Archive for the ‘Regulation’ Category

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Tarullo Confronts 'Too Big to Fail'

Friday, October 23rd, 2009

Daniel K Tarullo, Member of the Board of Governors of the US Federal Reserve System, has delivered a speech to the Exchequer Club, Washington DC, 21 October 2009:

Generally applicable capital and other regulatory requirements do not take account of the specifically systemic consequences of the failure of a large institution. It is for this reason that many have proposed a second kind of regulatory response – a special charge, possibly a special capital requirement, based on the systemic importance of a firm. Ideally, this requirement would be calibrated so as to begin to bite gradually as a firm’s systemic importance increased, so as to avoid the need for identifying which firms are considered too-big-to-fail and, thereby, perhaps increasing moral hazard.

While very appealing in concept, developing an appropriate metric for such a requirement is not an easy exercise. There is much attention being devoted to this effort – within the U.S. banking agencies, in international fora, and among academics – but at this moment there is no specific proposal that has gathered a critical mass of support.

I support the idea of assessing a progressive surcharge on risk-weighted assets such that, for instance, RWA in excess of $250-billion wiould be increased by 10% for capital calculation purposes, RWA in excess of $300-billion another 10% on top of that, and so on. Very few formal ideas have been proposed in this line; the US Treasury wish-list does not mention such an idea but endorses a special regime for those institutions deemed too big to fail.

A second kind of market discipline initiative is a requirement that large financial firms have specified forms of “contingent capital.” Numerous variants on this basic idea have been proposed over the past several years. While all are intended to provide a firm with an increased capital buffer from private sources at the moment when it is most needed, some also hold significant promise of injecting market discipline into the firm. For example, a regularly issued special debt instrument that would convert to equity during times of financial distress could add market discipline both through the pricing of newly issued instruments and through the interests of current shareholders in avoiding dilution.

I heartily endorse this idea, which was first proposed by HM Treasury in its response to the Turner report and endorsed by William Dudley of the New York Fed. It looks like this idea is gaining some traction!

To my gratification, he does not forget to mention the systemic risk posed by money market funds:

Of course, financial instability can occur even in the absence of serious too-big-to-fail problems. Other reform measures – such as regulating derivatives markets and money market funds – are thus also important to pursue.

Posted in Contingent Capital | 2 Comments »

OSFI to Address Insurer's Double Leverage?

Wednesday, October 21st, 2009

Mark White, who seems to have become OSFI’s chief public apologist, delivered a speech to the Osgoode Hall Financial Regulatory Reform Conference.

Assiduous Readers will remember my complaints about insurers’ double-leverage and lack of disclosure thereof. In the best news I’ve had all week, there seems to be recognition by OSFI that this is a problem:

Second, recent events, such as those at AIG, have shown that holding company strength is important to their regulated subsidiaries. This is particularly true where the holding company is the primary issuer of capital or is required to raise debt.

OSFI regulates both non-operating insurers acting as holding companies, and entities that are formed as holding companies under applicable financial institution legislation. Currently, this only affects the life insurance industry. OSFI is considering updating its current regulatory guidance for these entities.

For example, OSFI’s Minimum Continuing Capital and Surplus Requirements (MCCSR) tests could be used to evaluate a financial group’s consolidated riskbased capital – and an ACM like-test could be used to evaluate leverage.

It’s my guess that this is happening under Treasury’s resolve to look at consolidated capital – but the intellectual dishonesty of OSFI is such that no acknowledgement is made of any external source of ideas.

They are also considering changes in the MCCSR requirements as it applies to seg funds:

Currently, segregated fund guarantees are the only area where Canadian insurers use such models to determine capital requirements. The recent financial turmoil has shown flaws with internal capital models, and segregated fund models are no exception. Particularly as both traditional life insurance risks and non-diversifiable market risks are concerns when dealing with segregated fund guarantees.

OSFI is conducting a fundamental review of internally-modeled capital requirements for segregated fund guarantees. We hope to present the results to the MCCSR Advisory Committee early in 2010, and to use this as a cornerstone for our ongoing work.

It’s nice to know they’re actually going to spend some time thinking about it rather than just taking dictation from well-connected companies … but OSFI has blown its credibility as an enforcer; all credit analysis must be performed with the assumption that in times of trouble, the rules will be changed so it doesn’t look like trouble any more.

Update, 2009-12-26: I’m sure I’ve mentioned this before, but I do not fully understand Mr. White’s assertion that OSFI regulates both non-operating insurers acting as holding companies, and entities that are formed as holding companies under applicable financial institution legislation. Currently, this only affects the life insurance industry.

Both Fairfax Financial (FFH) and E-L Financial (ELF) are holding companies that own P&C insurers. However, it is possible that they are not “formed as holding companies under applicable financial institution legislation.”

Posted in Regulation | 5 Comments »

Tussle in UK over Banks May Influence Future Regulation

Wednesday, October 21st, 2009

Mervyn King of the Bank of England has inserted himself into the bank regulation debate:

Bank of England Governor Mervyn King opened a rift with Prime Minister Gordon Brown’s government by signaling the biggest banks could be broken up to prevent taxpayers having to shoulder the cost of future bailouts.

King’s suggestion to separate investment banks from operations that take deposits from consumers and manage payment systems was ruled out by Chancellor of the Exchequer Alistair Darling as recently as yesterday.
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“The key issue is not one of breaking up banks but of financing the economy,” Angela Knight, chief executive officer of the British Bankers’ Association, said in an e-mail. “Big businesses may want big banks which offer a range of products and services while individuals may look to something smaller. Large universal banks are the way forward.”

The G-20, whose finance chiefs meet in two weeks for talks in Darling’s native Scotland, is focusing on pushing banks to raise capital and restrain pay rather than devising an international approach to curbing the size of banks. Darling is writing laws to make banks write a “living will” that enables a quick wind-down of institutions that fail.
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King said yesterday that, while global efforts to bail out banks had prevented economic disaster, they had created “possibly the biggest moral hazard in history.” He said that it is “hard to see why” proposals such as those made by Volcker to separate proprietary trading from retail banking are “impractical.”

“What does seem impractical are the current arrangements,” King said. “Anyone who proposed giving government guarantees to retail depositors and other creditors and then suggested that such funding could be used to finance highly risky and speculative activities would be thought rather unworldly. But that is where we are now.”

Brown, Darling and other ministers have repeatedly said such a split would have failed to prevent the collapse of Lehman Brothers Holdings Inc. or Northern Rock Plc.

King’s remarks put him somewhat at odds with the US Treasury, which wants separation based on size, not function.

Assiduous Readers will remember that I prefer separation of function based on parallel regulation, in which institutions that consider themselves banks would be, by differentiation of risk-weighting, encouraged to buy-and-hold long term assets. Institutions opting to be regulated as brokers would be discouraged from buy-and-hold investing. I greatly prefer this to be done by means of risk-weighting than by flat prohibitions, because sharp lines between asset classes and investment styles increase systemic cliff risk.

Note that I similarly believe that Canadian banks’ insurance operations should be penalized via risk-weighting; Canada’s current policy on bank-owned insurers is just plain dumb.

It was buy-and-hold arbitrage that brought down the dealers; it was excessive funding risk, combined with poor credit quality that brought down Northern Rock.

Posted in Regulation | No Comments »

Dudley of FRBNY Supports Contingent Capital

Wednesday, October 14th, 2009

The British government indicated interest in a debt security that would convert to capital in times of stress, as discussed in the post HM Treasury Responds to Turner Report.

Such an instrument is of interest to preferred share investors since preferred shares are the natural basis for the first wave of such instruments. For example, a preferred share issued at a time when the bank’s common equity was trading at $50 might have a provision that, should the common price fall below $25 for a specific period of time (say, the Volume Weighted Average Price for any given period of twenty consecutive trading days), then the preferred would automatically convert into common, receiving its full face value of common valued at $25 per share.

Now William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, has delivered a speech titled Some Lessons from the Financial Crisis indicating support for the general idea:

the introduction of a contingent capital instrument seems likely to hold real promise. Relative to simply raising capital requirements, contingent capital has the potential to be more efficient because the capital arrives as equity only in the bad states of the world when it is needed. It also has the benefit of improving incentives by creating two-way risk for bank managements and shareholders. If the bank encounters difficulties, triggering conversion, shareholders would be automatically and immediately diluted. This would create strong incentives for bank managements to manage not only for good outcomes on the upside of the boom, but also against bad outcomes on the downside.

Conceptually, contingent capital instruments would be debt instruments in “good” states of the world, but would convert into common equity at pre-specified trigger levels in “bad” states of the world. In principle, these triggers could be tied to deterioration in the condition of the specific banking institution and/or to the banking system as a whole.

There are many issues that would need to be worked out regarding how best to design such instruments, including how to determine their share of total capital as well as how to configure and publicly disclose the conversion terms and trigger. But, in my view, allowing firms to issue contingent capital instruments that could be used to augment their common equity capital during a downturn may be a more straightforward and efficient way to achieve a countercyclical regulatory capital regime compared to trying to structure minimum regulatory capital requirements (or capital buffers above those requirements) that decline as conditions in the financial sector worsen.

So what might such a contingent capital instrument look like? One possibility is a debt instrument that is convertible into common shares if and only if the performance of the bank deteriorates sharply. While, in principal, this could be tied solely to regulatory measures of capital, it might work better tied to market-based measures because market-based measures tend to lead regulatory-based measures. Also, if tied to market-based measures, there would be greater scope for adjustment of the conversion terms in a way to make the instruments more attractive to investors and, hence, lower cost capital instruments to the issuer. The conversion terms could be generous to the holder of the contingent capital instrument. For example, one might want to set the conversion terms so that the debt holders could expect to get out at or close to whole – at par value. This is important because it would reduce the cost of the contingent instrument, making it a considerably cheaper form of capital than common equity.

Consider the advantages that such an instrument would have had during this crisis. Rather than banks clumsily evaluating whether to cut dividends, raise common equity and/or conduct exchanges of common equity for preferred shares and market participants uncertain about the willingness and ability of firms to complete such transactions and successfully raise new capital, contingent capital would have been converted automatically into common equity when market triggers were hit.

He also had some things to say about dividends:

In times of stress, banks may have incentives to continue to pay dividends to show they are strong even when they are not. This behavior depletes the bank’s capital and makes the bank weaker. To correct this shortcoming in our system, we should craft policies that either incent or require weak and vulnerable firms to cut dividends quickly in order to conserve capital. This would introduce a dampening mechanism into our system.

I don’t know about this. It gives a lot of discretion to the regulators – or requires the imposition of rules that will of necessity be so complex as to be useless during the next crisis – and the regulators have shown they are not up to the task.

Now that the moment has passed, they are getting tough on banks that are already mostly nationalized, but throughout the crisis they have routinely approved the redemption of sub-debt, which is particularly galling since the sub-debt was virtually all resetting to yields less than that required to issue new senior debt.

It would have been the easiest thing in the world for regulators to have announced that the required approval for subordinated debt redemption would be withheld in cases where this would have reduced the total capital ratio below – say – 12%. Such an announcement would have been transparent, recognized as being arguably justified and not to be considered a regulatory judgement on the soundness of any particular bank.

But they muffed it, rubber-stamped their approvals and blew their credibility.

Posted in Contingent Capital | 2 Comments »

HM Treasury Responds to Turner Report

Monday, September 28th, 2009

The Turner Report on Financial Regulation was reported on PrefBlog in March. The government has now taken some time off from its regularly scheduled banker-bashing to address the issues raised.

The response was released on July 8 with the admission:

There were many causes of the financial crisis:

  • first and foremost, failures of market discipline, in particular of corporate governance, risk management, and remuneration policies. Some banks, boards and investors did not fully understand the complexities of their own businesses;
  • second, regulators and central banks did not sufficiently take account of the excessive risks being taken on by some firms, and did not adequately understand the extent of system-wide risk; and
  • third, the failure of global regulatory standards to respond to the major changes in the financial markets, which have increased complexity and system-wide risk, or to the tendency for system-wide risks to build up during economic upswings.

… which is a lot more balanced than what they spout for the benefit of the man in the street.

The British firm Barrow, Lyde & Gilbert has prepared a precis of the government response; there are, however, two proposals in the full-length report worthy of highlighting for preferred share investors:

Box 6.C: New international ideas for improving access to funding markets

Two ideas to improve banks access to capital during downturns or crises are being aired in academic and policy circles. Both have merits although how they could be applied in practice is yet to be determined.

Capital insurance:Banks essentially face an insurance problem: when faced with a shortage of capital, rather than having to raise new capital at a high market cost it would be more efficient if banks were delivered capital at a pre-agreed (lower) price though a pre-funded insurance policy. Paying the insurance premium in an expansion would be one method of providing some cost to the expansion of credit in an upturn. However, in a systemic crisis the insurance policy would need to pay out to several banks together. In order to ensure that these obligations could always be met, the insurance would probably need to be run by the state sector.

Debt-equity conversion: When banks are forced to raise new equity capital the initial benefits are shared with the existing debt holders as they have a senior claim over equity in the event of liquidation. One solution would be to make some of the debt (perhaps the subordinated debt tranche only) convertible into equity in the event of a systemic crisis and on the authority of the financial regulator. This would immediately inject capital into the bank and reduce the need to raise any new equity capital. The holders of the debt would also have more incentive to impose market discipline on the banks.

The reference supplied for the second option is “Building an incentive-compatible safety net”, C. Calomiris, in Journal of Banking and Finance, 1999; this article is available for purchase from Science Direct and is freely available in HTML form from the American Enterprise Institute for Public Policy Research. Assuming that the AEI transcript is reliable, though, I see very little support for the idea in the Calomiris paper (Calomiris’ ideas are frequently discussed on PrefBlog, but I certainly don’t remember seeing this one).

Regardless of origin, I consider this a fine idea at bottom, although I am opposed to the idea that the triggering mechanism be a ruling by regulatory authorities. I suggest that greater certainty for investors, regulators and issuers could be achieved with little controversy if conversion were to be triggered instead by the trading price of the bank’s common.

In such a world, regulators approving a preferred share for inclusion in Tier 1 Capital would require a forced conversion at some percentage of the current common price if the volume-weighted trading price for a calendar month (quarter?) was below that conversion price. Thus, assuming the chosen percentage was 50%, if RY were to issue preferreds at $25 par value at a time when its common was trading at $50, there would be forced conversion of prefs into common on a 1:1 basis if the common traded below $25 for the required period.

This could bring about interesting arbitrage plays with options – so much the better!

One effect would be that as the common traded lower – presumably in response to Bad Things happening at the company – the preferred share would start behaving more and more like an equity itself – which is precisely what we want.

We shall see, but I hope this idea gains some traction in the halls of power.

Update: Dr. Calomiris has very kindly responded to my query:

Yes, the citation of my work is relevant to the proposal, although it takes a little explaining to see the connection. I have been advocating the use of some form of uninsured debt requirement as part of capital requirements for a long time. The conversion of hybrid idea is a new version of that, which has the advantages of my proposal and also some additional advantages that Mark Flannery and others have pointed to. I like the idea of requiring a minimal amount of “contingent capital” which would take the form of sub debt that converts into equity in adverse circumstances.

You may quote me.

Posted in Contingent Capital, Interesting External Papers | 10 Comments »

SEC Proposes More Credit Rating Agency Paperwork

Friday, September 18th, 2009

The SEC has proposed new rules for Credit Rating Agencies.

Chairman Schapiro introduced debate on the new NRSRO rules:

Specifically, the following six items related to NRSROs are being considered:

A recommendation to adopt rules to provide greater information concerning ratings histories — and to enable competing credit rating agencies to offer unsolicited ratings for structured finance products, by granting them access to the necessary underlying data for structured products.

A recommendation to propose amendments that would seek to strengthen compliance programs through requiring annual compliance reports and enhance disclosure of potential sources of revenue-related conflicts.

A recommendation to adopt amendments to the Commission’s rules and forms to remove certain references to credit ratings by nationally recognized statistical rating organizations.

A recommendation to reopen the comment period to allow further comment on Commission proposals to eliminate references to NRSRO credit ratings from certain other rules and forms.

A recommendation to require disclosure of information including what a credit rating covers and any material limitations on the scope of the rating and whether any “preliminary ratings” were obtained from other rating agencies — in other words, whether there was “ratings shopping”

A recommendation to seek comment on whether we should amend Commission rules to subject NRSROs to liability when a rating is used in connection with a registered offering by eliminating a current provision that exempts NRSROs from being treated as experts when their ratings are used that way.

There was a statement from Commissioner Kathleen L. Casey:

Second, we must not become so obsessed with conflicts of interest to the point that it detracts from more important policy considerations. We are now at or beyond that point, or at least perilously close. Indeed, an obsessive and myopic focus on conflicts could become a sideshow that diverts our attention from more significant issues, the most important of which are enhanced access to information and the regulatory use of ratings.

If we truly believe that trying to mitigate or eliminate all conflicts, or potential conflicts, should be the overriding concern of our regulatory program, then why don’t we just skip the small stuff and adopt a rule banning the biggest conflict of all, the issuer-pays system of compensation? I am not recommending that we do so, by the way. That would result in a situation where the solution is worse than the problem.
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Third — and this is related to the first two points about competition and conflicts of interest rules — before adopting still more regulations that are not market-based, the Commission needs to step back and take stock of all the new rules it has adopted over the past two years. The simple fact is that rating agencies are highly regulated today. That is not to say that they will always issue accurate ratings for investors. Government regulation could never deliver such results. And it does not mean that we can second-guess their rating judgments or seek to regulate their rating methodologies. The Rating Agency Act precludes the Commission from such actions, and properly so, in my view. But what it does mean is that we have adopted comprehensive regulations in many key areas. We should seek to establish regulatory certainty. At some point, we need to be able to see if the rules we have on the books are having their intended effect.

In many cases, particularly in structured finance, rating judgments are more art than science. We need to stop pretending that adopting more rules and regulations will lead to higher quality ratings. Some policymakers want to sanction rating agencies for inaccurate ratings. Absent fraud, that is the wrong approach.
…
My fourth point. I sincerely believe that exposing NRSROs, which are subject to the antifraud provisions of the securities laws, to additional, costly, and inefficient private litigation from class action lawyers will not serve to protect investors, it will not improve ratings quality, and it absolutely does not reflect in any way the explicit policy goals of Congress as reflected in the statute that we are charged with administering, the Rating Agency Act.
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Last, but certainly not least, the issue of government-sanctioned ratings firms. The divisions of Trading and Markets and Investment Management are recommending that we adopt removal of NRSRO references from certain Exchange Act and Investment Company Act rules and forms. I support these recommendations, but as noted earlier, believe that the Commission needs to eliminate the government imprimatur given to certain debt analysts by removing NRSRO references in all of our rules. When we crafted those rules, I think it is fair to say that we did not intend to anoint certain firms with a government seal of approval.

A statement from Commissioner Troy A. Paredes:

rule amendments are before the Commission that would require NRSROs to disclose their ratings track records publicly and that would make information available so that NRSROs can rate structured products on an unsolicited basis.

Regarding track record disclosures, one concern has been the extent to which such disclosures could deprive NRSROs of revenues, in some instances challenging the commercial viability of certain NRSROs. This is a particular concern for the subscriber-pay model. To address this concern, the disclosures are to occur on a delayed basis.

In the future, it will be important for the Commission to monitor the overall impact of track record disclosures to ensure that competition is not inadvertently stiffled.
…
One proposal would require an NRSRO to disclose the percentage of its net revenue attributable to the 20 largest users of the NRSRO’s credit rating services. How useful is this information if, say, the percentage of an NRSRO’s net revenue attributable to the largest user is considerably more than the percentage attributable to the twentieth largest user of the NRSRO’s credit rating services? If the aggregate net revenue attributable to the 20 largest users is substantial, what should investors infer about the quality of particular ratings?

A second rule amendment would require NRSROs to disclose the relative standing of the person paying the NRSRO to issue a rating — namely, whether the person was in the top 10%, top 25%, top 50%, bottom 50%, or bottom 25% of contributors to the NRSRO’s revenues. Again, to what use will investors put this information? Might the disclosure leave a misimpression that a conflict exists if the NRSRO’s client is in a top tier, even if the client contributes a relatively small portion of the NRSRO’s total revenue? To what extent might the disclosure negatively impact smaller NRSROs if clients prefer to receive ratings from larger NRSROs to avoid being in a top revenue tier?
…
We also are considering a concept release that explores subjecting NRSROs to section 11 of the Securities Act. I look forward to the considerable comment I expect we will receive. For now, I will simply note that while subjecting NRSROs to section 11 may lead to more legal accountability, it may result in less competition if certain NRSROs are unable to bear the resulting risk of liability. Competition itself is a source of investor protection that may be lost if the risk of legal liability increases. We need to consider this and other tradeoffs in evaluating the proper liability regime for the credit rating industry.

Better disclosure of past performance is always a good thing, but why stop there? Any advisor with discretionary authority over client money should provide composites to his regulator and have these published by the regulator as part of his on-line registration review package. That will do more to protect investors than any fiddling with the CRAs.

The rule on sharing data is a step in the right direction, but only a step. CRAs are entitled to use material non-public information in the course of their business, a fact which makes second-guessing them a risky business. Strike down the Regulation FD Exemption!

Posted in Interesting External Papers, Regulation | 1 Comment »

SEC Proposes to Ban Flash Orders

Friday, September 18th, 2009

The SEC has released Elimination of Flash Order Exception from Rule 602 of Regulation NMS which will ban Flash Orders, which contains the first defense I’ve seen of the practice:

The Commission recognizes that flash orders offer potential benefits to certain types of market participants. For those seeking liquidity, the flash mechanism may attract additional liquidity from market participants who are not willing to display their trading interest publicly. Flash orders thereby may provide an opportunity for a better execution than if they were routed elsewhere. There is no guarantee, for example, that an order routed to execute against a displayed quotation will, in fact, obtain an execution. The displayed quotation may already be executed against or cancelled before the routed order arrives. Of course, the delay in routing during a flash period may further decrease the likelihood of an execution in the displayed market for the flash order because prices at the displayed market may move away from the flash order during the flash process. Those who route flash orders, however, may use them selectively in those contexts where they believe an order is less likely to receive a full execution if routed elsewhere.

In addition, many markets that display quotations charge fees (often known as “take” fees) for accessing those quotations. Flash orders may be executed through the flash process for lower fees than the fees charged by many markets for accessing displayed quotations. Indeed, some markets have offered rebates on orders that are executed during a flash, so that the order, rather than paying a fee, will earn a rebate. The combined difference between receiving a rebate for an executed flash order versus paying a fee for accessing a displayed quotation may be a significant incentive for traders to submit flash orders.

Finally, some market participants that choose to receive and respond to flash orders may represent large institutional investors that are reluctant to display quotations publicly to avoid revealing their full trading interest to the market, but are willing to step up on an order-by-order basis and provide liquidity to flash orders. Such investors may have the sophisticated systems themselves to respond to flash orders or may rely on the systems of their brokers. Executions against flash orders could help lower the transaction costs of these institutional investors.

The Commission expects that any negative effect of the elimination of the exception for flash orders from Exchange Act quoting requirements would be mitigated by the ability of market participants to adapt their trading strategies to the new rules. In addition, higher incentives to display liquidity and alternative forms of competition for order flow could mitigate any negative effect of the proposal.

The SEC released a statement on flash orders by SEC Commissioner Troy A. Paredes:

The proposing release identifies the following benefits of flash orders. These benefits help explain why there is a market for flash orders in the first place.

First, flash orders may induce liquidity from those who are unwilling to have their quotes displayed publicly. This in turn may create opportunities for better execution.

Second, flash orders may be executed for lower fees than markets charge for executing against displayed liquidity. Indeed, executed flash orders earn a rebate in some trading venues instead of paying a fee.

Third, investors who are unwilling to display may reduce their transaction costs by responding to flash orders.
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I support today’s proposal, but am mindful that a ban is an unequivocal step. I look forward to considering the comments we receive, including any data that commenters can provide. I would especially welcome any data commenters can provide demonstrating how the current low volume of flash order trading has impacted securities markets.

Dammit! There’s always somebody who wants some facts!

There was also a statement from Commissioner Elisse B. Walter:

While flash orders may potentially provide benefits to certain market participants, such as lower transaction costs, increased liquidity, and choice to the trading community, today’s action reflects the Commission’s concern that flash orders may not fit well with the Commission’s fundamental policy objectives for the securities markets, including price transparency, public quoting, fair competition, and best execution of investor orders.

In particular, the Commission has long emphasized the importance of displayed liquidity in promoting efficient equity markets and has acted over the years to encourage the display of trading interest.

And a statement by Chairman Mary L. Schapiro:

In today’s highly automated trading environment, the exception for flash orders from quoting requirements, while potentially providing benefits to certain traders, may no longer serve the interests of long-term investors or the markets. The Commission has consistently stated that the interests of long-term investors should be upheld as against those of professional short-term traders, when those interests are in conflict.
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…flash orders have the potential to significantly undermine the incentives to display limit orders and to quote competitively. In addition, flash orders may create a two-tiered market by allowing only selected participants to access information about the best available prices for listed securities.

Investors that have access only to information displayed as public quotes may be harmed if market participants are able to flash orders and avoid the need to make the order publicly available.

Posted in Interesting External Papers, Regulation | No Comments »

US Judge Rakoff Decries Regulatory Extortion

Monday, September 14th, 2009

This is important enough and encouraging enough to deserve its own post.

On August 26 I highlighted Judge Jed Rakoff’s handling of the BAC / MER / SEC conspiracy:

I’m not usually a big fan of bureaucrats, but Jed Rakoff, the US District Judge hearing the SEC / BAC / MER case is saying some unusually sensible things:

U.S. District Judge Jed Rakoff has twice refused to approve the Securities and Exchange Commission’s $33 million settlement over the bank’s failure to better disclose bonuses it had authorized Merrill Lynch & Co, which it was acquiring, to pay.

Rakoff has faulted the SEC for appearing to let the bank off too easily, and dismissed as nonsensical why the bank would agree to pay anything without admitting it had done anything wrong.

Hear, hear, Mr. Rakoff! Regulators are quick to tout their negotiated settlements, but a negotiated settlement without admission of guilt is either a license to cheat or simple regulatory extortion. The politicians who ultimately bear responsibility for the conduct of their regulators should revise legislation such that negotiated settlements are banned.

Not content with saying one sensible thing, Judge Rakoff continued:

In the Bank of America case, executives said they relied on lawyers’ judgments as to what bonus details should be revealed. Yet the bank did not waive attorney-client privilege, meaning the names of the decision makers remained secret. An exasperated Judge Rakoff questioned why the SEC would agree to this.

“If the company does not waive the privilege,” the Manhattan judge wrote, “the culpability of both the corporate officer and the company counsel will remain beyond scrutiny. This seems so at war with common sense.”

The SEC’s position, if it has been reported correctly by Reuters, is nothing short of insane. Everything’s OK as long as you sought legal counsel? This implies that the SEC has out-sourced the interpretation, prosecution and judgement of securities law to any two-bit shyster with a law degree who happens to be consulted. By the SEC’s reasoning, if I put every cent of client money into sub-prime paper and lose the whole whack, I should be able to claim that I consulted the rating agencies and so did nothing wrong!

Where is the responsibility here? Regardless of what was discussed with whom, the fact is that BofA – and BofA’s executives – knew X and disclosed Y. The consultation of legal advisors is irrelevant to the question of whether X is sufficiently close to Y to meet their legal obligations; the consultation is not wholly irrelevant to personal responsibility, but it is merely a detail.

He has now overturned the proposed settlement:

A Federal District judge on Monday overturned a settlement between the Bank of America and the Securities and Exchange Commission over bonuses paid to Merrill Lynch executives just before the bank took over Merrill last year.

The $33 million settlement “does not comport with the most elementary notions of justice and morality,” wrote Jed S. Rakoff, the judge assigned to the case in federal court in Lower Manhattan.

The ruling directed both the agency and the bank to prepare for a possible trial that would begin no later than Feb. 1.
…
The proposed settlement, the judge continued, “suggests a rather cynical relationship between the parties: the S.E.C. gets to claim that it is exposing wrongdoing on the part of the Bank of America in a high-profile merger; the bank’s management gets to claim that they have been coerced into an onerous settlement by overzealous regulators. And all this is done at the expense, not only of the shareholders, but also of the truth.”

Jed Rakoff for the Supreme Court!

Update: Jim Hamilton’s World of Securities Regulation has summarized the SEC’s position.

Update, 2009-9-17: Bloomberg has published a feature on Rakoff.

Update, 2009-9-18: Felix Salmon posted on August 6:

I hope this sends a clear signal to Mary Schapiro: quiet bilateral settlements with companies should come to an end, and as a rule all companies paying fines should at the same time admit, in public, exactly what they did wrong. All too often companies spin SEC fines as a cost of making legal trouble go away, rather than a real indication that they made a serious mistake. They shouldn’t be allowed to do that.

Mr. Salmon seems to be of the view that all negotiated settlements are instances of actual material wrongdoing … there’s no way of telling, but I’ll bet the proportion is not, in fact, 100.00%.

Posted in Regulation | 3 Comments »

BIS to Grant Most of Treasury's Wish List

Tuesday, September 8th, 2009

Treasury announced a bank capitalization wish-list last week prior to the G-20 London meeting.

Now, the Bank for International Settlements has announced that most negotiation points will be granted. All this has obviously been orchestrated and was agreed long before the G-20 ministers got on their planes to London:

The Central Bank Governors and Heads of Supervision reached agreement on the following key measures to strengthen the regulation of the banking sector:

  • •Raise the quality, consistency and transparency of the Tier 1 capital base. The predominant form of Tier 1 capital must be common shares and retained earnings. Appropriate principles will be developed for non-joint stock companies to ensure they hold comparable levels of high quality Tier 1 capital. Moreover, deductions and prudential filters will be harmonised internationally and generally applied at the level of common equity or its equivalent in the case of non-joint stock companies. Finally, all components of the capital base will be fully disclosed.
  • •Introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration. To ensure comparability, the details of the leverage ratio will be harmonised internationally, fully adjusting for differences in accounting.
  • •Introduce a minimum global standard for funding liquidity that includes a stressed liquidity coverage ratio requirement, underpinned by a longer-term structural liquidity ratio.
  • •Introduce a framework for countercyclical capital buffers above the minimum requirement. The framework will include capital conservation measures such as constraints on capital distributions. The Basel Committee will review an appropriate set of indicators, such as earnings and credit-based variables, as a way to condition the build up and release of capital buffers. In addition, the Committee will promote more forward-looking provisions based on expected losses.
  • •Issue recommendations to reduce the systemic risk associated with the resolution of cross-border banks.

The Committee will also assess the need for a capital surcharge to mitigate the risk of systemic banks.

The Basel Committee will issue concrete proposals on these measures by the end of this year. It will carry out an impact assessment at the beginning of next year, with calibration of the new requirements to be completed by end-2010. Appropriate implementation standards will be developed to ensure a phase-in of these new measures that does not impede the recovery of the real economy. Government injections will be grandfathered.

The interesting parts are the elements that are on Treasury’s wish list but are not incorporated into this announcement:

Core Principle #1: Capital requirements should be designed to protect the stability of the financial system (as well as the solvency of individual banking firms).

This one is addressed, a little, through the non-bulletted committment to “assess the need for a capital surcharge to mitigate the risk of systemic banks.” I am glad to see that BIS is leaning towards PrefBlog’s recommendation, rather than Geithner’s. What does Geithner know, anyway?

Core Principle #2: Capital requirements for all banking firms should be higher, and capital requirements for Tier 1 FHCs should be higher than capital requirements for other banking firms.

See above for increased emphasis on systemic banks – note that there is nothing in the BIS release that indicates agreement on a need to segregate “Tier 1 FHC’s” from other banks.

Core Principle #3: The regulatory capital framework should put greater emphasis on higher quality forms of capital.

This is addressed in the first bulletted point. It seems to me that to avoid confusion – and, perhaps, to ensure that the “Third Pillar” of the investment community is encouraged to follow this emphasis – they will need to define a new capital ratio, the “Tangible Common Equity Ratio” or something.

Core Principle #4: Risk-based capital requirements should be a function of the relative risk of a banking firm’s exposures, and risk-based capital ratios should better reflect a banking firm’s current financial condition.

This was just ‘let’s do it better next time’ boiler-plate; while not particularly significant, it is interesting none-the-less that the issue is not mentioned by BIS.

Core Principle #5: The procyclicality of the regulatory capital and accounting regimes should be reduced and consideration should be given to introducing countercyclical elements into the regulatory capital regime.

Addressed by the fourth bulletted point.

Core Principle #6: Banking firms should be subject to a simple, non-risk-based leverage constraint.

Addressed by the second bulletted point. This is probably the single most important committment to improvement in the release.

Core Principle #7: Banking firms should be subject to a conservative, explicit liquidity standard.

Addressed by the third bulletted point. I am disappointed to see that the favoured treatment for paper issued by other banks in the risk-weighting process is not being addressed.

Core Principle #8: Stricter capital requirements for the banking system should not result in the re-emergence of an under-regulated non-bank financial sector that poses a threat to financial stability.

I’m glad to see that this principle is not addressed in the BIS release – it is the only Treasury proposal with which I have serious philosophical problems.

I don’t like the second bullet of the last bit of the BIS release:

The Group of Governors and Heads of Supervision endorsed the following principles to guide supervisors in the transition to a higher level and quality of capital in the banking system:

  • •Building on the framework for countercyclical capital buffers, supervisors should require banks to strengthen their capital base through a combination of capital conservation measures, including actions to limit excessive dividend payments, share buybacks and compensation.
  • •Compensation should be aligned with prudent risk-taking and long-term, sustainable performance, building on the Financial Stability Board (FSB) sound compensation principles.
  • •Banks will be required to move expeditiously to raise the level and quality of capital to the new standards, but in a manner that promotes stability of national banking systems and the broader economy.

    • Supervisors will ensure that the capital plans for the banks in their jurisdiction are consistent with these principles.

Compensation is none of the regulator’s damn business. If they want to regulate risk, they can regulate risk, no problem; but micro-management will only lead to problems. Unfortunately, the regulators have won the public relations war and diverted attention from their own inadequacy towards the memes of “sloppy credit raters” and “greedy bankers”.

Posted in Regulation | 3 Comments »

RBS Sub-Debt Will Not Be Called

Friday, September 4th, 2009

Royal Bank of Scotland has announced:

In the context of ongoing discussions between the UK Government and European Commission about the RBS restructuring plan and the Commission’s recent communication on restructuring, which states that, where possible, banks subject to restructuring under State aid rules should not use this aid to remunerate their own equity and subordinated debt, the FSA has objected to RBS calling at this time the following four subordinated debt instruments with call-dates in October 2009:

National Westminster Bank plc securities: Upper Tier 2 securities, EUR 400m, callable 5 October

National Westminster Bank plc securities: Upper Tier 2 securities, EUR 100m, callable 5 October

Royal Bank of Scotland plc securities: Lower Tier 2 securities, AUD 590m, callable 28 October

Royal Bank of Scotland plc securities: Lower Tier 2 securities, AUD 410m, callable 28 October

RBS is therefore not calling these subordinated debt instruments, consistent with their terms and conditions. Further, future decisions on whether or not to call capital instruments will be subject to consultation with the same parties, as well as circumstances (economic or other) prevailing at the time, pending the European Commission’s decision on RBS’s restructuring plan.

The terms of this sub-debt are not stated in the Annual Report 2008, but it is safe to assume that RBC could not borrow on commercial terms at the step-up rate.

Bloomberg reviews other European issues:

The executive arm of the European Union is insisting investors share with taxpayers the burden of saving banks, and already told Bayerische Landesbank, Germany’s second-largest state-owned lender and Anglo Irish Bank Corp. to defer payments on subordinated debt.

As well as not calling junior notes, some European banks bailed out with state funds have skipped interest payments on the debt. Northern Rock Plc, the first lender nationalized by the U.K. in the deepest credit crisis in decades, said last month it would defer coupons on eight subordinated bonds with an aggregate face value of about $2.74 billion.

Earlier this year Moody’s, DBRS and S&P downgraded bank hybrids on fears that exactly this would happen: that banks would be forced to treat their sub-debt in a businesslike fashion.

The issue of bank sub-debt redemptions has been previously discussed on PrefBlog.

Update, 2009-9-28: See also Hybrid Debt Attack: A Posse of Regulators is on the way.

Posted in Regulation | 1 Comment »

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