Eugene Scalia, of the family Scalia, has been the scourge of the SEC with his until recently effective insistence on a cost-benefit analysis to justify the imposition of new major rules on the capital markets. Now he's working for MetLife, the insurance company recently designated as a SIFI (which stands for "dangerously big bank-like institution"), and I guess the argument will be that the designation was arbitrary and capricious, and so inconsistent with the federal standards for administrative procedure, which probably, in Scalia's view, require a quantitative cost-benefit analysis done with meticulous care. Some thoughts:
- Courts often stay out of financial stability inquiries, but, then, they used to defer to the SEC's capital markets expertise, until Eugene Scalia came along. Perhaps Scalia can do something in this really nascent field of disputing SIFI designations. Still, uphill battle.
- If the FSOC somehow lost this case, it could always go global, and ask the Financial Stability Board to designate Met Life as a G-SIFI, which would give foreign regulators the right to persecute the firm's foreign operations, and maybe super-persecute it, if the American regulators could do nothing to control its SIFIness.
- The basic idea, by the way, which is hardly ludicrous, is that insurance companies aren't subject to bank runs, even if they are really big, and that only one of them failed, or was even at risk, during the last financial crisis. Since Met Life isn't in the business of writing unhedged credit default swaps (which is what AIG did, bolstered by its AAA rating and huge balance sheet), why should it have to hold bank-like levels of capital? There's more to that story, but I assume that is part of the story that MetLife will be telling.
HT: Matt Levine
Okay, the headline was made to draw in the reader. Non-banks will be allowed to securitize to their heart's content, and banks will likely basically continue to do the same. However, the Basel Committee orchestrated a meeting in Tianjin between central bankers (they do monetary policy) and bank supervisors (they do safety and soundness),and came up with, among other standards, an approach to the ability of banks to hold collateralized debt obligations, the sort of obligations that have been blamed for the financial crisis.
I will quote the report made from the meeting, though that's pretty dull and bureaucratic. However:
- the freedom of banks to hold derivatives is being set in these informal international meetings among bureaucrats, a fact always worth repeating
- the limits on bank holdings of securitized assets is being set through a negotiated, and global, process involving bank regulators and capital market regulators
- some people, the US very much not included, would see no reason to consult those who set monetary policy, or what the currency is worth, on the appropriate way to limit the power of banks to hold derivatives, or whether derivatives would fail to protect a bank in crisis times
- the supervisors and central bankers met in Tianjin, which means that some of them hopefully took the world's fastest train from Beijing's airport to Beijing's port city.
It's all very global and committee of regulators oriented. Anyway, here's the report on securitization assets held by banks:
The Committee also reviewed progress towards finalising revisions to the Basel framework's securitisation standard and agreed the remaining significant policy details that will be published by year-end. It also recognised work that is being conducted jointly by the Basel Committee and the International Organization of Securities Commissions (IOSCO) to review securitisation markets. The Committee looks forward to the development of criteria that could help identify - and assist the financial industry's development of - simple and transparent securitisation structures. In 2015, the Committee will consider how to incorporate the criteria, once finalised, into the securitisation capital framework.
Turkey's largest Islamic bank believes that it has been targeted for destruction by the Turkish government, and, given the way things seem to go in that country, the level of conspiratorial innuendo is high. But also high is the discretion of the government to act against banks and observers of same. Banks generally did well in the financial crisis of 2008, if not so well before then. Usually, supervision is done for safety and soundness. But here's Euromoney's quote of one of the principles of Turkish banking law:
The 'protection of reputation’ article of Turkey’s banking law, introduced after the country’s devastating banking crisis of 2001, states "no real or legal person shall intentionally damage the reputation, prestige or assets of a bank or disseminate inaccurate news either using any means of communication". Convicted violators of the code face up to three years in prison.
That seems like almost untrammeled regulatory discretion to me, joined with severe penalties. You could go after shorts, any sort of speaker, and probably the banks themselves, for soiling their own reputation. Via Matt Levine.
Geoffrey Graber, who is heading up a mortgage fraud task force for DOJ, is motivated by Glengarry Glen Ross, and the results have evinced an ouch from the banking community:
The surge of settlements engineered by Graber in the past year has helped neutralize some of that criticism and rehabilitate a key piece of Holder’s legacy. Still, the settlements have been controversial. Critics such as Roy Smith, a professor at New York University’s Stern School of Business, say prosecutors were driven by “political fever” to extract massive penalties from Wall Street.
“They have to deliver something, so they come up with this,” said Smith, a former Goldman Sachs Group Inc. (GS) partner. “The fact that it’s unfair never really gets considered. The banks have no choice but to hunker down and accept it.”
A bracing corollary to those capture stories, though notice that it's the enforcement officials who win headlines for big settlements, and the bank examiners who are subject to the expose about go along get along.
Steven Davidoff Solomon and I opine on a recent opinion dismissing cases brought by Fannie and Freddie shareholders against the government in DealBook. A taste:
In one Washington court, Maurice R. Greenberg, the former chief executive and major shareholder of A.I.G., is suing the United States government, contending that the tough terms imposed in return for the insurance company’s bailout were unconstitutionally austere.
In another closely watched case in a different Washington court, the shareholders of Fannie Mae and Freddie Mac, led by hedge funds Perry Capital and the Fairholme Fund, lost a similar kind of claim.
Parsing what the United States District Court did in the Fannie and Freddie litigation offers a window into the ways in which the government’s conduct during that crisis might finally be evaluated.
There are three main points to the decision. For one, the court held that the government’s seizure of Fannie’s and Freddie’s profits did not violate the Administrative Procedure Act’s prohibition on “arbitrary and capricious” conduct. It also found that the Housing and Economic Recovery Act barred shareholders of Fannie and Freddie from bringing breach of fiduciary duty suits against the boards of the companies and that the government’s seizure of profits was not an unconstitutional “taking.”
This American Life has a banking supervision story (!) that turns on secret recordings made by a former employee of the New York Fed, Carmen Segarra, and it's pretty good, because it shows how regulators basically do a lot of their regulating of banks through meetings, with no action items after. That's weird, and it's instructive to see how intertwined banking and supervision are. There's a killer meeting after a meeting with Goldman Sachs where Fed employees talk about what happened, and - though we don't know what was left on the cutting room floor - the modesty of the regulatory options being considered is fascinating. Nothing about fines, stopping certain sorts of deals, stern letters, or anything else. The talk is self-congratulation (for having that meeting with Goldman) and "let's not get too judgmental, here, guys."
The takeaway of the story, which is blessedly not an example of the "me mad, banksters bad!" genre, is that this kind of regulation isn't very effective. It clearly hasn't prevented banks from being insanely profitable until recently, in a way that you'd think would get competed away in open markets.
But here's the case for banking regulation:
- Imagine what it would be like if Alcoa and GE had EPA officials on site, occasionally telling them to shut down a product line. That's what bank regulators do, and, more broadly, did with things like the Volcker Rule (with congressional help).
- Since the financial crisis (and that's the time that's relevant here), regulation has made banking less profitable, not more, share prices are down, so are headcounts, etc.
- Regardless of how it looks, regulators that essentially never lose on a regulatory decision - that includes bank supervisors, but also broad swaths of agencies like Justice and DoD - don't experience themselves as cowed by industry. Kind of the opposite, actually. So what you really worry about is the familiarity leading to complacency, not fear. Regulators can fine any bank any number they like. If they want someone fired, they could demand it without repercussion.
The fact that TAL pulled off this story, given that it was centered around an employee who lasted at the Fed for 7 months before being fired, who made secret recordings of her meetings with colleagues (who does that?), who mysteriously and obviously wrongly alleged during her time at the Fed that Goldman Sachs did not have a conflict of interest policy, whose subsequent litigation has gone nowhere, and whose settlement demand was for $7 million (so that's one million per month of working as a bank examiner, I guess), is impressive. But that's the former government defense lawyer in me, your mileage may vary.
Morover, even skeptical I was persuaded that maybe the Fed could do with a more ambitious no-holds-barred discussion among its regulators, at the very least.
The Basel Committee is doing a lot of Basel III capital accord implementation this week. Page 10 of this report makes it look like the largest banks hold slightly less capital than smaller banks, which is the opposite of what you would want (smaller banks hold more variable capital though). And this report suggests that the effort to have banks deal with a hypothetical effort to adopt the new capital rules was messy. Not to worry, though! As is the case with all Basel documents, bland positivity about the success of the regulatory effort is the tone of the day.
One of the reason that bank capital regulation became an international affair was to ensure a regulatory "level playing field," which would be paired with market access to the US and UK. That is, as long as the rest of the world complied with the Anglo-American vision of capital requirements, access to London and New York would be assured.
But as former law professor and current Fed Board member Daniel Tarullo will testify to Congress today, as those global (call them "BCBS") rules have become more elaborate and comprehensive, some countries have elected to depart from them - only upwards, not downwards. Switzerland is trying to use very, very heightened capital requirements to shrink its universal banks into asset managers. And now the United States is enacting global rules with its own pluses. For example, the liquidity coverage ratio, which requires banks to keep a certain percentage of their assets in cash-like instruments,
is based on a liquidity standard agreed to by the BCBS but is more stringent than the BCBS standard in several areas, including the range of assets that qualify as high-quality liquid assets and the assumed rate of outflows for certain kinds of funding. In addition, the rule's transition period is shorter than that in the BCBS standard.
The Fed is also imposing an extra capital requirement on the largest American banks:
This enhanced supplementary leverage ratio, which will be effective in January 2018, requires U.S. GSIBs [very large banks] to maintain a tier 1 capital buffer of at least 2 percent above the minimum Basel III supplementary leverage ratio of 3 percent, for a total of 5 percent, to avoid restrictions on capital distributions and discretionary bonus payments
And another such requirement based on the amount of risk-based capital,
will strengthen the BCBS framework in two important respects. First, the surcharge levels for U.S. GSIBs will be higher than the levels required by the BCBS, noticeably so for some firms. Second, the surcharge formula will directly take into account each U.S. GSIB's reliance on short-term wholesale funding.
I think of the global efforts in financial regulation as being notable precisely because they created, incredibly informally, some reasonably specific and consistently observed rules that comprise most of the policy action around big bank safety and soundness. The little new trend towards harmonization plus is a bit comparable to the trade law decision to create the WTO for global rules, but to permit regional compacts like NAFTA and the EU to create even freer trade mini-zones. Some find this multi-speed approach to be inefficient and, ultimately, costly to the effort to create a consistent global program. We'll see if the Basel plus approach rachets up bank regulation, or just disunifies it.
You'd think that the state that's home to the center of American business would take a Delaware-style light touch approach to overseeing it. But instead, the New York paradigm is to take ambitious politiicans, blend with broadly worded supervisory or anti-fraud statutes like the Martin Act, and come up with stuff that, to my ears, sounds almost every time like it is off-base, at least in the details. So:
- Eliot Spitzer pursued research analysts for the sin of sending cynical emails even though they issued buy recommendations, despite that fact that analysts never issue negative recommendations, and if cynical emails are a crime, law professors are the most guilty people in the world.
- I still don't understand what Maurice Greenberg, risk worrier par excellence, did wrong when he was running AIG. I do know that after he was forced out by Spitzer, the firm went credit default swap crazy.
- Maybe there's something to the "you didn't tell your investors that you changed the way you did risk management for your mortgage program" prosecutions, but you'll note that it is not exactly the same thing as "you misrepresented the price and/or quality of the mortgage products you sold" prosecutions, which the state has not pursued.
- Eric Schneiderman's idea that high frequency trading is "insider trading 2.0" is almost self-evidently false, as it is trading done by outsiders.
- Federal regulators wouldn't touch Ben Lawsky's mighty serious claims that HSBC or BNP Paribas were basically enabling terrorist financing.
- And now Lawsky is going after consultants for having the temerity to share a report criticizing the bank that hired them to review its own anti-money laundering practices with the bank, who pushed back on some, but not all of the conclusions.
The easiest way to understand this is to assume that AGs don't get to be governor (and bank supervisors don't get to be AGs) unless people wear handcuffs, and this is all a Rudy Giuliani approach to white collar wrongdoing by a few people who would like to have Rudy Giuliani's career arc.
But another way to look at it is through the dictum that the life of the law is experience, not logic. The details are awfully unconvincing. But these New York officials have also been arguing:
- Having analysts recommending IPO purchases working for the banks structuring the IPO is dodgy.
- HFT is front-running, and that's dodgy.
- This new vogue for bank consulting is dodgy, particularly if it's just supposed to be a way for former bank regulators to pitch current bank regulators on leniency.
- If we can't understand securitization gobbledegook, we can at least force you to employ a burdensome risk management process to have some faith that you, yourself, understand it.
- And I'm not saying I understand the obsession with terrorism financing or what the head of AIG did wrong.
Their approach is the kind of approach that would put a top banker in jail, or at least on the docket, for the fact that banks presided over a securitization bubble in the run-up to the crisis. It's the "we don't like it, it's fishy, don't overthink it, you're going to pay for it, and you'll do so publicly" approach. It's kind of reminiscent of the saints and sinners theory of Delaware corporate governance. And it's my pet theory defending, a little, what otherwise looks like a lot of posturing.
Steve Davidoff Solomon and I have put together a paper on the litigation between the government and the preferred shareholders of Fannie Mae and Freddie Mac. Do give it a look and let us know what you think. Here's the abstract:
The dramatic events of the financial crisis led the government to respond with a new form of regulation. Regulation by deal bent the rule of law to rescue financial institutions through transactions and forced investments; it may have helped to save the economy, but it failed to observe a laundry list of basic principles of corporate and administrative law. We examine the aftermath of this kind of regulation through the lens of the current litigation between shareholders and the government over the future of Fannie Mae and Freddie Mac. We conclude that while regulation by deal has a place in the government’s financial crisis toolkit, there must come a time when the law again takes firm hold. The shareholders of Fannie Mae and Freddie Mac, who have sought damages from the government because its decision to eliminate dividends paid by the institutions, should be entitled to review of their claims for entire fairness under the Administrative Procedure Act – a solution that blends corporate law and administrative law. Our approach will discipline the government’s use of regulation by deal in future economic crises, and provide some ground rules for its exercise at the end of this one – without providing activist investors, whom we contend are becoming increasingly important players in regulation, with an unwarranted windfall.
Portugal took the kind of quick action on its second largest bank that is completely by the book. What can we learn about the current reality of bank bailouts from it?
- Even medium sized banks are global: BES was doomed not by its Portuguese operations, but by its Angolan unit. This sort of thing has driven supervisors to set up global regimes - the idea that their domestically safe and sound bank is in trouble internationally, but they don't know it - or that its foreign counterparties are, and they don't know that.
- The government created a good bank and a bad bank, meaning that BES stakeholders now have one bank with depositors and branches, and another with dodgy loans in Angola. This is a way of giving everyone - creditors, shareholders, employees - a haircut, but, since the Portuguese government is loaning BES $4.5 billion, it is hard to say this isn't also a lender of last resort bailout. Still, a textbook approach.
- This sort of ring-fencing, on a much larger scale, is one of the ways that some regulators would like to practice bank safety. A British bank would have its British assets segregated from its overseas ones, and so on. That obviously creates internal inefficiencies in the bank, but there you go.
- What Portugal did was to "resolve" BES. You can perhaps see why some think that one of the failures of the post financial crisis reforms is the failure to, so far, come up with a cross-border resolution scheme. The British couldn't do this with Barclays, or couldn't without agreement by the Americans, and who knows if, when the chips are down, that would be forthcoming?
Over at DealBook, I've got something on the financial regulatory reform that Europeans, in particular, love. Give it a look. And let me know if you agree with this bit:
Can a supervisory college work in lieu of a vibrant global resolution authority regime? The problem with these colleges is not that they are implausible, but that they have not really been tried in a crisis. The best-known supervisory college outside of the European Union was created in 1987 to monitor the Luxembourg-based, but international, Bank of Credit and Commerce International. Rumors of widespread fraud in the management of the bank were plentiful, but the collegiate approach did not mean that these problems were nipped in the bud. Although coordinated supervision led regulators to close many of bank’s branches at once after the bank’s accountant resigned and its insolvency became obvious, it is not clear whether Bank of Credit and Commerce International is a college success story or cautionary tale.
There are other reasons to worry about relying on colleges. The collegiate approach is meant to encourage communication more than action. Colleges operate as peers, convened by the home banking regulator, without the sort of hierarchy of decision-making and direction that leads to coordinated action.
After the SEC settled with Citigroup over misreprsentations made about a toxic security it sold during the financial crisis for a centimillion dollar fine among other things, Judge Rakoff rejected the settlement for failing to contain "cold, hard, solid facts established either by admissions or trials." I've been pretty critical of the decision, which was always headed for reversal. Not that Judge Rakoff cares: his familiarity with the agency (he once was in it), his generally respected status as a judge, and rumblings of discontent by other courts asked to approve other settlements once he fired his shot across the SEC's bow has led to a change in approach by the agency; I talked about the new policy here.
The problem with the decision was twofold, according to the Court of Appeals, at least as I interpret it.
Problem 1: Doctrinally, a settlement decision is an exercise of enforcement discretion, and enforcement discretion is basically unreviewable because the alternative - making it reviewable - would thrust the courts into the heart of what the executive branch does. Because the SEC wanted continuing court supervision of Citigroup as a consequence of the settlement, Rakoff did, indeed, have something to do. But if the SEC had simply dismissed its suit in exchange for the payment of a fine, which is less onerous than a fine plus continuing supervision by a court, Rakoff would have had, literally, no role to play in the resolution of the case. So requiring cold, hard facts to be established as a condition of signing off on a deal was a radical increase in the oversight of the SEC by a court.
No surprise, then, that the Second Circuit said that "there is no basis in the law for the district court to require an adminision of liability as a condition for approving a settlement between the parties. The decision to require an admission of liability before entering into a consent decree rests squarely with the SEC."
Problem 2: Settlements are not about right and wrong, while admissions of guilt are. Settlements are about moving on. We don't expect private parties to establish whether management caused the bankruptcy or someone else did, whether that product really was dangerous, or was misused by consumers, or whatever. And these can be matters of great public import. So it was never clear why the government, even though, yes, it is a state actor, should be treated very differently.
No shock, then, that the Second Circuit has said that "consent decrees are primarily about pragmatism" and "normally compromises in which the parties give up something they might have won in litigation and waive their rights to litigation."
According to the appellate court, the right way to review consent decrees is for procedural clarity and, as far as the public interest is concerned, with Chevron deference to reasonable decisions by the agency. It's not totally clear what that deference means - the court faulted Rakoff for figuring out whether the public interest in the truth was served by the deal when he should have been deciding "whether the public interest would be disserved by entry of the consent decree." But there you go.
Anyway, I think this stuff is interesting, because it's a tool in the regulatory arsenal, and indeed, my first baby law professor article was on just that.
Frank Partnoy returns to the subject he wrote about early in his academic career, the role of law and regulation in financial crises, with a new book chapter on Financial Systems, Crises, and Regulation. I read Frank's earlier 1999 article avidly: this was back before the topic was fashionable. This new chapter includes a discussion of theories of the roles that information asymmetries and agency costs play in propagating crises. Later, the chapter moves on to talk about mandatory disclosure, anti-fraud enforcement, and corporate governance as crisis prevention tools. This swims against the tide of conventional wisdom which has focused more on prudential financial regulation (which Partnoy also discusses) as antidote to crisis.
Here is a critical excerpt from the chapter:
In the aftermath of the 1929 crash, regulators imposed a twin pillar regime of mandatory disclosure and anti-‐fraud enforcement. Those two pillars were the key architecture features that supported well functioning markets for decades. Both have been eroded in recent years, as disclosures became boilerplate and anti-‐fraud prosecution more limited and infrequent. The response to the Global Financial Crisis could have included architecture moves to rebuild those pillars. But instead the Dodd-‐Frank legislation focused on other priorities and architecture changes in the areas of disclosure and anti-‐fraud enforcement were minimal.
This provocative line of thought raises an important question: If disclosure and corporate governance rules are key for systemic risk too, should these rules be tailored for financial institutions? After all, Coca Cola's securities disclosure and corporate governance played no role in our latest crisis. Shouldn't we tailor securities disclosure and corporate governance reforms for banks rather than a blunderbuss approach? After all, banks (including those by any other name) are special; they play special roles in the economy and pose special risks.
In Governor Tarullo’s closely watched speech on bank regulation (I already blogged on the idea of a sliding scale of regulation based on bank size), he also argued for ending the IRB approach to capital requirements. How does IRB translate into Plain(er) English: DIY capital requirements for big banks. Tarullo’s argument is based in part on obsolescence: all the increases to capital in Dodd-Frank and Basel III dwarfed the IRB component. But it is also based on the fact that DIY capital requirements was a spectacularly bad idea (something I wrote about back when). Big banks have built in incentives (courtesy of government guarantees, explicit and implicit) to lower their capital and increase their leverage. Tarullo’s coming to bury not praise this part of Basel II calls for revisiting some of Joe Norton’s prescient work critiquing that accord as a political economy product of lobbying by behemoth banks. If we take New Governance and its experimentalism seriously, it is vital that we look at experiments that failed.