Regulation

Dwight Cass

Banks’ Corona Response Lives Down to Worst Expectations

Hard to argue with nonprofit Better Markets’ scathing take on banks’ grotesque attempt yesterday to use the Corona Crisis to slip their regulatory leash. From Better Markets:

Wall Street Biggest Banks Shamelessly Trying to Use Coronavirus to Get Federal Reserve to Weaken Rules

March 2, 2020

FOR IMMEDIATE RELEASE
March 2, 2020
Contact:  Christopher Elliott, 202-618-6433, press@bettermarkets.com

Washington, D.C.  –  Dennis M. Kelleher, President and Chief Executive Officer of Better Markets, issued the following statement in response to the Bank Policy Institute’s request for “Actions the Fed Could Take in Response to COVID-19”:

“It is shameless but not surprising, that Wall Street’s biggest banks would use the coronavirus to attack the financial rules they have been trying to weaken for a decade, including weakening critically important capital and liquidity requirements.  It is even less surprising that they would direct their request to their favorite regulators at the Federal Reserve, which secretly doled out trillions of dollars bailing out Wall Street in 2008-2009 with virtually no public transparency, oversight or accountability.  That was great for Wall Street’s biggest banks, but a disaster for Main Street and should not be repeated now.

“As the coronavirus-created uncertainty mounts and the possibly of financial deterioration increases, the worst thing anyone could do is reduce the biggest banks’ ability to withstand a downturn or shock, which is exactly what Wall Street’s biggest bank lobby group is arguing.  Reducing capital and liquidity while preemptively taking action under Section 13(3) just tees up more taxpayer bailouts and makes them more likely. 

“Most importantly, current conditions relate to the entire economy and financial system, not just Wall Street’s biggest banks.  Rather than one-off reactions to the importuning of a subgroup of self-interested financial actors, the Financial Stability Oversight Council (FSOC) should be meeting and planning daily to be prepared for a comprehensive response if economic activity decreases dramatically and financial conditions deteriorate.  The FSOC was created for these very circumstances:  to provide a coordinated response for the entire financial system in the best interests of the country, not just the best interests of Wall Street’s biggest banks.

“Finally, to the extent Wall Street’s biggest banks are genuinely concerned about having enough capital and liquidity to support the real economy, then they should immediately stop making any additional distributions of capital via dividends or buybacks until there is certainty regarding the threat posed by the coronavirus.  If Wall Street’s biggest banks are unwilling to take that action immediately, then their real motives will be clear, and their deregulatory requests should be seen for what they are: part of their ongoing, years-long attack on the rules.”

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Dwight Cass

Of Falling Knives and Vicious Circles: Will the Corona Crisis Spread Like the 2008 Crash?

Catching a falling knife? Check. Rushing the exits? Yup. Vicious circle? Yeah, that one too. Market clichés last heard during the 2008 Financial Crisis are back in vogue among the financial commentariat. But there are important differences between that disaster and the market meltdown unfolding this week. It’s unlikely the Corona Crisis will metastasize in the same way.

The 2008 crisis had several novel characteristics. A significant driver was incorrect risk management assumptions about the correlations among assets. When mortgages proved to be more correlated than models assumed, mortgage-backed securities bombed. More broadly, entire bank business models based on the assumption that diversification was an unchallengeable law became fountains of red ink when different types of assets began declining in lockstep.

Two related factors meant to improve risk management ended up acting as vectors of contagion, turning a housing problem into a disaster for the bond and equity markets, too. The first were regulatory capital rules, which require banks to set aside more capital against high-risk assets than they set aside against safer ones. The second factor is the market practice of requiring a firm to stump up more collateral when a trading position declines in value.

These all sound sensible. But if the assets becoming riskier (mortgage-backed bonds in 2008) cannot be sold easily, banks have to get the money to pay their capital and collateral requirements by selling other types of assets, like stocks, Treasuries and corporate bonds. Banks started pouring these assets into the markets in 2008, driving down prices on the securities, some of which they retained in their portfolios, triggering the need for yet more capital and collateral, and so on – the archetypical vicious circle.

As these assets fell in price, potential buyers stepped back, not wanting (as the pundits put it) to try to catch a falling knife. So prices of all types of assets plunged further. The result was the worst multi-asset market meltdown since the Great Depression.

The Corona Calamity looks different, so far. If it does become an undifferentiating multi-asset meltdown, it will be because the coronavirus wreaks terrible havoc on the world’s economies, and not because of the types of unanticipated structural links that spread woe in 2008.

There are some positive signs. The negative correlation among asset classes, described by old wives as not keeping all your eggs in the same basket, and finance professors as diversification, appears to be back. The Fed’s abuse of savers through ultra-low rates forced investors to take more risk in the equity markets than they really wanted. Now that stock prices are dropping, “safe haven” assets like Treasuries are in demand. Stocks go down, Treasuries go up – just like the textbooks say should happen.

Regulatory capital rules are still problematic, forcing banks to pony up capital at what appears to be just the wrong times – when the value of their assets are falling. But the Dodd Frank and Basel Committee rules implemented since the Financial Crisis boosted the core capital requirements, so firms are better capitalized from the start. That should give them a bigger margin of error and reduce the chance of igniting a (sorry) run for the exits. And, assuming the Fed’s brain trust doesn’t gut the Volcker Rule, banks are barred from dabbling in ultra-risky proprietary trading, which should help to keep collateral calls to a manageable level.

This means the Corona Crisis could remain an equities problem. Sure, corporations could fail due to supply chain disruptions or falling sales, and so bond investors could take a bath on the squillions they have invested in junk and marginal investment-grade securities. Banks, meanwhile, might have a lot of senior loan write-offs in their future. But equities aren’t principally held by banks, so the regulatory capital and collateral issues should not act as vectors of contagion the way they did during the Financial Crisis.

The Financial Crisis was so pernicious, in part, because it was accelerated and magnified by structural and modeling issues that had never been tested – new product technologies, newish regulatory capital rules, new risk management models. The current meltdown appears to be a refreshingly straightforward catastrophe, with an obvious exogenous trigger and reasonably straight causal lines to be drawn from independent to dependent variables. But I vaguely remember thinking that in early 2008, too….

Dwight Cass

Volcker Rollback is a Camel’s Nose Under the Wrong Tent Flap

It all seems reasonable. New rules from the Fed, OCC and FDIC would only tweak technical bits of the Volcker Rule to ease bank business interactions with hedge funds and private equity. What’s wrong with that? After all, the 3 percent limit on direct ownership of these funds remains in place, ostensibly keeping banks from running amok and reviving the risky proprietary trading businesses that the rule, part of the Dodd Frank reforms passed in response to the Global Financial Crisis, effectively quashed. Banks and regulators portray the measure, out for public comment until April 1, as an exercise in fine tuning, rather than a strategic change.

That might be the case. But the rule change, along with other mods to compliance regulations related to prop trading made last summer, reflect how financial regulation is subject to its own version of the second law of thermodynamics. The regulatory trend is always toward entropy. And this is troubling.

Many at the time of its passage thought the Volcker Rule was downright draconian, separating banks from one of their core revenue-generating businesses. Hotshot traders left investment banks in droves in order to set up their own hedge funds, only to step into a decade-long performance abyss for active managers, where buying a dirt-cheap index-tracking ETF was almost always a better bet than paying 2 and 20 to some guy in red suspenders who never beat the market. The archetypical alpha chaser struggled along like a fat man running after beta’s bus.

That’s still the case. So why worry? Well, to its boosters, myself included, the Volcker Rule seemed like a step toward what the financial system really needed, which was (and is) a new Glass-Steagall Act separating banking and speculative investment businesses. When Sandy Weill convinced Bill Clinton to withdraw the Act in 1999, so the former could stitch together his shambolic Frankenstein’s monster, Citigroup, it was one step on the path toward the Financial Crisis.

During the crisis, the big commercial/investment bank hybrids essentially held their massive retail deposits hostage, forcing the government to bail them out when their “financial engineering” products started blowing up in their faces. The Volcker Rule was meant to keep banks from dabbling in novel, high-risk, nontransparent investment strategies in order to avoid this happening again.

But the banks and investment banks are still joined at the hip. In some cases, even more so. Goldman Sachs is getting into retail. Morgan Stanley is buying E Trade – admittedly, not FDIC-insured, but with over $300 billion in mostly retail assets, something the government is going to be watching closely. And there’s always Citi, with its unerring talent for stepping on every possible land mine.

Even Fitch, which did not exactly cover itself with glory during the run-up to the Financial Crisis, wrote an admirably canary-in-the-coalmine report today saying that the changes were “indicative of loosening regulation and recalibration of post-crisis regulatory rules.” The rating firm “views robust regulation and capital requirements as supportive of credit ratings; therefore relaxation would be viewed as a credit negative.”

It would be more encouraging to see bank regulators laboring to build a more robust wall between taxpayer-insured businesses and the hedge fund and private equity casinos. This mod represents a step – granted, a baby step – in the wrong direction.