Category Archives: Data and Transparency

SROs Caution Firms to Distinguish between Debt “Securities” and “Loans

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FINRA and the MSRB jointly reminded member firms of obligations connected to: (i) privately placing municipal securities directly with a single purchaser; and (ii) using bank loans as alternatives to traditional public offerings in the municipal securities market.

FINRA and the MSRB stated that many firms failed to:

  • conduct sufficient due diligence and analysis to determine whether financing the instruments are municipal securities or bank loans when the financing instrument is described as a “loan”;
  • fully understand the nature of their roles in transactions where they have engaged in placements of these instruments; and
  • fully consider how federal securities laws and the regulations and rules thereunder (i.e., FINRA and MSRB rules) apply to these transactions.

FINRA and the MSRB urged firms to:

  • undertake a threshold analysis of whether the nature of the financing instrument of the municipal entity constitutes a security or a loan, as determined by Securities Exchange Act Section 3(a)(10) and the decision of the U.S. Supreme Court case, Reves v. Ernst & Young, Inc. (494 U.S. 56 (1990));
  • review transaction documentation when considering whether a particular financing instrument is a municipal security or a loan;
  • consider consulting with counsel to determine whether a particular financing instrument is a municipal security or a loan; and
  • voluntarily disclose the existence and terms of bank loans in a timely manner.

FINRA and the MSRB expressed mutual concern that the increasing use of direct purchases of municipal securities and bank loans as alternatives to publicly-offered municipal securities may: (i) increase compliance risks for firms engaging in this activity; and (ii) ultimately “erode market transparency.”

Lofchie Comment: The problem with this guidance is that the dividing line between a loan and a debt security is economically indeterminate. That said, the guidance does point out “bad language” in documents that would indicate that a credit obligation to a bank might be deemed a security rather than a bank loan; e.g., the use of the instrument of terms such as “bond” or “security” or “purchaser.” In short, if it is desired that a credit instrument be treated as a “loan,” then the instrument should use loan terminology and not debt security terminology.

 

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

OFR Researchers Question the Utility of SEC Form PF as a Risk Management Tool

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Office of Financial Research (“OFR”) researchers questioned the utility of SEC Form PF. In a published working paper, the researchers stated that they found “significant ‘wiggle room” in the application of the Form as a risk-management instrument. It made several recommendations for improvements.

The authors generated a range of simulated portfolios and equity options in order to assess the precision of Form PF as a measurement tool for risk exposure. They also considered the effect of basic options strategies on certain risks that Form PF is intended to measure.

Specifically, they examined the “cross-sectional distributions of standard risk and performance measures of simulated portfolios” in order to determine the “dispersion of the actual portfolio risk and performance of funds with identical presentation on Form PF,” with particular attention to value-at-risk (“VaR”) portfolios. Through these “cross-sectional distributions,” the authors found “significant and widespread dispersion in risk and performance among both VaR-unconstrained and VaR-constrained portfolios” despite their identical presentation on Form PF. The authors concluded that the inclusion of options has a “significant impact” on actual portfolio risks. The range of permitted actual risk is especially large for portfolios that include options but do not report VaR on Form PF.

The authors recommended that the SEC:

  • rearrange the strata of characteristics that are utilized by Form PF to represent complex portfolios or, alternatively, capture additional characteristics on Form PF in order to constrain the range of possible risk profiles more tightly; and
  • revise Form PF to require, as does SEC Form 13F, position-level details about portfolio holdings.

The paper’s publication is timely in light of the new provisions in Section 404 of the Dodd-Frank Act financial reform law that enable enhanced regulatory reporting on private funds seeking to protect investors and assess systemic risk.

Lofchie Comment: A comment published in 2013 in the Guide to Hedge Fund Regulation captured the prevailing view of Form PF at that time.

[M]any of the questions in Form PF are horrendously written with the result that it is not entirely clear that the Form is even getting at useful information. Even if the information might be useful, funds will inevitably answer the questions in quite different ways, making the information far less useful than it might have been if the Form were better drafted. The questions that are the most poorly designed are the ones that might in theory be the most important; i.e., the questions about leverage and borrowing by hedge funds. These questions are so poorly written that it is sometimes hard to know even what information the authors of the Form intended to collect or even how much they understood about leverage and collateral.

Three years later, researchers at the OFR engaged in a complicated study of options with “cross-sectional” data and determined that Form PF is useless. Any sophisticated professional who works in this area could tell by looking that the questions on the form never had value.

Treasury debt ceiling: Inside the Fed’s `D-Day’ War Games…

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Yesterday staff on the House Financial Services Committee released a report critical of Treasury activities during the debt ceiling crisis. Treasury told Congress that the department was unable to prioritize debt payments to keep the government from violating its borrowing limit.

Of course, Treasury had the ability to prioritize payments. Emerging economies have done this for years!

The 322-page report includes documents received under subpoena highlighting table top exercises to precisely prioritize debt payments – http://financialservices.house.gov/uploadedfiles/debt_ceiling_report_final_01292015.pdf.

I am quoted in Bloomberg’s “Inside the Fed’s `D-Day’ War Games for Breach of U.S. Debt Limit” – http://www.bloomberg.com/news/articles/2016-02-01/inside-the-fed-s-d-day-war-games-for-breach-of-u-s-debt-limit.

FINRA Fines Firm for Submitting Inaccurate Blue Sheet Data

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FINRA censured and fined a financial services firm (the “Firm”) for failing to provide “complete and accurate trade data” in automated form when requested by the SEC and FINRA. Such trade data, commonly known as “blue sheets,” provide information about securities transactions, including the security, trade date, price, share quantity, customer name, and whether the transaction was a buy, sale, or short sale.

FINRA found that from January 2012 to September 2015, the Firm submitted to the SEC and FINRA inaccurate trade data as a result of problems with the Firm’s automated systems. According to FINRA, these problems were caused by technical deficiencies in the Firm’s blue sheet systems; errors in its blue sheet logic; and the fact that information was pulled from a front-end database that did not accurately reflect actions that sometimes occurred after a trade was executed.

FINRA also found that the Firm failed to have adequate audit systems in place for providing accountability of its blue sheet submissions.

In addition to the censure and fine, the Firm must also conduct a comprehensive review of its policies, systems and procedures related to blue sheet submissions, and to subsequently certify that it has established procedures reasonably designed to address and correct the violations.

Lofchie Comment: This is yet another very significant penalty for a firm providing the regulators with bad data. Accordingly, it behooves firms to devise methods of self-auditing the financial information that they provide, recognizing that this may not always be easy because there is no inherent feedback system to tell a firm when it has made a mistake for which it may be censured.

Federal Reserve Vice Chair Fischer Discusses Financial Stability and Shadow Banking

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Board of Governors of the Federal Reserve System Vice Chair Stanley Fischer: (i) offered an assessment of vulnerabilities in the financial system; and (ii) identified gaps in the current understanding of conditions inside and outside of the banking sector that should be addressed by regulators and researchers.

In discussing the current financial system’s cyclical developments, Mr. Fischer mentioned the following “five factors that contribute to financial fragility”: (i) high debt burdens at households and firms; (ii) elevated leverage and maturity transformation within the financial sector; (iii) complexity and interconnectedness in intermediation chains; (iv) low risk premiums on assets, especially assets funded with debt; and (v) complacency on the part of investors, supervisors and decision-makers in the private sector of the financial system.

Mr. Fischer made the following assertions regarding what needs to be understood to monitor financial stability:

  • A Closer Look at Shadow Banking: The reduction in leverage and maturity transformation associated with better regulations leaves the financial system “much more resilient – even if such regulations have modestly affected market liquidity.”
  • What We Know and What We Do Not: Data on a range of activities – including securities lending, bilateral repos, and derivatives trading – that create funding and leverage risks “remain inadequate and hence could prove destabilizing if sufficiently large or widespread.”
  • Data Are Not Enough: We Need Theory Too: An “important area in need of development” is economic modeling on interconnectedness, particularly on the interaction of shadow banking, banks and the broader financial system. Further, research that distinguishes between banks and nonbanks, or highlights how their interactions are driven by economic incentives, could guide regulator efforts to collect data and set policies to limit possible instabilities associated with interconnectedness.

“An essential element of [the federal regulatory] infrastructure is learning the lessons of history – both the lessons of what happened, and the fact that supervisors and regulators will on occasion be surprised,” he stated.

Mr. Fischer delivered his remarks at the “Financial Stability: Policy Analysis and Data Needs” 2015 Stability Conference sponsored by the Federal Reserve Bank of Cleveland and the Office of Financial Research.

Lofchie Comment: In his remarks, the Vice Chair of the Federal Reserve announced that “the Federal Reserve will be developing regulations that would establish minimum margins for securities financing transactions on a marketwide basis. The margins would apply to all market participants, thereby mitigating the risks associated with regulation along institutional lines.”

It is not clear under what process, or under what authority, the Federal Reserve will propose and implement these regulations governing all market participants. Whatever the process is, the proposed rulemaking would seem to be of a type that goes materially beyond the Federal Reserve Board’s historical discretionary authority to regulate the money supply. If the Federal Reserve Board believes that such broad rulemaking should not be subject to Congressional oversight, it would at least be useful for the Federal Reserve Board to indicate what it believes are the furthest reaches of its discretionary authority.

Further deference to the Federal Reserve Board might be all to the good if one were really convinced that the Federal Reserve is consistently correct in its actions. The strength of that argument is, however, uncertain. Similarly uncertain is the assertion that the economy is now more structurally resilient than it was before the crash. By what measure? How resilient would the economy (or housing prices) be if interest rates were to soon rise 2 or 3%?

Vice Chair Fischer’s prescriptions are important to consider in the debate over the degree of control that Congress should exercise with respect to the Federal Reserve. Even if one questions the wisdom possessed by legislators (and is there anyone who does not at one time or another?), one should still accept that certain powers are properly exercised by the legislative branch, or at least are properly overseen by the legislative branch. The powers to be exercised by the legislative branch should include the oversight of the making of rules by the federal financial regulators.

Historical Financial Statistics Takes a Leap Forward

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CFS Historical Financial Statistics has just added a substantial amount of new data. Annual data points now total about 150,000, while high-frequency data points exceed 2 million. Coverage extends to 150 countries, though the depth of coverage varies widely.

In the five years since Historical Financial Statistics went online, computers have become faster and have gained memory, so we have consolidated many formerly separate files into a small number of often quite large files, which make data easier to find and use. We have also streamlined the Web format of Historical Financial Statistics so that everything is now accessible from one page.

New data include the following:

  • Extensive financial statistics on Austria-Hungary and the Balkans from the 1800s to World War II, by scholars in the South-East European Monetary History Network (whose impressive work I previously discussed here).
  • Three centuries of British data, by Sally Hills, Ryland Thomas, and Nicholas Dimsdale.
  • Balance sheet data from many currency boards around the world from the mid 1800s to the present, gathered mainly by Nicholas Krus and me.
  • Government finance data for many British colonies in the 19th and early 20th centuries, by Ewout Frankema.
  • Wages in a number of African countries in the 19th and early 20th centuries, by Ewout Frankema and Marlous Van Waijenburg.

We expect to add some other large data sets later this year. By bringing together previously scattered data, Historical Financial Statistics makes possible novel comparisons and new insights.

Data from IMF Databases Now Available for Free

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The International Monetary Fund has expanded the data it makes available for free online. In addition to its widely used and valuable but rather basic World Economic Outlook database, it has now added material from its eLibrary, which comprises a huge amount of additional data from International Financial Statistics, Balance of Payments Statistics, Government Finance Statistics, Direction of Trade Statistics, and Trade and Investment. Between the IMF eLibrary and the Federal Reserve Bank of St.Louis’s FRED database, it is now possible to find easily for free what a few years ago would have been difficult, costly,  or impossible to find.

In the IMF eLibrary, the default time period seems to be approximately the last decade for annual data, but you can go far back by changing the start date to as early as 1900, though in my experience with IMF databases, 1948 has generally been the first year for data availability. The site requires free registration to make greatest use of its capabilities.

A Trove of Data on Currency Boards

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With Nicholas Krus, I have written a book-length working paper called Currency Board Financial Statements. Spreadsheets accompanying the paper contain the digitized balance sheet data of currency boards from dozens of countries, both as raw data and in standardized form similar to what the International Monetary Fund does in its International Financial Statistics database. The paper itself gives information necessary to understand the balance sheets and some other aspects of the operations of the currency boards. (Fair warning: the details are often dull, and most readers will want to treat the working paper as they would an encyclopedia, dipping in here and there rather reading cover to cover.)

Data extend from as far back as the mid 1800s to as recently as 2013. For a number of currency boards we have monthly data on currency in circulation as well as annual balance sheet data. The paper fills a large gap in world monetary history. Currency boards have been widespread, existing in more than 70 countries, but their data have not hitherto been available in machine-readable form except for a few recently established cases. Our paper, while not complete, contains data on most of the major currency boards and many of the minor ones. We intend to update the paper as we accumulate further data.

The paper is jointly issued by the CFS and  the Johns Hopkins University Institute for Applied Economics, Global Health, and the Study of Business Enterprise, one of whose directors is CFS Special Counselor Steve H. Hanke. Nick Krus, my coathor, has twin interests in music and economics. While doing much of the work on the paper as an undergraduate student at Johns Hopkins and a researcher at the Institute, he was also in a band that was good enough to go on tour. Currently he combines his interests in his work as an Associate Analyst at Warner Music Group in New York.

New! Hyperinflation Book by CFS…

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Despite the recent slip in inflation, many ponder a future of unexpectedly higher or more volatile inflation in the wake of extraordinary monetary measures over the last six years. While the Center for Financial Stability (CFS) is clearly NOT anticipating a return to runaway inflation, analysis of hyperinflation reveals lessons worth active study for public officials, investors, and the interested public.

CFS is delighted to release “Studies in Hyperinflation & Stabilization” by Professor Gail Makinen with a foreward by Thomas J. Sargent, co-recipient of the 2011 Nobel Prize in Economics.

Hyperinflation imposes heavy economic costs and undermines political and social stability – especially in emerging and frontier markets. Similarly, study of the evolution and stabilization of hyperinflation offers lessons to strengthen monetary and financial stability in advanced economies (For specific lessons)

Despite fears over the last few years regarding a surprise increase of inflation, CFS has warned against these concerns – based on the results of our Divisia monetary and financial data developed under the leadership of Professor William A. Barnett.

Best wishes into the holiday season and 2015.

Lawrence Goodman