06.28.10

Financial Reform Bill, Part 2

Posted in Financial Markets, Politics and Policy at 4:56 pm

In this post I’ll address Section 2, entitled, “Ends Too Big to Fail Bailouts”.

From the summary:

Ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy by: creating a safe way to liquidate failed financial firms; imposing tough new capital and leverage requirements that make it undesirable to get too big; updating the Fed’s authority to allow system-wide support but no longer prop up individual firms; and establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses.

It smacks of hubris to talk of “ending the possibility” of another crisis that will require government intervention to save the system. As Minsky taught us, financial systems are inherently unstable. We should instead aim to minimize the probability of another crisis, minimize the expected severity of one should it materialize, and ensure that regulators have the tools to promptly and effectively deal with it.

Here are the “specifics”:

ENDING TOO BIG TO FAIL BAILOUTS

Limiting Large, Complex Financial Companies and Preventing Future Bailouts

No Taxpayer Funded Bailouts: Clearly states taxpayers will not be on the hook to save a failing financial company or to cover the cost of its liquidation.

That last statement is literal nonsense. It is absurd to think that the government would actually stand by that position in the event a failing institution threatened to bring down the system, nor would any reasonable person expect it. It’s akin to telling a nuclear power plant – “we’re tired of your safety violations, if you have a meltdown that threatens to kill everyone in a 200 mile radius, don’t expect our help in containing it.”

Discourage Excessive Growth & Complexity: The Financial Stability Oversight Council will monitor systemic risk and make recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with significant requirements on companies that pose risks to the financial system.

As is typically the case, the devil is in the details. Unfortunately, it appears the legislation prefers to leave all of the details to the discretion of the regulatory agencies, to be determined at some unspecified future date, and subject to change at any time.

Volcker Rule: Requires regulators implement regulations for banks, their affiliates and holding companies, to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit relationships with hedge funds and private equity funds. Nonbank financial institutions supervised by the Fed will also have restrictions on proprietary trading and hedge fund and private equity investments. The Council will study and make recommendations on implementation to aid regulators.

This is less detailed than what was provided to the media on Friday. No mention of the 3% limit on bank investments in hedge funds. No mention of how customer transactions will be distinguished from proprietary trades.

I’m also sensing a common thread with the last sentence – establish a committee to study an issue and make non-binding recommendations to a regulator who has the discretion to do what they want (or not do anything) regardless.

Extends Regulation: The Council will have the ability to require nonbank financial companies that pose a risk to the financial stability of the United States to submit to supervision by the Federal Reserve.

Covered in the previous post.

Payment, clearing, and settlement regulation. Provides a specific framework for promoting uniform risk-management standards for systemically important financial market utilities and systemically important payment, clearing, and settlement activities conducted by financial institutions.

Gibberrish. If you want to view banks as utilities and isolate and protect the payments system, then re-instate an updated version of Glass-Steagall (I fully support this idea). Don’t pretend you’re accomplishing the same thing without actually doing anything.

Funeral Plans: Requires large, complex financial companies to periodically submit plans for their rapid and orderly shutdown should the company go under. Companies will be hit with higher capital requirements and restrictions on growth and activity, as well as divestment, if they fail to submit acceptable plans. Plans will help regulators understand the structure of the companies they oversee and serve as a roadmap for shutting them down if the company fails. Significant costs for failing to produce a credible plan create incentives for firms to rationalize structures or operations that cannot be unwound easily.

This is the “living wills” provision. These plans are likely to be as effective as BP’s spill disaster plans were, in the actual event they’re needed.

Liquidation: Creates an orderly liquidation mechanism for FDIC to unwind failing systemically significant financial companies. Shareholders and unsecured creditors bear losses and management and culpable directors will be removed.

I addressed this in my Preview post. There are significant questions that need to be answered here. For example, how can the FDIC deal with an institution that depends on short term repo financing to fund its assets without creating chaos in the repo market? Repos are not like insured bank deposits, which the FDIC can exercise control over because they guarantee them. Additionally, how will the FDIC resolve a multinational conglomerate with operations in numerous countries, all with unique bankruptcy laws?

Liquidation Procedure: Requires that Treasury, FDIC and the Federal Reserve all agree to put a company into the orderly liquidation process because its failure or resolution in bankruptcy would have adverse effects on financial stability, with an up front judicial review.

So the FDIC doesn’t even have full authority even within the US. The unanimous judgement of the FDIC, the Treasury, and the Fed is required to even start the process.

Costs to Financial Firms, Not Taxpayers: Taxpayers will bear no cost for liquidating large, interconnected financial companies. FDIC can borrow only the amount of funds to liquidate a company that it expects to be repaid from the assets of the company being liquidated. The government will be first in line for repayment. Funds not repaid from the sale of the company’s assets will be repaid first through the claw back of any payments to creditors that exceeded liquidation value and then assessments on large financial companies, with the riskiest paying more based on considerations included in a risk matrix

Putting the government ahead of all other creditors in the event a rescue is needed is a good idea. However, it appears this provision prevents a rescue from even being initiated if the FDIC does not believe it will not be repaid in full. This could serve as a straightjacket in the event of an actual crisis where time is of the essence.

Federal Reserve Emergency Lending: Significantly alters the Federal Reserve’s 13(3) emergency lending authority to prohibit bailing out an individual company. Secretary of the Treasury must approve any lending program, and such programs must be broad based and not aid a failing financial company. Collateral must be sufficient to protect taxpayers from losses.

Wait, what? Does this apply only to non-bank financials or to banks as well? Hopefully the latter (as would be indicated by the 13-3 reference). If the former, it would essential mean requiring Treasury consent for each and every Discount Window borrowing. More broadly, however, the reality is that in any financial crisis, the weakest firms will go first, and then contagion will spread to other firms. It won’t all happen simultaneously. Preventing rescues of individual firms effectively prevents rescues of the system itself.

Bankruptcy: Most large financial companies are expected to be resolved through the bankruptcy process.

Absurd, both in theory and in practice. Standard bankrupcty doesn’t work for large financial firms, which is the entire point of this legislation.

Limits on Debt Guarantees: To prevent bank runs, the FDIC can guarantee debt of solvent insured banks, but only after meeting serious requirements: 2/3 majority of the Board and the FDIC board determine there is a threat to financial stability; the Treasury Secretary approves terms and conditions and sets a cap on overall guarantee amounts; the President activates an expedited process for Congressional approval.

I like this provision. When the FDIC went and guaranteed the bonds of the big banks, it was clearly overstepping. The FDIC is supposed to provide DEPOSIT insurance, not become a monoline and insure bonds. While those steps may have been necessary, if the government is going to guarantee ALL bank liabilities, then we need to rethink banking on a fundamental level, which we’re clearly not prepared to do, given the limited scope of this legislation. At least this provision establishes some controls around the matter.

Overall, a very weak section. Some tentative steps are taken in the right direction, but much is left to the discretion of the regulatory agencies again. Additionally, claiming to end the posiibility of taxpayer-funded bailouts and declaring that systemic measures are not to be used to save individual firms, while not doing enough to actually minimize the likelihood and severity of future crises may have the perverse effect of constraining government action when it is most needed and make a future crisis worse than it otherwise would have been.

Financial Reform Bill, Part 1

Posted in Financial Markets, Politics and Policy at 4:51 pm

The death of Robert Byrd has thrown a bit of a wrench into the plans to have the Financial Reform legislation up for final vote before July 4.

There’s still not much in the way of specific language from the financial reform legislation, but the House Financial Services Committe has released a summary ( http://online.wsj.com/article/BT-CO-20100626-701056.html ).

In this post I’ll address Section 3, entitled, “Advance Warning System”.

From the summary:

Creates a council to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the economy.

Well, it’s a start, but the obvious question is – why were existing regulators not worried about systemic risk in the past? It’s not a new concept. Furthermore, one can’t argue that no regulator had a mandate to do so, since the Federal Reserve, as a central bank, has always been the lender of last resort, and has always had a dual mandate that includes the maintenance of full employment, in effect making them the systemic risk regulator.

Here are the “specifics”, and I use the term loosely:

The Financial Stability Oversight Council

Expert Members: Made up of 10 federal financial regulators and an independent member and 5 nonvoting members, the Financial Stability Oversight Council will be charged with identifying and responding to emerging risks throughout the financial system. The Council will be chaired by the Treasury Secretary and include the Federal Reserve Board, SEC, CFTC, OCC, FDIC, FHFA, NCUA and the new Consumer Financial Protection Bureau. The 5 nonvoting members include OFR, FIO, and state banking, insurance, and securities regulators.

This is largely an expansion of the existing President’s Working Group On FInancial Markets.

The big question here is – what exactly are they empowered to do once they have identified an “emerging risk”?

See below:

Tough to Get Too Big: Makes recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with significant requirements on companies that pose risks to the financial system.

Ahh, they can “make recommendations” to the Fed, who already regulates these institutions, yet failed to spot the emerging risks that developed from 2004-2007. Got it.

Regulates Nonbank Financial Companies: Authorized to require, with a 2/3 vote, that a nonbank financial company be regulated by the Federal Reserve if the council believe there would be negative effects on the financial system if the company failed or its activities would pose a risk to the financial stability of the US.

Interesting that they chose to require a supermajority for all votes.

A few questions to ask:

1. What is the definition of a Nonbank Financial Company? Would a hedge fund like LTCM fall under that umbrella? What about an insurance company like AIG? Or for that matter a monoline insurer?
2. Does the stipulation that the Council must demonstrate the presence of systemic risk for their decision open up the vote to a legal challenge?
3. What happens to the existing regulator of that institution? Will they just go away or will they share authority with the Fed?

It’s also interesting to note that the Council’s vote doesn’t actually impose any restrictions on the firm’s activities, it merely subjects them to the regulation of the Fed.

Break Up Large, Complex Companies: Able to approve, with a 2/3 vote, a Federal Reserve decision to require a large, complex company, to divest some of its holdings if it poses a grave threat to the financial stability of the United States – but only as a last resort.

Who determines what holdings must be divested, and according to what guidelines?

Is this decision open to legal challenge? One of the original bills explicity identified a specific appeal process. Did that survive the negotiations?

Also note the modifiers “grave threat” and “only as a last resort”. This seems to imply there is criteria for distinguishing grave threats from ordinary threats and also that there will be a defined sequence of steps to be taken prior to the “last resort”.

Technical Expertise: Creates a new Office of Financial Research within Treasury to be staffed with a highly sophisticated staff of economists, accountants, lawyers, former supervisors, and other specialists to support the council’s work by collecting financial data and conducting economic analysis.

Fantastic! Where do I apply?

More seriously, it’s safe to assume that Treasury already employs these types of professionals, so this really amounts to a new Director position and perhaps some additional funding for more FTEs.

Make Risks Transparent: Through the Office of Financial Research and member agencies the council will collect and analyze data to identify and monitor emerging risks to the economy and make this information public in periodic reports and testimony to Congress every year.

.

Ok. More information is generally better.

No Evasion: Large bank holding companies that have received TARP funds will not be able to avoid Federal Reserve supervision by simply dropping their banks. (the “Hotel California” provision)

This seems to be intended to apply specifically to Goldman and Morgan Stanley, which became Bank Holding Companies during the crisis. Other TARP recipients actually are banks, and so cannot simply drop that status.

Capital Standards: Establishes a floor for capital that cannot be lower than the standards in effect today.

It’s odd that capital adequacy requirements (and its inverse twin, leverage restrictions), being so central to the entire subject of regulating systemic risk, only received a single sentence in the document. The choice of language is also puzzling – capital standards cannot be lower than they are today (without stating explicitly that they need not necessarily be higher). Is that a flowery way of stating “maintain the status quo”?

Overall, this section is very weak. It establishes a couple of new regulatory bodies, shifts around the responsibilities of existing regulators a bit, and provides some vague guidance to the regulators on where they should focus. However, it is extremely short on specifics.

06.27.10

Financial Reform Preview

Posted in Financial Markets, Politics and Policy at 3:59 pm

Over the next week or so, I intend to do a series of somewhat detailed looks at the various components of the nascent financial reform legislation.  It’s a bit premature at the moment, since all we have are the versions of the bill originally passed by the House and Senate along with comments made to the media regarding agreements reached in negotiation late last week.  Since the announced intent is for the reconciled bill to be put up for a final vote before the Independence Day weekend, we should see something tangible soon.

Here are some preliminary comments on the key components of the bill, with more to come:

  • Resolution Authority – Much of the discussion during the negotiation focused on whether or not the resolution authority would be pre-funded.  This was just a giant red herring in reality.  It appears that the FDIC will end up with jurisdiction over resolutions, and I anxiously await details on the exact structure.  It’s hard to see how the approach the FDIC has historically taken with depositories will work with the large financial conglomerates.  When the FDIC takes over an insolvent deposit bank, it first tries to sell the bank to another bank, with the buyer assuming all assets and liabilities of the failed bank.  That’s the quickest and easiest approach with the least disruption.  If that doesn’t work, then the FDIC responsibility for insured deposits (it has its own fund paid for by member bank premiums) and sells the failed bank’s assets at market to recover funds paid.  This works because the failed bank’s funding source (deposits) is already insured by the FDIC, and given the history of insured depositors never having lost a penny, there’s no reason for depositors to rush for the exits.  The large conglomerates use repos and other funding sources, so it will be interesting to see how the FDIC attempts to deal with such a failed institution without locking up entire markets.  It will also be interesting to see how the FDIC will approach foreign subsidiaries of these firms.
  • Proprietary Trading/Volcker Rule – Preliminary information suggests banks will be allowed to invest up to 3% of Tier 1 Capital in hedge funds.  This significantly weakens the proposed ban on proprietary trading.  What will be of particular interest is how the final legislation defines customer trading and market making activities.  This will largely determine the effectiveness of these provisions.  It’s likely there will be significant room for interpretation in the definitions, such that many activities that do in fact objectively represent trading for the bank’s books will be allowed.
  • Derivatives Reform – Some types of derivatives trades will end up having to be moved to separate subsidiaries of the bank holding company, and these susbs will have to raise their own capital.  There appear to be exemptions for interest rate swaps, foreign currency swaps, and exchange traded Credit Default Swaps, among other instruments.  The legislation also requires many derivative instruments currently traded OTC to have to be traded through a clearinghouse and possibly on an exchange (this is an area where the media has been sloppy, essentially using clearinghouse and exchange interchangeably when they are not).  There appear to be exemptions in the legislation for “legitimate hedgers”, and there will be a two year transition period.
  • Consumer Protection – It appears there will be an exception for auto dealers, due to fairly intense lobbying.  I won’t spend much time on this one.  While consumer protection is important, it’s not something that is central to preventing another crisis.
  • Credit Ratings Agencies – I’ve seen conflicting reports here.  The latest seems like the legislation will likely establish a commission to study the issue further rather than implementing change now.  Ultimately, the conflict of interest inherent in having a security issuer pay for the rating needs to be resolved.
  • Leverage, Capital, and Liquidity Requirements -  Again, lots of conflicting reports.  We’ll see what develops over the week, but this is a crucial area for reform, and it should not simply be left to the discretion of the regulators to determine.

The latest reports indicate there will not be any hard size caps on financial institutions, though regulators may be given some discretion here over institutions they deem systemically important.  It also appears that there isn’t anything in the latest version of the legislation regarding the GSEs.

Much more to come……..

Fiscal Policy

Posted in Economics at 9:15 am

The best way to illustrate how fiscal policy can help during a recession is with a Production Possibilities Frontier (PPF).  This is particularly effective for those who get hung up on crowding out effects (e.g., the Treasury View).

PPF

PPF

The PPF can be drawn several different ways.  One axis can represent consumption spending while the other represents investment spending.  Or government spending vs private sector spending.  Or guns vs butter.  In all cases, the frontier represents a technology constraint and shows the tradeoff between two choices.  If the economy is operating on the frontier (by definition it can’t be outside the frontier) then any increase in consumption necessarily implies a decrease in investment and vice versa, any increase in government spending necessarily implies a decrease in private spending and vice versa, any increase in the production of guns necessarily implies a decrease in the production of butter and vice versa.  This is what Keynes was talking about when he spoke of the classical view.

Here’s the problem with the classical view.  Operating on the frontier means that the economy is operating at full capacity.  All labor and all capital is fully employed.  During a recession, the economy is NOT operating at full capacity.  There is unemployed labor and unemployed capital.  By definition, the economy is not operating on the PPF, rather it is operating inside of it.  Therefore it is possible to increase consumption and investment simultaneously, government and private spending simultaneously, guns and butter simultaneously.  Doing so represents a move towards the PPF, which in turn means higher capacity utilization, and greater employment of resources.  An economy operating on the PPF is a special case – the general case is that the economy can be operating anywhere inside the PPF or on the PPF but not outside of it.  Keynes recognized this (hence the title of the GENERAL Theory) and then went on to explain the determinants of where the economy will find equilibrium and the policy choices that could move the economy toward the full employment equilibrium (on the PPF).

06.26.10

Firewalls In Financial Regulation

Posted in Financial Markets, Politics and Policy at 7:00 am

The term firwall originally referred to a physical separator or wall designed to prevent or slow the spread of a fire from one area to another.  Firewalls exist in buildings, where they are designed to limit the spread of fire from one section within a building to another or between buildings.  They also exist in automobiles (the metal wall between the back of the engine and the passenger compartment) where they serve to slow the spread of a fire that develops in the engine compartment to the passenger department.

Somewhere along the line, the computer industry picked up on the term, and started using it to refer to the security software used to protect computer networks.  The idea is largely the same – the firewall sits between the internal network and the external network (e.g., the Internet) and prevents problems on the outside from coming in.

Wherever they exist, the principle remains the same – problems (be they fire or malicious computer code) can never be completely avoided, but we can take steps to contain them or limit their spread.

Firewalls can also be used within a financial system to prevent contagion – a problem in one market from spreading to others.  Probably the most famous example of a financial firewall is the Glass-Steagall Act passed during the Great Depression.  Essentially, it created a firewall between the commercial banking system and the investment banking system.  The former was limited to taking deposits and making loans, while the latter was restricted to capital market activities like underwriting securities and providing broker-dealer functions.  The idea was to prevent problems in the capital markets from spreading to banks, where they could cause the entire payments system to collapse.

In general, firewalls should be an integral part of any financial system.  As noted above, we can never fully anticipate and prevent future problems.  However, we can take steps now, to build a system that structurally, can stop or slow problems from spreading, and thus give regulators sufficient time to address them when they arise.

One has to wonder – why are there essentially no firewalls in the latest version of the Financial Reform bill?

06.25.10

The Shadow Banking System

Posted in Financial Markets, Politics and Policy at 9:24 pm

What we saw from mid-2007 through early-2009 was a run on the shadow banking system.

There were two primary channels by which the shadow banking system operated: the Money Market/Commercial Paper Channel and the Repo Channel.  Note that I am deliberately avoiding a discussion of SIVs, Conduits, and other SPEs which at one point made up a substantial part of the shadow banking system, because they were generally sponsored by banks as off balance sheet entities, and the sponsoring banks generally had to bring them back on balance sheet during the crisis, so they are presently of limited concern.

The Money Market/Commercial Paper Channel worked as follows:  Individuals and firms, seeking higher yields on cash accounts than offered by banks, deposited money in money market mutual fund (MMMF) accounts.  These MMMFs, in turn, used the deposits to purchase, among other things, commercial paper.  In some cases, they bought commercial paper of non-financial firms directly; in most cases they bought commercial paper issued by financial firms (broker-dealers) who in turn bought commercial paper from non-financial firms.  Commercial paper represents a short term (30-270 day), generally unsecured, largely unregulated, debt security that often substitues for bank loans.  In fact, during the few years before the crisis, commercial paper did displace bank lending as a source of short term industrial funding to a large degree.  So here we have largely unregulated entities (MMMFs) taking deposits (largely withdrawable on demand and usually checkable) and making the equivalent of loans, in other words, acting as banks.  Except that the MMMFs were not subject to much in the way of prudential regulation beyond some broad parameters that dictated what investments they could buy, did not have access to FDIC deposit insurance, and did not have lender of last resort access to the Fed’s discount window.  They were a disaster waiting to happen.

The Repo channel was a little less direct.  A repo (repurchase agreement) is a transaction where a seller agrees to sell a security to a buyer and agrees to then buy it back at a specificed point in the near future.  The seller is in effect borrowing money from the buyer at an interest rate represented by the difference in price of the security on the two dates that is agreed upon up front, with the security serving as collateral.  Thus a repo is really just a short term, collateralized loan.  Repos also became a very popular mechanism for raising funds in the pre-crisis days, with MMMFs becoming large buyers of repos (lenders) and the broker dealers becoming both buyers and sellers (borrowers and lenders).  An added wrinkle is that in many cases the collateral pledged for a repo could be “rehypothecated” or used by the buyer (lender) as collateral to sell another repo (borrow) and so on down the chain.  There are obvious paralells here to the expansion of deposits in a traditional commercial banking system.

What went wrong during the crisis, in both channels, was that longer term assets (commercial paper bought by MMMf in the first case and investments by broker dealers in the second case) were funded by shorter term liabilities (MMMF deposits and repos).  This is the classic maturity mismatch situation faced by commercial banks in general (where loans are funded by deposits that may be withdrawn on demmand) that exposes them to bank runs.  Commercial banks, however, have deposit insurance and access to the Fed discount window, designed to protect them against this possibility.  In the case of the shadow banking system, concerns about the quality of commercial paper held (triggered by the collapse of Lehman who had issued a signficant amount of commercial paper) led MMMMF investors to attempt to withdraw their funds en masse, just as concerns about the value of securities pledged as collateral in repos led to additional collateral calls by repo buyers (lenders) along with a general fall in their willingness to engage in repo transactions, which made it difficult for repo sellers (borrowers) to roll over the funding needed to support their longer term asset holdings.  Without the traditional protection of deposit insurance and lender of last resort financing by the Fed, it turned into a full blown panic in late 2009.

The Fed and FDIC took a number of steps, once the panic started, to try and alleviate the stress.  This included extending deposit insurance to MMMF depositors and the expansion of liquidity facilities to make both short term funding and “safe” Treasuries more available to market participants.  However, most of the emergency measures were temporary by design.

Any meaningful financial reform must bring the shadow banking system out of the shadows.  It must be treated as banking, and its institutions regulated as banks.  That means prudential regulation and capital adequacy standards in exchange for the protections traditionally afforded to commercial banks.  Perhaps the shadow banking system was only profitable because it was able to externalize risks in the absence of banking regulation and the extension of regulation to it will make it unprofitable and drive its activities back to the traditional banks.  Perhaps not.  What’s not acceptable or sustainable, however, is maintenance of the status quo.

Out with the old, in with the new

Posted in Uncategorized at 9:08 pm

I’m reviving the blog, this time hopefully it stays alive.

An archive of the old blog postings can be found here:

http://www.disequilibria.com/blog/Disequilibria_Old.html