One of the many headlines out of Basel this past week was that the Basel Committee is delaying the final compliance deadline for some of its new liquidity rules until 2019.
Economically, that makes a degree of sense. It is devilishly hard to balance containing and cleaning up one financial crisis and preventing the next one. A lot of rules that make eminent sense in preventing future liquidity and solvency catastrophes arguably might run counter to efforts to get the economy back on track. The rub lies in when to switch from containment to prevention.
Politically, the delay is problematic. I would bet big money (I am sorry, I meant "hedge") that by 2019 the story from large banks (and possibly from Basel) will have changed considerably. "Things are fine, why do we need these rules anyway? Relax, have some more spaetzle."
The banks moved today to put a large chunk of the blame for the financial crisis behind them with big dollar settlements. BofA settled Fannie suit against its Countrywide acquisition, alleging that the mortgages it sold to federal packager were done with fraudulent misrepresentations, thereby violating the False Claims Act. BofA press release here, story here. The topline number is $10 billion, but only $3.6 billion of that is a fine.
That's more than BofA will be paying in the global settlement of mortgage foreclosure chicancery also announced today, which will cost 14 banks (i.e., basically all the big ones) $8.5 billion in total. That is smaller than the settlement with state AGs for the same stuff, which was brokered by the Department of Justice. This settlement is with the banking regulators, and in both cases the relief is meant to go to homeowners, this time in cash, rather than through a cumbersome foreclosure relief process.
Some brief thoughts:
- In including every bank in the settlement, the costs of this relief will be pretty easy to pass along to consumers, it seems to me. No bank will be hurt disproportionately by the settlement, at least, unless the proportions are designed oddly.
- At the same time, including every bank leads to a big number which is not so big as to threaten the safety and soundness of the banking system - which is, after all, the woe is us last line of defense for banks, and one that came up in the Standard Chartered money laundering settlement.
- That is one of the reasons why it is very hard to interpret monetary settlements with financial intermediaries. Taken together, the settlements aren't bad for Fannie's bottom line, will result in thousands of dollars of relief for homeowners subject to foreclosure, and yet may not really bother the bankers at all.
- Semi-finally, a note of process, and one that shows the power of banking regulators. Unless I missed something, this settlement has come to fruition absent the filing of even a complaint. I don't even know what the theory of liability is, and OCC hasn't explained it to us. They talk of earlier enforcement orders related to mortgage abuses, but those orders partly deal with the future conduct of banks, not the past. And the part that does deal with the past refers to 12 U.S.C. 1818(b), which broadly prohibits banks from "unsafe and unsound" practices, including "management." (Here is the BofA enforcement order in that proceeding, e.g.) Again, this is not referred to in the current settlement notice for a case never filed. And even if it is the legal theory, it means that the regulators are relying on their ability to ensure that banks are solvent to police their relationships with consumers; we created the CFPB partly because we thought that they frequenty failed to square that circle.
- Interestingly, though, the federal regulators, even if they didn't get around to filing a case, did run the proposed settlement by stakeholders, consumer advocates, and others. That's often what you get in finance - not so much notice and comment as informal checking in.
DealBook, on Treasury's plan to sell off its GM holdings:
Unlike the A.I.G. rescue, however, the government’s wind-down of its G.M. bailout is expected to lose money. The Treasury Department’s break-even pricepoint is generally estimated at about $53 a share, following the car maker’s I.P.O.
But the Treasury Department has long argued that the auto makers’ bailout was always expected to be unprofitable, offset by both the A.I.G. rescue and the bank recapitalization program.
Shares in G.M. were up 5.7 percent in early morning trading, at $26.93.
- Anderson on Zywicki on Skeel on the financial crisis.
- This is a nice overview of private equity's transformation into a regulated group of financial products players, and a useful corrective to those who think that money doesn't want to be regulated, and so will increasingly opt for hedge funds and, well, PE.
- Barney Frank: "In no rational world will you have a separate Securities and Exchange Commission and a Commodity Futures Trading Commission. So that one I would have liked to change."
It looks like the DC Circuit will say no, in a case of interest to those bemused by the massive number of deferred prosecution agreements signed by corporations in white collar crime/securities violation situations. Sometime those DPAs include corporate monitoring requirements. One enterprising reporter requested AIG's consent decree monitor reports after the firm went belly-up, hopeful that it would tell her something about the financial crisis:
AIG agreed to the final judgment in Washington federal district court in November 2004 with the SEC without admitting or denying the allegations, rooted in transactions between AIG and PNC Bank. The company agreed to give up $46.3 million in profit in the SEC civil action. DOJ entered a deferred prosecution agreement with AIG that same month in federal district court in Pennsylvania.
The terms of the deal with the SEC required AIG to hire an independent consultant to, among other things, keep tabs on the work of AIG's "transaction review committee." The committee was tasked with reviewing transactions that "involved heightened legal or regulatory risk because of the dangers of questionable accounting by counterparties," AIG lawyers said in court papers.
It would be interesting to know what that consultant thought about all of AIG's unhedged credit insurance activity, wouldn't it? But is it a judicial record? Even though the court never saw it? It sounds like the DC Circuit will not conclude that keeping the report in camera is akin to holding private trials. And more's the pity for those who want to know more about the collapse of AIG ... or the usefulness of corporate monitoring consent decrees.
- The SEC just let Wells Fargo off the hook for its sales of mortgage securities, meaning that not every bank is being sent to the firing squad for these products.
- Kevin LeCroix reviews the legal theories plaintiffs may assert in civil litigation against the banks that packaged and sold the MBS before the crisis.
- As does this nice law firm memo.
These sorts of suits should be the heart of the way that the financial crisis finds itself subject to resolution in the courts - if it was indeed these toxic securities were sold under false representations taken about the care with which they were selected that caused the crisis. It's a contest between "buyer beware" and "seller be truthful," and it looks like the courts are quite willing to entertain the claims by private litigants, even as agencies have only sanctioned a few institutions for their conduct in the area. Stay tuned.
Is market discipline dead? Market discipline as a means to check the systemic risk posed by financial institutions was very much in vogue in financial institution scholarship until the financial crisis. Not any more. There are certainly calls for restraining government bailouts and some interesting work on contingent convertible capital requirements. But, by and large, this pillar seems to have been moved to the back of the financial regulation temple.
Kate Judge (Columbia) has a new paper (forthcoming in the UCLA Law Review) that cuts against this contemporary conventional wisdom. She argues for revisiting and rethinking the idea of interbank discipline – that is the incentives and capacities of large, complex banks to monitor and check the risk-taking of their counterparties. Here is her abstract:
As banking has evolved over the last three decades, banks have be-come increasingly interconnected. This Article draws attention to an effect of this development that has important policy ramifications yet remains largely unexamined—a dramatic rise in interbank discipline. The Article demonstrates that today’s large, complex banks have financial incentives to monitor risk-taking at other banks, the infrastructure, competence and information to be fairly effective monitors, and mechanisms through which they can respond when a bank changes its risk profile.
The rise of interbank discipline has both positive and negative ramifications from a social welfare perspective. The good news is that self-interested banks may be expected to penalize a bank when it takes excessive risks, thereby deterring such risk taking. The bad news is that the interests of banks and society are not always so well aligned. Other banks, for example, may be expected to reward a bank when it changes its risk profile in a way that increases the probability that the government would bail the bank out rather than allowing it to fail. This is because a bailout protects a bank’s creditors, even though it is socially costly. Interbank discipline may thus encourage banks to alter their activities in ways that increase systemic fragility.
In drawing attention to the powerful yet mixed effects of interbank discipline on bank activity, this Article contributes to a new generation of scholarship on market discipline. Its aim is not to question whether we need regulation, but to address the pressing issue of how we should allocate inherently finite regulatory resources. It suggests that by reducing the regulatory resources devoted to activities that other banks are performing relatively well, increasing the resources devoted to activities that regulators are uniquely situated or incentivized to address, and seeking to counteract the adverse effects of interbank discipline, bank oversight could be redesigned to more effectively promote the stability of the financial system.
The paper is a valuable springboard for talking about the flip side of bank “interconnectedness” – not merely as transmission lines for contagion, but as a crucial feature of market and regulatory architecture.
Yesterday, while the world was busy watching football of one shape or another, the Financial Stability Board issued a series of new reports and recommendations on the shadow banking system (a subject close to my heart).
Bottom line: the system is getting bigger. The FSB estimates that shadow banking markets had $67 trillion in assets by the end 2011 (which it says would equal 111% of the aggregated GDP of all 24 FSB member countries, the remaining nations in the Euro area, and Chile). That is about five trillion bigger than its size in 2007, before the crisis hit full bore.
The FSB collected reams of other valuable data on shadow banking in its annual monitoring exercise. Data collection alone is invaluable to understand the scope and dimensions of shadow banking. As G.I. Joe says, “knowing is half the battle.”
- The FSB may have provided some more ammunition to the FSOC and SEC Chair Mary Schapiro when it recommended converting fixed NAV money market funds to floating “where workable.”
- Of all the elements of the shadow banking system, the FSB seems to be making the most progress in the area of securities lending and repos. Its separate repo report contains a lot of helpful, if somewhat vague and high level recommendations, including
- Advocating for greater disclosure;
- Minimum haircuts to control leverage;
- Restrictions on cash collateral reinvestment and rehypothecation of collateral;
- Studying a move towards central clearing of repos
- These proposals sound great in the abstract, but are couched in terms of “more study.” Each of these moves would likely encounter fierce resistance when translated into concrete rules.
- The FSB beats a strategic retreat on the issue of changing the bankruptcy treatment of repos. While not surprising, this is ducking a large issue. When Congress exempted repos from much of the bankruptcy regime in 1984, it added jet fuel to this market and gave financial institutions a powerful new avenue to increase short-term lending. At the same time, the FSB makes noises about reducing excessive reliance by financial institutions on short term lending. Instead of out-and-out punting, the FSB should at least try to connect the analytical dots a little more; a legal preference jumpstarted the repo market, just like the same kind of bankruptcy preferences created meteoric growth in the swaps market two decades later.
There are a number of items I wish the FSB devoted much more time on, including:
- Consolidating weakness: Putting more pressure on the Basel Committee to ensure better rules for when financial institutions need to consolidate securitization vehicles. Off-balance sheet accounting games are a nightmare that keeps recurring. The FSB and Basel need to devote more intellectual firepower to this, and to the related issue of when financial institutions have implicit support (moral recourse) for entities. (For example, when Bear Stearns bailed out the hedge funds it sponsored or when asset-backed commercial paper or money market fund sponsors rode to the rescue of their failing funds).
- Show me the money supply: strangely, the FSB speaks little about coordinating the prudential regulation of the shadow banking system with monetary policy. It clearly recognizes the research that the leverage of shadow banking instruments like repos can have profound expansionary monetary effects. In other words, shadow banking, like depository banking, serves as a “transmission line” for monetary policy. The growth of shadow banking means the monetary system grew a turbojet engine. Integrating monetary and prudential regulatory policy has not just been a crusade of mine, but a drumbeat of “macroprudential” banking economists too.
- To pick one example, numerical floors on repo haircuts could have profound consequences on not only counterparty risk, but the capacity of repos to change monetary conditions. o
- As I have written elsewhere, it is time to take a hard look at the monetary capacities of a host of financial regulations.
- Credit derivatives are part of shadow banking too: In its separate document on “shadow banking entities,” the FSB lists a series of other entities that could constitute part of the shadow banking system, including securitization vehicles, credit investment funds, credit hedge funds, and finance companies. It also lists: “credit insurance providers/financial guarantors.” This sounds like “bond insurers.” But how is this not credit derivatives by any other name? I have argued that we need to think about credit derivatives as an integral piece of the shadow banking plumbing. But perhaps the FSB doesn’t want to be so explicit for fear of courting more resistance.
- Reduce the Addiction to Short-term Funding: Short term financing via repos and other shadow banking markets, makes banks less stable. The FSB makes noises about reducing this dependency, but offers nothing concrete.
- Back on the Chain Gang: Similarly, the FSB highlights the risks that come with long chains of shadow banking instruments (think mortgage-backed securities to CDOs to CDO squared to CDO cubed), but offers little concrete proposals to disfavor longer concatenations. Does the marginal additional social utility in terms of liquidity and risk spreading between a CDO and a CDO squared justify the additional opacity and systemic fragility?
- Correlated risk-taking: The FSB spills a little ink on reducing the concentration of bank investments in certain asset classes. It would be helpful to put the intellectual frame around the problem though. Leverage and liquidity are huge concerns in banking – whether of the depository or shadow varieties. But so is correlated investment and risk-taking. This has been another longstanding concern of the macroprudential movement, but one that curiously has not received much airtime with the FSB shadow banking working groups.
- Which of these is not like the other? Securitization and “skin in the game”: In reading previous FSB materials on shadow banking, I was struck by how the analysis of “skin in the game” rules for securitization seems out of place. After all, bank regulators want banks to unload as much risk as they can via securitization (albeit not take it back on by investing in asset-backed securities). Studies have also questioned the evidence that less-skin-in-the game led to deterioration in credit underwriting standards. In this latest raft of FSB documents, the skin-in-the-game analysis again seems tacked on to the end and maybe a little half-hearted. It might be better to invite a knock-down-drag-out fight over this particular policy proposal rather than muddle through.
It took President Obama a while to nominate a candidate for the inaugural Director of the Office of Financial Research. (Rumor has it that the new body was not popular among some Administration officials). Now Senators Grassley and Kirk have put a hold on the nominee, Richard Berner, to protest what they see as the Treasury Department’s inadequate response to the LIBOR scandal.
The long odyssey of the Office of Financial Research is a shame, and a surprising one. Like Brett McDonnell and Dan Schwarcz, I saw this new Office as being one of the hidden gems in Dodd-Frank: an agency tasked with gathering information about systemic risk. It promised to serve as a mix between an early warning system for future financial crises and a think-tank for improving financial regulation. But sometimes the least controversial bodies in Washington are the most likely to be used as pawns in other chess games.
On the bright side, the Treasury Department did announce an all-star advisory board of economists for the Office of Financial Research. Although, at a glance, it doesn’t appear that there are any lawyers (other than Damon Silvers). Does this create a blind spot in terms of understanding how policies translate into concrete legal rules or tracking regulatory arbitrage?
For a new agency – the tone at the top is critical, and this agency still lacks a permanent leader.
I just returned from speaking at a panel at the Clearing House’s Annual Meeting in New York that focused on the regulation of shadow banking. My fellow panelists included Amias Gerety (Deputy Assistant Secretary for Financial Stability, U.S. Dept. of Treasury), Ed Greene (Senior Counsel, Cleary Gottlieb), Sandy Krieger (Executive Vice President, FRBNY), and Barney Reynolds (Moderator, Shearman & Sterling).
Our first bone of contention was whether shadow banking is actually a useful concept for financial regulation. I think it is, as I have written elsewhere. Shadow banking describes how a series of financial instruments, markets, and institutions came to perform the same economic functions as banks:
- credit intermediation/credit risk transfer,
- maturity transformation, and
- liquidity transformation (i.e. creating money-like instruments that have theoretically high liquidity and low credit risk) (see Morgan Ricks).
We discussed several of these instruments and institutions at the panel including: securitization, money market funds, repos, and prime brokerage. These markets not only performed similar economic functions as banks, in the Panic of 2007-08, they also suffered runs and solvency crises just like banks.
In response, the federal government refashioned some of the same conceptual tools historically used to address banking crisis to staunch a shadow banking crisis. What, after all, was TARP and the alphabet soup of Federal Reserve liquidity facilities other than the government:
- acting as lender-of-last resort,
- providing deposit insurance to investors in shadow banking markets, and
- resolving institutions that failed because of shadow banking investments (albeit resolution without wiping out existing shareholders).
So if it quacks like a bank, suffers runs like a bank, and is saved like a bank, it needs to be regulated like a bank.
The difficulty is how to narrowly tailor bank-like regulations (from capital requirements to liquidity regulations) to address the specific forms of risk posed by each kind of shadow market. As I put it, you don’t regulate a turkey the same as a duck or a chicken. This turducken problem led some of my co-panelists to believe a bottom-up approach to regulation (one that focuses on market failures of individual instruments) makes more sense than a top-down approach (starting with the conceptual problems of shadow banking and then figuring out how to tailor policy approaches to particular contexts).
I continue to think a top-down approach helps focus on what are the big picture market failures and systemic risks that we should care about – bank runs and liquidity crises; high leverage; and correlated risk-taking and herd behavior by financial institutions.
Here were my takeaway points from a great panel discussion:
- Size matters, but it ain’t the only thing: the Too-Big-To-Fail problem has obscured the dangers of many smaller financial institutions moving as a herd.
- The FSOC’s power to designate certain institutions as systemically significant, however has asset size as a threshold. It cannot subject an entire class of institutions or instruments to systemic regulation by the Fed.
- This means that FSOC must deal with the danger of herd behavior or the systemic risk posed by smaller institutions through its recommendation power. The FSOC’s recent proposed proposals on money market reform will provide a test of this power.
- One oft-overlooked problem is how securitization did not effectively transfer risk, because the financial institutions that securitized assets also purchased asset-backed securities. This daisy chain meant that much risk stayed within the regulated banking system.
- Why did so much risk stay within the system? In part, this occurred because shadow banking instruments (particularly securitization, asset-backed commercial paper, and repos) were increasingly used not to transfer credit risk but to game bank capital requirements (aka “regulatory capital arbitrage”).
The bottom-up approach may also obscure a couple of key problems, including:
- These markets – from securitization to repos to money market funds – have been tightly connected. For example, asset-backed securities often “collateralized” repo loans. Money market funds invested in asset-backed commercial paper and repo markets. A focus on instruments means less attention is given to the network as a whole.
- If you want to regulate a network, you focus on the hubs. Who were at the hubs of the shadow banking network? Investment banks! They have their finger in every shadow banking pot, including via:
- Securitizing assets off their own balance sheet;
- Sponsoring securitizations and underwriting asset-backed securities;
- Purchasing asset-backed securities;
- Borrowing through repos...
I could go on – the whole business of investment banks is to “make markets” and serve as the intermediary of a web of transactions. Focusing exclusively on instruments means we may overlook the role of critical institutions in making the plumbing of shadow banking work.
- Perhaps the greatest myth of the shadow banking system is that only unregulated entities were involved. In fact, regulated entities were deeply involved. Banks securitized assets off their balance sheets. Banks, investment banks, insurance companies, and a host of other institutional investors purchased asset-backed securities. They also issued securities that were bought by money-market funds, which, in turn, are regulated by the SEC.
- Indeed, the real sweet spot of the crisis, came not with heavily regulated institutions or unregulated institutions (like hedge funds), but less regulated affiliates of heavily regulated entities. Think AIG’s London affiliate that wrote all those credit derivatives or Bear Stearns’ hedge funds. These examples indicate that conglomerates were playing games to transfer the benefits of government guarantees (explicit or implicit) and other subsidies from regulated to less-regulated affiliates.
- In many cases, it was not a lack of regulation that caused shadow banking to flourish, but the presence of regulation. In other words, Congress and regulators often granted preferences that allowed the markets for various shadow banking instruments to flourish. For example, Congress exempted repos (and later swaps) from various bankruptcy rules. (see Roe) Or, to pick a hot topic, consider the 1983 SEC rule change that allowed money market funds to price their shares at a fixed Net Asset Value, which made these investments appear more safe and bank-deposit-like. (see Birdthistle).
Shadow banking provides a vital conceptual framework to remind policymakers why and what they should regulate. It also provides a field guide to studying new financial instruments. When new financial innovations arise, when should financial regulators take heed and what should they watch for.
Reserve Primary is the mutal fund that broke the buck during the financial crisis, and the SEC sued it and the Bent family that ran it for fraud and negligence in 2009. Would this case be the one that showed that the financial crisis is being policed?
No, the consensus seems to be, given that the jury failed to find that either of the Bents had committed fraud. Once again, the agency found itself in the difficult position of indicting the kind of things that worked against Ken Lay and Jeffrey Skilling (but there was also Andy Fastow's extremely dodgy featherbedding there), but doesn't always work in tough times: prosecuting executives for trying to calm the passengers as the ship was going down.
That didn't work with the jury, though they did find one Bent to be negligent, and got the company (as opposed to its managers) for fraud. Some observations:
- As we have observed, thousands of individuals went to jail after the S&L crisis, which makes the zero individuals going to jail in the wake of this much bigger crisis mystifying. But maybe we should start crediting the surmises of prosecutors that cases against individuals are hard to win. The question would be: what changed? Just the locus of the crimes - Wall Street now, Main Street then?
- “Today’s verdict of liability sends the message that fund executives cannot withhold from investors and trustees key information about their fund’s vulnerability,” [SEC Enforcement Director Robert Khuzami] said. “This case, along with our actions against more than 100 other entities and individuals, demonstrates our continuing commitment to pursuing cases arising out of the financial crisis." I'd be very interested in knowing what this "100 defendants" group includes. Can't be the hedge fund investigations (which are being handled by DOJ and the SDNY anyway). Shouldn't be the usual affinity scams about stimulus money, or whatever. So that seems like a pretty large group of relatively anonymous targets.
- It could be that the better conclusion is that the SEC was making a mountain out of a molehill here. As we observed upon reading the complaint:
The key, though, appears to be that the Fund didn't reveal how exposed it was to Lehman Brothers (the defendants are there "for failing to provide key material facts to investors and trustees about the fund's vulnerability as Lehman Brothers Holdings, Inc. sought bankruptcy protection," as the SEC puts it). Since Reserve Primary did tell everyone this three days after Lehman folded, the allegation appears to be that the three day delay was fraudulent. Yikes!
One interesting question is whether this is sorta a case broken by journalists, given that the SEC has been talking about hiring them - the WSJ did a takedown of Reserve Primary, alleging that the putatively staid fund began chasing alpha with more exotic investments, in December. It didn't emphasize the Lehman exposure angle, but maybe there isn't too much gap between that story and this complaint.
David and I presented at a great financial regulation workshop at Brooklyn Law School on Friday. Many thanks to Claire Kelly and Roberta Karmel for putting together a great program (particulary during a few extraordinary weeks in Brooklyn).
Among the doom and gloom at the conference: banks are taking on unknown amounts of commodities risk, coco bonds and TRUPs aren’t all they are cracked up to be, and auditors make lousy agents for financial regulators.
Among the bright spots: there may be better ways to fix the tax incentives for financial institution leverage, and the Volcker Rule may offer opportunities to address the market structure for OTC swaps markets.
Illuminated: why EU counties and other went gaga over collective action clauses in sovereign debt, what international financial regulation can teach international public law, and new insights into the corporate governance role of credit derivatives.
With the earlybird registration deadline for the AALS Annual Meeting in New Orleans two days away, here are two events to put on your calendar:
Friday, January 4th: Joint Program of the Securities Regulation and FInancial Institutions/Consumer Financial Services Section [AALS Code 4160]
The Securities Regulation and Financial Institutions & Consumer Financial Services sections have joined forces to put together a Joint Program on the “The Regulation of Financial Market Intermediaries: The Making and Un-Making of Markets” on Friday, January 4th from 2 pm to 5 pm.
The program will give us a chance to look at the intersection of capital markets and financial institution regulation, a sweet spot that was overlooked until the global financial crisis hit. The program will include a panel of scholars who have been looking at this intersection for quite a while, including, Onnig Dombalagian (Tulane), Claire Hill (Minnesota), Tamar Frankel (Boston University), Donald Langevoort(Georgetown), Geoffrey Miller (NYU), David Zaring (Univ. of Pennsylvania – Wharton School of Business),David Min (UC Irvine and author of How Government Guarantees in Housing Finance Promote Stability) and Kimberly Krawiec (Duke) (Moderator).
The program will also include the following four papers picked from a large response to our Call for Papers:
- “The Federal Reserve’s Use of International Swap Lines,” Colleen M. Baker (Notre Dame);
- “Investment Company as Instrument: The Limitations of the Corporate Governance Regulatory Paradigm,” Anita K. Krug (Univ. of Washington); and
- “The Case for Decentralizing Financial Oversight: A Strategy for Overseeing the Derivatives Industry,” Jeffrey Manns (George Washington Univ.).
Saule Omarova (North Carolina) will moderate the call for papers panel.
Saturday, January 5th: Financial Institutions/Consumer Financial Services Lunch [AALS Code 1413]
Our keynote speaker will be Michael Barr of the University of Michigan Law School. Professor Barr returned to Michigan after serving as Assistant Secretary for Financial Institutions at the U.S. Department of Treasury in the Obama Administration. Professor Barr was one of the architects of the Dodd-Frank Act. Anna Gelpern (American Univ.) will introduce Professor Barr.