Tags: Shadow | banking | commission | SEC

Conservative Economists Highlight Regulatory Issues

By    |   Tuesday, 14 May 2013 01:40 PM

Leaders of the Shadow Financial Regulatory Committee, a group composed mostly of eminent conservative economists, held its last quarterly meeting of the year on Monday and issued five statements on topics of current interest pertaining to financial regulation:

Statement #338: Lessons from Cyprus – Robert Eisenbeis

Eisenbeis, vice chairman and chief monetary economist at Cumberland Advisors, noted that this statement is especially timely because the European Commission is supposed to meet this week to consider measures to be taken on a community-wide basis. The statement includes a useful timeline and a list of the accommodations that were made over time in response to political pressures.

He recalled the conditions that prevailed when the Cyprus crisis broke in March and the authorities imposed penalties on deposits in Cyprus banks that made the situation even worse. The initial agreement in return for a 10 billion euro bailout provided for a 9.9 percent levy on deposits over 100,000 euros and 6.7 percent on deposits below that threshold.

The lessons he identified were: 1) There is clear evidence of a shift away from 100 percent guarantees of deposits and toward the imposition of losses on creditors, but the finance ministers made mistakes in their initial response; 2) When a nation's banking system grows disproportionately large in relation to its gross domestic product and doesn't have the ability to fund the banks, the system becomes vulnerable to runs; therefore, the European Commission needs to establish a deposit insurance system similar to that of the United States that would be guaranteed at the federal level; 3) There is widespread interest in "bail-in proposals," but a system to distribute losses among creditors needs to be established before, not after, runs occur; and 4) Even a bail-in system misses the point that the European community needs a system of supervision and monitoring of financial institutions focused on "prompt corrective action" that would require institutions to shore up their capital, but there is a tendency for these politically powerful institutions immediately to seek exemptions from whatever system is established.

I would caution that the U.S. model would not be a good one to follow, because it has none of the elements Eisenbeis recommends and has devolved into an unfunded, open-ended entitlement program for the banking industry.

Statement #339: Restricting Access to Regulatory Data – Chester Spatt

Spatt, a finance professor at Carnegie Mellon and former chief economist and director of the Office of Economic Analysis for the Securities and Exchange Commission (SEC), explained that this issue arose as a result of a complaint by the Chicago Mercantile Exchange (CME) that Commodity Futures Trading Commission (CFTC) researchers had engaged in the illegal use of sensitive that the CME is required to provide in support of supervision by the CFTC, and that these breaches could have allowed outsiders to infer proprietary high-frequency trading strategies.

There are echoes of the problem in other agencies, such as when the Federal Reserve fought to block the release of data on its rapidly growing portfolio, including the sub-portfolios called Maiden Lane.

Regulators need the required data in order to understand what is going on in the markets and to attract the talented personnel needed to conduct market surveillance and prevent manipulation of markets. The data are also needed in order for agencies such as the CFTC to comply with requirements that they provide thorough analyses of costs and benefits of regulations such as those required under the Dodd-Frank Act.

Statement #340: Substituted Compliance for Derivatives Regulation – Edward Kane

Title VII of the Dodd-Frank Act requires derivatives of entities other than financial institutions to be cleared through central clearing platforms (CCPs) in order to bring transparency and competition to the opaque world of over-the-counter derivatives commonly used for hedging the risks of farmers, ranchers, airlines, bakers and other industries whose operations expose them to the risks of commodities markets.

Kane, a professor of finance at Boston College, pointed out that ironically this regulation that is intended to reduce the risk to the financial system creates in the CCPs a new class of "too big to fail" entities that could end up being bailed out by the federal government. As the CFTC, which has authority for 90 percent of derivatives trading, struggles to promulgate required regulations, traders and regulators in foreign jurisdictions, especially the European Union, have complained to U.S. legislators that the CFTC regulations would unfairly bring their activities under U.S. regulation by defining "U.S. person" to encompass transactions conducted by U.S. entities through foreign platforms.

I want to point out that CFTC Chairman Gary Gensler has argued that broad application of regulation is necessary, because when trading firms fail, the losses almost invariably show up back in the United States in the form of demands for bailouts. However, Gensler has been opposed by his colleagues on the CFTC and on the SEC, which has jurisdiction over security-based derivatives.

Now the SEC has gifted the industry with a regulation that provides a roadmap through "substituted compliance" for U.S. traders to escape regulation by demonstrating, with the help of their lawyers, that foreign regulators can provide "broadly equivalent" regulation. The Shadow Committee is concerned that the SEC proposal sets the stage for regulatory arbitrage, and it suggests that the European Union create a mechanism for monitoring regulation by member states to identify and curb deviations from established best practices.

The statement identifies two crucial issues: 1) how to determine when one set of rules is and is not analogous to those of the United States, and (2) how to verify the adequacy of the enforcement of analogous rules on a continuing basis. Kane observed that the second issue has yet to be addressed and the first issue has emerged as a point of contention between the CFTC and SEC.

Statement #341: Questions about Brown-Vitter Proposal – Peter Wallison

The Senate Banking Committee has been holding a series of hearings on how to end the policy of too big to fail, an objective that the defenders of Dodd-Frank contend has already been accomplished. As an outgrowth of the hearings, Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., have circulated draft legislation that would put in place specific measures, such as a 15 percent leverage ratio, to contain the risk posed by the largest financial institutions, defined as those over $500 billion in assets.

Wallison, Arthur F. Burns Chair in Financial Policy Studies at the American Enterprise Institute, identified two main concerns that have prompted the senators to advance the proposal: 1) the funding advantages size confers on the too big to fail banks, and 2) the systemic risk the institutions pose. The Shadow Committee adopted Wallison's view that measures to reduce the risk posed by too big to fail institutions should be voluntary on the part of management rather than imposed by regulation. He has also questioned whether reducing the size of banks to $500 billion would ultimately make much difference, since they could still be too big to fail.

Statement #342: Money Market Fund Regulation – George Kaufman and Kenneth Scott

This statement is an update on the ongoing controversy over whether to strengthen the regulation of money market mutual funds, which played a key role in the 2008 episode of the financial crisis. During the crisis, the Reserve Fund wrote off its investment in securities of Lehman Brothers, which constituted only 1 percent of the portfolio, but this caused the fund to "break the buck" and triggered a run on other funds.

As Mary Schapiro's term as SEC chairman wound down, the SEC deadlocked over her proposal to institute capital requirements and permit the stated net asset value (NAV) to float.

The SEC is considering ideas like establishing a distinction between funds of government securities and prime funds that hold corporate securities, and a distinction could also be drawn based on institutional versus retail investors.

However, expectations that current SEC Chairman Mary Jo White might unveil her ideas at a major speech to the Investment Company Institute were unfulfilled. The SEC suggests that management be granted broad discretion to design fund features that would reduce the risk of funds and help break the deadlock at the SEC.

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Leaders of the Shadow Financial Regulatory Committee, a group composed mostly of eminent conservative economists, held its last quarterly meeting of the year on Monday and issued five statements on topics of current interest pertaining to financial regulation.
Tuesday, 14 May 2013 01:40 PM
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