappropriately insulated the agency from both Presidential and Congressional control. The President could remove the CFPB Director only “for cause.” Senator Warren seems to be arguing that SEC Chair White’s actions don’t amount to appropriate “cause” for removal, but are sufficient to designate an alternative Commissioner as Chair. Under the CFPB’s structure, that would not be possible, given that there is only one Director.

Senator Warren and her Congressional colleagues should revisit the CFPB’s design in toto, ideally replacing the single-director model with a five-person bipartisan model (i.e., similar to that of the SEC), and provide for Congressional control over the CPFB’s budget. Sauce for the goose (the SEC, the CFTC, and a host of other federal agencies) should be sauce for the gander (the CFPB).

As far as the Senator’s actual request, there is no possibility of it being granted. (Unsurprisingly, the White House indicated support for the SEC Chair.) If the President were to take the action that the Senator calls for, Chair White would resign, which would leave the SEC with only two Commissioners and, thus, the Democrats would lose their majority.

CFTC Commissioner Giancarlo Urges Regulators to Analyze Post-Dodd-Frank “Flash Crashes”

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CFTC Commissioner J. Christopher Giancarlo called for a “thorough and unbiased analysis by U.S. financial regulators and their overseas counterparts of the systemic risk of unprecedented capital constraining regulations on global financial and risk-transfer markets.” Commissioner Giancarlo observed that there have been “at least twelve major flash crashes since the passage of the Dodd-Frank Act” including last week’s “abrupt ‘flash crash'” of the British pound. He asserted that:

[Regulators] can no longer continue to avoid the question of whether the amount of capital that bank regulators have caused financial institutions to take out of trading markets is at all calibrated to the amount of capital needed to be kept in global markets to support the health and durability of the global financial system [emphasis in original].

In reference to a Cabinet comment by Steve Lofchie on May 27, 2015, Commissioner Giancarlo asked the following question: “How big will the next flash crash have to be before we realize that markets in which few are able to take risks are markets that are very risky?”

Lofchie Comment: In addition to Commissioner Giancarlo’s concerns about market liquidity, his request for an “unbiased analysis” of the the systemic risk of “unprecedented capital constraining regulations on global financial and risk-transfer markets” is noteworthy. Regulators seem either reluctant or incapable of assessing whether their rulemakings have been successful, or whether certain benefits of the rulemakings might be outweighed by unintended consequences. On that topic, see this recent story about central clearing, in which we ask whether regulators are capable of judging their own work.

 

Treasury Secretary Lew Defends FSOC Before House Financial Services Committee

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In testimony before the House Financial Services Committee on the Financial Stability Oversight Council (“FSOC”) 2016 Annual Report, Treasury Secretary Jacob Lew stated that “reforms adopted in the Dodd-Frank Act, including the creation of the Council, have made the financial system safer, more resilient, and supportive of long-term economic growth.”

Secretary Lew stated that the Annual Report is “a key mechanism for public accountability and transparency regarding the Council’s work.” He identified twelve themes in the Report: (i) cybersecurity, (ii) risks associated with asset management products and activities, (iii) capital, liquidity and resolution, (iv) central counterparties, (v) reforms of wholesale funding markets, (vi) reforms relating to reference rates, (vii) data quality, collection and sharing, (viii) house finance reform, (ix) risk management in an environment of low interest rates and rising asset price volatility, (x) changes in financial market structure and implications for financial stability, (xi) financial innovation and migration of activities, and (xii) global economic and financial developments.

As to the overall impact of the FSOC since inception, he argued:

As the forum designed to bring the financial regulatory community together to collaboratively identify and respond to potential threats to financial stability, the [Financial Stability Oversight] Council has done what Congress established it to do, including asking the tough questions that help us make our financial system safer.

Secretary Lew stated that the FSOC:

  • published “a number of findings regarding potential liquidity and redemption and leverage risks, based on careful analysis that included engagement with key stakeholders”;
  • plans to provide timely public updates as analysis continues;
  • will monitor market responses to the implementation of SEC money market mutual fund reforms that go into effect next month; and
  • will continue to monitor for potential threats posed by nonbank financial companies.

Lofchie Comment: The FSOC is a largely partisan organization. It is comprised of members of a single political party, and is made up of regulators assessing the impact of their own regulation. This results in the FSOC’s work product appearing to be more politically motivated than policy-minded, and more self-aggrandizing than self-critical.

The FSOC was intended to bring together perspectives from different regulators; however, it is clearly dominated by the banking regulators and, therefore, the work product very clearly imposes that perspective on the world (which is quite different from the perspective of participants in the capital markets). This perspective, or bias, is most evident by the FSOC’s focus on funds or, as the FSOC calls them, “shadow banks.”

Finally, the FSOC seems oddly focused on securities lending and other securities financing transactions, and inappropriately indifferent to big picture concerns that seem much more likely to create systemic risk, such as the potential for failures by municipal entities or the underfunding of pension plans.

GAO Urges Department of Commerce to Fulfill Conflict Mineral Obligations

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The Government Accountability Office (“GAO”) examined (i) company disclosures filed in 2015 in response to the SEC conflict minerals regulations, (ii) challenges to companies’ due diligence efforts concerning the processing facilities in conflict minerals supply chains, and efforts to mitigate those challenges, and (iii) actions by the Department of Commerce (“Commerce”) regarding its conflict minerals-related requirements under the Dodd-Frank Act.

In a report titled: “SEC Conflict Minerals Rule: Companies Face Continuing Challenges in Determining Whether Their Conflict Minerals Benefit Armed Groups,” the GAO determined that:

  • as a result of country-of-origin inquiries, the number of companies that filed specialized disclosure forms (“Forms SD”) with the SEC and reported that they knew or had reason to believe they knew the source of the conflict minerals in their products rose in 2015 by an increase of 19% over the previous year (based on a generalizable GAO-reviewed sample of filings);
  • after an estimated 79 percent of the companies that filed a Form SD performed due diligence, an estimated 67 percent reported they were unable to confirm the source of the conflict minerals in their products, and about 97 percent reported they could not determine whether the conflict minerals financed or benefited armed groups in the Democratic Republic of the Congo (“DRC”) and adjoining countries;
  • facilities that process conflict minerals pose challenges to the disclosure efforts of companies filing Forms SD because (i) these facilities rely generally on documentary evidence about the origin of conflict minerals, which evidence can be susceptible to fraud, and (ii) processing operations involve multiple levels that can introduce the risk of fraud and increase costs associated with disclosures;
  • industry and other stakeholders have developed or are pursuing methods for mitigating these risks, such as chemical “fingerprinting” to verify documentary evidence; and
  • as of July 2016, the Department of Commerce had not submitted a report, as required in January 2013, assessing the accuracy of the Independent Private Sector Audits (“IPSA”) filed by some companies that filed Forms SD, nor had it developed a plan to do so.

The GAO urged the Secretary of Commerce to submit a plan to the appropriate congressional committees that would outline steps to be taken within associated timeframes. Those steps included the following:

  • assessing the accuracy of IPSAs and other due diligence processes described under Section 13(p) of the Securities Exchange Act;
  • developing recommendations for processes to be used when executing such audits, including ways to improve the accuracy of and establish standards of best practices for such audits; and
  • acquire the necessary knowledge, skills and abilities to carry out these responsibilities.

Lofchie Comment: If ever a rule were designed to fail cost-benefit analysis, the SEC manifesto on conflict minerals is it. When 97% of companies are not sure where the money is going, chances are that the data is useless.

Streetwise Professor Claims Bipartisan Support for Restoring Glass-Steagall Is “Misguided”

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University of Houston Finance Professor Craig Pirrong characterized bipartisan advocates who would restore the Glass-Steagall Act (“Glass-Steagall”) in order to prevent future crises as “wholly misguided.”

Professor Pirrong identified the imposed separation between securities underwriting and commercial banking as the “part of the Glass-Steagall Act which its worshipers are most intent on restoring.” He argued that the banking structures outlawed by Glass-Steagall were not “materially important in causing the 2008 crisis,” noting that institutions responsible for nearly bringing down the financial system were mostly standalone investment banks and not depository institutions. Professor Pirrong stated that reimposition of a Glass-Steagall law would be potentially destructive:

Glass-Steagall restrictions are largely irrelevant to preventing financial crises, and some of their effects – notably, the creation of an investment banking industry largely reliant on hot, short-term money for funding – actually make crises more likely.

 

Lofchie Comment: The restoration of Glass-Steagall is a financial regulatory “reform” having a political moment. Most people seem to approve of it without knowing what it means or why it could be beneficial. The strangest premise of Glass-Steagall is the idea that commercial banking must be separated from investment banking in order to protect the banking business. In reality, the business of making commercial loans on collateral that is either illiquid or nonexistent seems far riskier than the business of securities underwriting. See CATO Institute Director Mark Calabra’s report, “Did Deregulation Cause the Financial Crisis?“

Lofchie on Financial Reform Platforms

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When considering financial regulation (and regulation generally) and their expressed attitudes towards the financial system, the two platforms are positioned almost diametrically in opposition. It is necessary, therefore, to say something about the parties’ views of the role that government should play both in providing employment and in the role of private enterprise. The Republican platform is based on the standard position that private enterprise is to be strongly encouraged and is generally preferable to governmental enterprise. By contrast, the Democratic platform is largely about governmental spending and enterprise; including, for example, government spending on infrastructure: drinking water and waste systems, climate change initiatives, education, industrial energy efficiency, broadband networks, health care, child care, care for the aged, housing, supporting groundbreaking research and so on. The Democratic platform supports such spending not only at the federal level, but also at the state and municipal level. While the summary above does not fully include these spending initiatives, it would not be possible to assess the Democratic position on financial regulation and the direct conduct of financial activities by the government without that context.

The focus of this discussion is on financial regulation. The Republican platform, provides little in the way of ambitious new plans. It is, at its core, completely skeptical of regulation, describing all of it as a “tax.” This is obviously not true: good regulations are necessary for growth because they keep market participants honest. Advocating for the abolition of the Internal Revenue Service, as the platform does at one point, seems to be a wholly unserious proposition. That being said, it is all a matter of perspective. If one believes that our current system of financial regulation is more in need of pruning than of fertilization, then such unseriousness is a bit of welcome relief from the unseriousness of our current debates.

The Democratic platform, by contrast, is breathtaking in its ambition. It is not possible to ignore the extent to which the Democratic platform envisions a substantial replacement of the private financial system by government-owned financial enterprises. A notable example: the platform advocates the idea that the Postal Service should provide “basic” banking services. While the only such service that is expressly mentioned is check cashing, the platform strongly suggests that such services would also include deposits and lending. In addition, the platform would establish an “independent, national infrastructure bank” to, among other things, “provide loans and other financial assistance for . . . multi-modal infrastructure projects.” (What in the world does that mean?) Then there are also the half dozen or more other loan and investment services for which the platform makes provision. The platform seems to intend that the Postal Service would enter into direct competition with community banks. It would seem to be the strong, albeit implicit, belief of the drafters of the Democratic platform that the government would be successful in not only community banking but in a whole range of investment banking-type activities.

The Democratic platform spends a fair amount of time demonizing all those who work in financial services as part of a hostile and criminal operation. Perhaps those who are in government should be a bit more modest given that the number of senior government officials who have been convicted of financial crimes is fairly substantial. That said, the supposedly corrupt “revolving door” between financial regulators and the financial industry seems to be overstated if not completely fictional. Where is the evidence that anyone at the SEC has been negatively influenced by their previous job? Whether or not the authors of the draft platform have any genuine goal in that regard, the effect of the assumption will be the same: preventing knowledgeable individuals from working for financial regulators. If being ignorant of how markets work should be considered to be such an asset, then perhaps financial regulators should be selected randomly from the phone book (though a lottery drawn from a list of academics might yield even more candidates with this particular asset).

Much of the detail of the Democratic platform is either unserious or intellectually incoherent. What does it mean to protect the independence of the Federal Reserve Board, but to make it more representative? If the Board is to be more “representative”; i.e., reflecting the popular will, what is the purpose of its independence? Likewise, is it absolutely necessary that “every Republican effort to weaken” Dodd-Frank must be stopped – i.e., that it is wrong to reassess the 2,000-page statute after six years of operation in order to gauge its failures and successes? Does anyone really believe that Dodd-Frank is such a perfect work of art that any attempt to revisit its contents is a form of desecration? The politicization of every issue makes it impossible to have a rational discussion about financial regulation.

Interestingly, there are some areas of agreement between the Democrats and the Republicans in their political platforms. Both express skepticism of international trade (both single out China) and both are opposed to “too big to fail” (which seems to be the regulatory equivalent of supporting the baking of apple pie).

It is perhaps unfair to critique political platforms given the general understanding that they are for the most part meaningless monologues that will be ignored by the soon-to-be elected officials. Nonetheless, even if they are not directly actionable documents, they do influence the parameters of the debate that is to come, and thus it seems appropriate to treat the documents as significant.

Republican Financial Reform Platform Summary

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The Republican platform position is highly critical of Dodd-Frank for “establish[ing] unprecedented government control over the nation’s financial markets,” forcing “central planning of the financial sector” and creating “unaccountable bureaucracies” that have “killed jobs.” In general, the Republican platform describes financial regulations as “just another tax” and states that Americans should “consider a regulatory budget that would cap the costs federal agencies could impose on the economy in any given year.” In particular, Republicans would:

  • abolish the Consumer Financial Protection Bureau or subject it to congressional appropriation;
  • “advance legislation that brings transparency and accountability to the Federal Reserve, the Federal Open Market Committee, and the Federal Reserve’s dealing with foreign banks”;
  • (regarding “too-big-to fail”) “ensure that the problems of any financial institution can be resolved through the Bankruptcy Code”; and
  • endorse prudent regulation of the banking system to ensure that FDIC-regulated banks are properly capitalized and taxpayers are protected against bailouts.

The Republican Platform criticized the Dodd-Frank Act:

Rather than address the cause of the crisis — the government’s own housing policies — the [Dodd-Frank Act] extended government control over the economy by creating new unaccountable bureaucracies. Predictably, central planning of our financial sector has not created jobs, it has killed them. It has not limited risks, it has created more. It has not encouraged economic growth, it has shackled it.