Regulatory Reform - An Update and Assessment

With Congress in summer recess it is an appropriate time to assess what has happened in this once in a lifetime opportunity to reform financial regulation. It is enticing to say not much and end this note now, but I can’t resist the opportunity to bore you a bit with my review of recent events and a cautionary note as we go forward.

In reality not much has been accomplished in terms of actual reform although there continue to be a substantial number of proposals on the table including the Administration’s proposal, which is comprehensive in approach. Congress has institutionalized bank compensation reviews and oversight although it is unclear precisely how this will work and what in fact it will accomplish. Also stockholders will now be given the right to vote on compensation packages for key executives, although such votes are non-binding. There must be some logic to that little piece of meaningless reform, but I am hard pressed to tell you what it is.

The more substantial proposals have gotten bottled up for several different reasons. My award for the most colorful moment in a not particularly colorful process was when the heads of the major regulatory agencies brought their turf war to a Congressional hearing. It was reported that the generally unflappable Secretary of the Treasury was less than subtle in voicing his dissatisfaction to the aforementioned group after that fiasco. Can’t say I blame him although it is a bit unusual for an Administration official to address the heads of supposedly independent regulatory agencies in such a way.

This lack of tangible accomplishments doesn’t mean the game is over. When Congress returns financial industry regulatory reform is likely to get attention assuming health care insurance doesn’t become completely overwhelming. What I find concerning at this stage is the likelihood of compromise resulting in costly regulation with inadequate attendant benefits to justify the changes. We have had a hint of that already. The SEC seems serious about adding to the industry data collection burden by requiring that information on activity in over the counter derivatives be provided periodically. This information will then be made public, but only in aggregated form and with a one-month lag. I suppose in about 10 years that may generate sufficient data points to support the empirical part of a Ph.D. dissertation, but I cannot understand what else will come of this additional collection burden. Will SEC staff be examining this data as it comes in and if so what will they be looking for? How will what they be looking for differ from what the examiners have on their list? You get the point. Financial institutions will be adding to their costs with no apparent associated benefits.

The aspect of regulation that seems to get little to no attention is that compliance is not free; in fact it can be very expensive. IT costs can escalate quickly when firms have to reengineer processes to effectively comply. Obviously there is no increase in revenue associated with these regulatory activities. That puts pressure on banks to find sources of additional revenue to counter these added costs. A particularly appealing source is fees. The high visibility recent changes in credit card terms are at least in part a response to an increase in the cost of doing business. (The other part is the curtailment of profitable, albeit risky activities, either because of regulation and/or management response to large losses.) There are other knock on effects that are worthy of further discussion, perhaps in a future note. For now we can agree that when bank costs are increased by added regulation and compliance, at least some of those costs are likely to be passed on to the banks’ customers. My cautionary note is that regulators should take these costs into consideration when reforming regulation to ensure that what we are paying for is worth the price.

Ben Wolkowitz Headstrong August 25, 2009

Financial Regulatory Reform. Is this all there is?

The proposed changes to financial regulation announced by President Obama on June 17th are significant, but somewhat less aggressive than I had expected given that this is supposed to be that once in a lifetime opportunity to reform financial regulation. The following are the highlights of the announcement.

1. Regulators will look at the financial system as a whole, not simply at individual institutions, to avoid a replay of the current situation. As expected the Federal Reserve will be charged with regulating systemic risk. Moreover to ensure that there are no gaps in regulation and also to facilitate oversight of the entire financial system a new organization, the Financial Services Oversight Council, will be established. Chaired by the Secretary of the Treasury, it will include the heads of all financial industry and market regulators.
   
   
   
   
2. A new regulatory agency will be established to look after the consumers’ interests in the financial markets. The Consumer Financial Protection Agency will be akin to a Consumer Products Safety Commission for financial instruments including mortgages.
   
   
   
   
3. Simplification of regulatory agency structure falls short of resolving the current labyrinth of regulatory agencies and responsibilities. One positive development is that the Office of Thrift Supervision is no more. Its responsibilities will be merged with those of the Controller of the Currency into a new agency, The National Bank Supervisor. This reflects the end of thrift charters; all federally chartered depository institutions will be banks. However the CFTC will continue to be an independent agency rather than merged with the SEC as many observers had expected. The historical and arcane distinction between contracts, as in futures contracts, and securities will prevail for no particularly compelling reason that I can discern. To make it interesting both agencies will be given enhanced authority to regulate derivatives.
   
   
   
   
4. The Federal Reserve wins a little and loses a little. On the plus side it gets to oversee all large institutions whose failure could jeopardize the stability of the financial system. On the negative side some of the authority that will go to the Consumer Financial Protection Agency had belonged to the Fed.
   
   
   
   
5. Hedge funds exceeding a to be specified size threshold will be required to register with the SEC, and with registration comes the requirement to open your books to the regulator. Surprisingly expanded registration will also be extended to private equity and venture capital firms.
   
   
   

There are also a substantial number of less dramatic but equally important provisions contained in the proposed regulatory reforms. One that I particularly like would give the SEC the authority to require a company to allow shareholders to vote on executive compensation packages. Opponents of the governments’ potential involvement in compensation guidelines have argued that this is the responsibility of shareholders knowing full well that shareholders have no real authority in this area. Now they will (or more accurately, might).

Another interesting provision will require the issuing institution to retain 5% of the loans in a pool underlying a securitized debt issue. This is less than the 20% that had been suggested by some European regulators, but probably still a sufficient amount to provide more discipline to the securitized debt market. A 20% requirement might well have been tantamount to ending that market.

Unfortunately the rating agencies come in for little attention. There is mention made of addressing compensation arrangements to avoid conflicts of interest. The brief mention of this topic relative to other areas leaves the impression that it is not a major priority. Equally puzzling is the lack of recognition that the supervisory process is broken. Although there are loopholes in regulation, if supervisors had been doing their jobs it is unlikely that we would gotten into all the difficulties we did. New regulations and regulatory structure is one thing and robust enforcement is another.

These proposals will have to be approved by Congress, which will no doubt be assaulted by the lobbying efforts of the financial industry, one of the most powerful lobbying organizations in the country and certainly one of the wealthiest. I still expect the outcome will retain much of the overall reach of these proposals because at least for now there appears to be widespread support for regulatory reform. But as the saying goes the devil is in the details. Certain trends reflected in these proposals seem unstoppable including greater oversight of the entire financial system, not just the component parts, more consumer protection and greater transparency and reporting.

Ben Wolkowitz Headstrong June 18, 2009

Briefing Note on Regulation: FASB

Early this week the Financial Accounting Standards Board (FASB) issued guidelines on the valuation of instruments for which there is no actively traded market. Mark to market has been the rule for the marking of financial assets. When an actively traded market does not exist there are approved procedures for coming up with a proxy for the market. For example in the case of aged corporate bonds, which commonly do not trade for days at a time, it is commonplace to identify cohorts, i.e. bonds with similar characteristics and then discount the price of the actively traded cohort by a reasonable amount to reflect the illiquidity of the security that is not actively traded. In other cases such as tailored derivatives a sample of dealer estimates of a fair market price is often obtained and averaged. Similarly private placements can be compared to market traded securities and again discounted for their illiquidity. Without belaboring the point illiquid securities are not a rarity and there are established procedures for assigning a market price.

Why tinker with the system now? Banks are currently burdened with significantly more non-traded securities than they had anticipated. The proliferation of mortgage backed securities, credit default swaps and other categories of ill considered securities has created a burden on bank earnings and capital that in a couple of well advertised cases has proven fatal. The market estimate for such securities is not surprisingly a fraction of par value. Any reasonable market price would have to be quite low.

Banks with some logic argue that although these securities may have been overvalued in the past they are far from worthless. They generate a revenue stream and in time the vast majority of underlying collateral will survive having less of an impact on these securities than the market currently estimates by its pricing. FASB has been under pressure to allow banks to generate alternative valuations that would basically reflect the discounted stream of cash flows over some average life properly adjusted for the likely mortgage defaults. Although this may sound logical it depends on the banks becoming more adept at valuing collateral than they proven so far. The only thing we can be fairly certain of is that banks will value these securities higher than any market driven estimate, and that’s where the timing comes in.

Recently the Treasury announced the introduction of a well-received plan to combine public and private capital to acquire these toxic assets from banks. The core issue in all such proposals is how will the two parties to these trades come together on price. Until now there was little doubt that there would be a wide spread between the bid and offer. However, given the way this particular plan is structured there was optimism in the market that the spread, at least on securities, would not be insurmountable especially given the inducements for buyers in this plan. Clearly anything that contributes to a widening of the spread increases the likelihood that market-clearing prices will not be discovered. FASB’s guidelines are likely to make that happen. While the sellers, the banks, are valuing securities on the basis of self-serving assumptions, the buyers will be looking for guidance from the market. This game isn’t going to be pretty if each side is playing by different rules. I doubt that the Treasury has sent a thank you note to FASB for their ill-timed contribution to continued financial instability.

Post Script: As of July 7th this program of making a market in toxic assets has yet to begin.
Ben Wolkowitz Headstrong April 15, 2009

Briefing Notes on Regulation : Credit Deafult Swaps

This week the credit default swaps market went through a momentous change that in time could dramatically affect that market. The International Swaps and Derivatives Association (ISDA) overhauled the $27 trillion market for credit default swamps on corporate and sovereign debt by standardizing the terms of many of these instruments and incorporating characteristics that will bring them more in line with the underlying bonds. Aptly named the Big Bang by ISDA, some 1,800 market participants including banks, hedge funds and money managers agreed to the new standards.

Standardizing swaps’ terms makes them more transparent and facilitates trading. It is a direct and effective way to address the accusations that the market is too opaque. Also standardizing the terms is a significant step toward centralized clearing and when necessary settlement of these swaps. By comparison achieving the standardization of the terms of interest rate swaps was a much longer and more difficult process. Far less than 1,800 market participants agreed to the new protocols on day one, which by comparison is a good reason for calling this the Big Bang.

As significant as these changes are not all CDS market problems are solved. Notably not all CDS are covered. Omitted are CDS based on mortgages and convoluted underlying instruments; just the type of CDS that AIG specialized in insuring. Also issues regarding concerns over counterparties to these swaps will be solved only when there is a clearinghouse involved that has sufficient financial backing to ensure participants that counterparty defaults in their obligations will be covered by the clearinghouse.

Minimal resistance from banks is surprising given that this will adversely affect their profit margins on these instruments. The history of fixed income markets demonstrates that once a sector becomes transparent the spread (between the bid and the offer) shrinks dramatically. I suppose the banks were being realistic recognizing that maintaining previous market practices would ensure a small to non-existent trading environment. If anything transparency in markets generally results in an increase in their size. As the expression goes, you can make it up in volume.

Ben Wolkowitz Headstrong April 9, 2009

Brieifing Notes on Regulation and Compliance: G-20

The communiqués that came out of the G – 20 meetings identified at least three areas that may well affect our clients.

1. The G – 20 agreed to the creation of a global regulator, The Financial Services Board (FSB), to work to prevent financial and economic crises, and to respond to them effectively when they do occur. This organization provides structure around global regulatory cooperation. Housed at the Bank for International Settlements (also home to the Basel Accords), this organization is likely to request information to assess the behavior and stability of financial markets. I expect that most data will be aggregated by country with the exception of the major global financial institutions that will be required to report individually.
   
   For our clients the FSB is yet another recipient of information that they will have to satisfy. What is not clear is how much will be provided by the regulators and how much will have to be provided by the large financial institutions directly. If the burden is on the regulators then little or no additional work will be required of our clients. If, however, the requirement for information directed to the company level our already overtaxed IT clients may find themselves with yet more to do.
   
   
2. The likelihood of hedge funds being regulated has increased. Hedge fund regulation was explicitly addressed in the communiqués. I would expect hedge funds to be subjected to less regulation and disclosure requirements than bank holding companies; most likely they will be covered, at least in the U.S., by a watered down version of the Investment Act of 1940. Briefly, I would expect that disclosure of balance sheets on some periodic basis, and perhaps also client lists (see 3 below) would be required. If possible, hedge funds are likely to rely on outside agents to ensure compliance. Whether those agents will be prime brokers, fund administrators or someone else will depend on the nature of the requirements.
   
   
3. Tax havens will no longer be tolerated. I found it surprising that this was a focus of the outcome of the meetings since tax havens have had little to nothing to do with our current situation. I can only assume that many nations are concerned about paying for their stimulus packages and associated activities, and are no longer willing to overlook a source of substantial revenue.

This suggests that financial institutions will have to disclose more information about their clients, in addition to greater focus on anti money laundering. Although most financial institutions currently have to comply with AML regulations, I anticipate a re-examination of what is currently required and how all categories of financial institutions comply. Some tightening of requirements may occur and additional reporting is likely to be part of any new regulations designed to eliminate tax havens.

Amidst the G – 20 display of global cooperation it was clearly stated in communiqués and by key participants, Treasury Secretary Geithner included, that financial industry regulation is a sovereign responsibility that cannot be relinquished to a global organization. Therefore I would anticipate that globally agreed on principles and guidelines will be subject to interpretation when it comes to implementation. This is not unlike the Basel Accords, which are drafted and agreed on by a globally representative committee, but put into action on a country level where they often need to be modified so that they are consistent with each country’s regulations. We will continue to monitor these developments.

Ben Wolkowitz
Headstrong

(This entry was published right after the G-20 meeting earlier this year; however we felt it was worth reviewing what came out of that meeting and how we felt about the outcome.)

Regulation and Compliance : The Headstrong Blog

Headstrong, an IT domain lead consulting firm with particular expertise in the financial services industry is going public. Not in the usual sense, we will continue to be privately held, but in the sharing of observations sense. Our clients are focused on regulatory change and the implications for compliance and so are we. Since the beginning of the year we have hosted a panel discussion on regulation with industry experts with more expertise and experience than the usual talking heads to tell us what to expect and how it will change the way the industry operates. In addition we have initiated a series of what we call Briefing Notes on Regulation, in which we comment on what we see happening in and to the financial services industry. The feedback we have received has been favorable and that has inspired us to begin a blog to make these commentaries more accessible. We do this with humbleness knowing that there are more commentators out there than is optimal by any measure. For that reason we will post only when we have something to say that we feel has not been said at all or at least has not been said with the emphasis that we believe is deserved.

To give you some idea as to what to expect we are beginning with a few older notes, which we believe still have something to add to the regulatory discussion. These will be distributed over the next few days. We have also included a link to the above-mentioned panel discussion.

To learn more about Headstrong go to http://www.headstrong.com/.

Ben Wolkowitz