Category Archives: Bank Regulation

Ten Years After

It about that time again. For the next financial crisis that is. I was thinking about past financial crises and how there has been a significant event, as opposed to a bear market, about every ten years since the October 1987 stock market crash. And with the exception of the Bear Stearns fire sale in the spring of 2008 most of the serious crises have happened in the later summer or fall (there was the mini EU crisis in 2011, again in the later summer; there was also the tech wreck in 2002). But the really earth-moving events have happened in ten-year intervals. They are as follows:

October 1987 – Stock market crash

August 1997 – Asian financial crisis

September 1998 – Long Term Capital Management failure

September 2008 – Lehman Brothers bankruptcy

So if the calendar is any indication 2018 should bring some sort of financial crisis.[1] With no dark clouds on the horizon, like the LTCM warning signs or Lehman’s 2008 summer from hell, what could it possibly be this time around? I’m no soothsayer so I don’t have a prediction for what, if anything, may befall us in 2018. Maybe all this financial regulation has de-risked the banking industry. Maybe. It is probably unduly pessimistic to think we will get a crisis like 2008 anytime soon. The Great Recession was a generational event like the Great Depression of the 1930’s.

The other factor to consider is the role of the government in past crises, either through action or inaction. Remember these are the people who in the early 2000’s decided everyone should own a home even if they didn’t have any money. Not giving any thought to the potential impact on the securitization market that had been part of the mortgage industry since the 1980’s. What have they been up to lately that could push us towards the next crisis? Will the unintended consequences of financial regulation, or deregulation[2], entice the bankers back into risky behavior thus endangering them like they did in 2008? The banks have done some de-risking on their own so I give this scenario a low probability. But again these things are hard to predict.

The last two crises have been all about interconnectedness and the systemic consequences. The new financial regulations have done little to address this. But again we’re talking about the last war. While you’re busy looking at what happened in the rear view mirror you sometimes crash into something completely different. What could be the cause of the next crisis?[3] A cyber attack affecting some but not all financial providers? Perhaps a system failure affecting the global payments system? Who knows but I have a feeling we may get something we haven’t seen before. Right now nothing seems to be looming. So as singer/guitarist Alvin Lee once sang, “Skies are sunny…” [4] At least for now.

Happy New Year.

[1] We made it through 2017 unscathed.

[2] See the Treasury white papers of June and October 2017. There is already some evidence of banks taking on more trading risk as they try to amp up lackluster revenues and returns.

[3] J.P Morgan and Deutsche Bank have recently published research that posits that the next crisis could be caused by a massive liquidity disruption.

[4] “I’d Love To Change The World”, Ten Years After

What’s It All About, Treasury?

Well it looks like the day may have finally come. After years of more and more regulations being heaped on the U.S. banks the Treasury announced in June plans to ease, or a least revisit, a number of the Dodd Frank rules. Most of the proposed changes will not require the approval of Congress, which makes it even more likely that many of these changes will happen (unlike the Financial Choice Act which will likely not get passed by the Senate). The upshot is that the Treasury is putting the brakes on any new regulation and is taking a significant look at what needs to be changed in the existing regulations.

Now that Fed Governor Daniel Turrullo is gone and bank-friendly folks are at the reins in the Treasury department the road has been cleared for this kind of action. Many have been calling for a time-out to evaluate the effects of the now seven year old Dodd Frank regulations. It only makes sense to take some time to do a review to see what is and what is not working. This type of discussion has been difficult with the extreme partisanship in Washington and lingering populist anger with Wall Street. That said, there have been many unintended consequences from the financial regulations and some recalibration needs to be considered. The Treasury proposal should be encouraging for the major banks. It gives them some hope that they won’t have to deal with any new regulations and what they already have to deal with may get dialed back.  

What does all this mean for prime brokers and hedge funds?

The Treasury proposal contains changes to two regulations that will be a positive for prime brokers: the Supplementary Leverage Ratio (SLR) and High Quality Liquid Assets (HQLA). Specifically the proposal addresses some of the inefficiencies of the SLR and broadens the definition of HQLA to more closely align with that of the foreign banks.

The change to the SLR would provide the prime brokers with more balance sheet capacity. The U.S. banks are already well above the leverage thresholds and these changes will only increase this buffer. The SLR changes and their impact on prime broker balance sheets may also lessen the balance sheet scarcity especially in a crisis. The change to the HQLA definition won’t directly impact the primes but it may reduce the internal liquidity charges allocated to their business.

That said, in the end these changes are incremental and it will take a while for whatever changes are made to flow through the hedge fund financing food chain. Therefore status quo will probably be maintained for the foreseeable future. The primes and the hedge funds have reached a steady state in terms of managing the balance sheet and client returns. In the end the current counterparty risks brought on by regulation probably won’t be eased much for two reasons. First as mentioned earlier, these changes will take time. Second, the banks will be slow to make any big changes to their capital and liquidity management process knowing that a change in the political winds could reverse what the treasury is proposing to roll back.

In the end I will paraphrase the legendary Barton Biggs who once said in reference to tough times “…the news doesn’t have to be good it just needs to be less bad.” The Treasury proposal news is less bad for the banks.

Capital Idea

Financial regulation in the U.S. is turning out to be the gift that keeps on giving. Hopes of repealing Dodd Frank could turn out to be a cruel bait and switch for the major U.S. banks. The major players in this drama are Representative Jeb Hensarling (R/TX), FDIC Vice Chairman Thomas Hoenig and outgoing Fed Governor Daniel Turullo.

In late 2016 the house banking committee passed the Financial Choice Act, which is the their version of “repeal and replace” for Dodd Frank. The basic outline of the bill is as follows: If the banks keep 10% CET1 to total (leverage?) assets they will be exempted from some regulatory standards. The bill also repeals the Volker Rule. The bill is wildly unpopular with democrats and generally viewed as more of a messaging tool i.e., conversation-starter for negotiations on changing or repealing Dodd Frank.

FDIC Vice Chairman Hoenig recently put forth a proposal (“term sheet”) that would have the banks create two interim holding companies (IHC) below the parent financial holding company (FHC). One IHC would be for commercial banking activities and the other for non-traditional activities, mostly related to investment banking. Both IHC would be separately capitalized and inter-IHC transactions would be prohibited. In essence a 21st century Glass Steagel as our friends at Cadwaladar point out:

“The enhanced restriction on affiliate transactions and the separate capitalization requirements effectively mean that the banking and nonbanking arms of the FHC would be run as two largely standalone entities operating under a common brand.”

Both IHC would be required to meet a “10% leverage” test and in exchange would be exempted from many of the current regulatory metric standards (CET1, SLR, LCR, Living Wills, and certain Stress Test requirements). The banks would be given three years to migrate to the proposed structure. Again is this an opening gambit to future negotiations or end-state alternative regulatory structure?

Next we have the exit of the regulatory hawk Fed Governor Daniel Turullo. His departure probably means a significant foot off the gas pedal on bank regulation. Turullo’s reign, unofficial as it was, which makes it even more impressive, brought, among other things, ever-stricter CCAR and Living Will standards and capital surcharges for the major U.S. banks. His absence will create at least a temporary vacuum in the bank regulatory space, which may end up being the most significant regulatory relief for the banks in 2017.

Not everyone is jumping on the “capital is king” bandwagon. There was a recent op-ed in the Wall Street Journal that took the other side of this argument[1]. Tim Congden and Steve H. Hanke wrote that excessive capital requirements at banks would result in the economy sliding back into the conditions experienced during the great recession. Their thesis is that banks can meet ever increasing capital ratios two ways: raise capital or cut assets (which is exactly what J.P. Morgan did to reduce the Fed’s 2015 capital surcharge). The bank assets that would be reduced are comprised of loans to the industrial and commercial sectors of the economy. Lower lending activity equals reduced access to credit thus damaging the economy.

Clearly the view in DC is that capital is the key to bank stability. The more capital the banks have the more stable they will be[2]. There are unintended consequences flying off in all directions with these proposals.

First there would be a further widening of the differences in standards for US and International banks. This would result in making it harder for the US banks to compete with the foreign banks. Then there is the Congden/Hanke argument that increased capital requirements for the banks would plunge the economy into a deep recession. More capital also means the banks have to generate higher revenues to maintain, or increase, their ROE. Most of the banks are already struggling to make 10% ROE.

Finally there is the FDIC proposal, which really only affects about four of the major banks: JPM, Citigroup, BAML and Wells Fargo[3]. Morgan Stanley and Goldman Sachs aren’t really banks, though they would probably benefit from a leveling of the playing field with the big banks (who have been making inroads into their prime brokerage market share). The FDIC proposal seeks to ring-fence a separately capitalized investment banking entity so that it can fail without impacting commercial and retail bank customers. However one has to ask, even with separately capitalized investment bank would the government not bail them out in a crisis? It doesn’t take a bank failure to destabilize the world economy (e.g., Lehman Brothers). It seems like a lot of effort that does nothing to solve for Too Big To Fail.

Admittedly it is early days for both these proposals, so how much should we worry about this? Congress isn’t looking too effective right now at getting anything passed. Dodd Frank reform, or repeal, is way back in the line behind tax reform, infrastructure spending, etc. The FDIC idea would also take an act of Congress and cooperation from the banking industry. Not such a high probability at the moment. Still the “capital is king” movement bears watching. Bank regulation, in the form of Dodd Frank but more importantly Basel III, has had a significant impact on banks’ financing of hedge funds. These proposals by the Congress and the FDIC would ratchet up the capital requirements at the major U.S. banks. Higher bank capital requirement will result in a further reduction in balance sheet and financing available to hedge funds. Not such a capital idea.

[1] “More Bank Capital Could Kill the Economy” by Tim Congdon and Steve H. Hanke, The Wall Street Journal, March 13, 2017

[2] We haven’t even discussed Minnesota Fed President Neel Kashkari’s call for bank capital levels of more than 20%. Yikes!

[3] It’s probably a good idea to keep the retail guys separate from those risky IB folks.

Will The Donald Trump Dodd-Frank?

Since the populist fervor swept Donald Trump into the presidency last week financials have been rallying based on the feeling that his dovish views on financial regulation will lesson the constraints on the banks. In particular Trump has talked about repealing or significantly rolling back parts of Dodd-Frank the landmark banking regulation that was put in place after the financial crisis. The House Republicans have also recently passed the Financial Choice Act that is aimed at paving the way for changes to Dodd-Frank.

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Another Inconvenient Truth

It has been the conventional wisdom that the big banks were at the heart of 2008 financial crisis that resulted in the “Great Recession”. Those on the inside of the industry have known for years that this was not the case but just try to convince someone in the press or government. They have been fanning these populist flames for eight years. Now there finally seems to be a little daylight being shed on the real story and it involves a larger cast of characters including the U.S. government. What is also interesting is that these similar views are bi-partisan.

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That’s Incredible

This past week the Fed and FDIC released the results of their review of the banks’ “Living Wills” as prescribed under the Dodd Frank Orderly Liquidation Authority (OLA). They found that five banks’ plans were “not credible” (BAML, BNY Mellon, JP Morgan, State Street and Wells Fargo) two had split decisions on the credibility of their plans (Goldman and Morgan Stanley) and Citigroup received a qualified pass.[1]  What I find to be “not credible” is the entire notion that the OLA and Living Wills could ever be executed successfully during the heat of a systemic crisis.

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Blame It On Cain

One thing that has caught my attention recently is how both political parties in the race for the 2016 presidency have amped up the vitriol again on how they are going to “get tough on Wall Street”[1].  I wrote about this a while ago in my piece on Elizabeth Warren. (Who by the way was recently mentioned as a potential running mate for Bernie Sanders. Just so you know I will be doing an Alec Baldwin and leaving the country.) How can they say something like this with a straight face after Dodd Frank and Basel III? Either they’re being dishonest or aren’t very bright. Based on past performance I would lean towards the former with a decent dose of the latter.

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When The Levee Breaks

“If it keeps on raining the levee’s going to break”[1]

In our case the levee is the prime broker industry and the rain is government regulation of the banking industry. The levee’s not looking too good these days. Recent news from some of the major foreign banks show we have moved, and are accelerating, into the next phase of re-structuring the prime brokerage business.  The script is playing out with the major prime brokers “focusing on our core client base” which is code for “we’re re-pricing or throwing everyone over the side that makes sub-optimal use of our balance sheet”.

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