The Committee releases its FDIC annual stress test letter

Posted by jgrygiel on April 30, 2012 | Comments Off

Re: Annual Stress Test, 77 Fed. Reg. 3166 (FDIC RIN 3064 – AD91).

Dear Executive Secretary Feldman:

The Committee on Capital Markets Regulation (Committee) appreciates the opportunity to comment on the Federal Deposit Insurance Corporation’s (FDIC) proposed rule regarding annual stress tests[1] (Proposed Rules) under § 165(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[2]

Since 2005, the Committee, composed of 31 members, has been dedicated to improving the regulation of U.S. capital markets. Our research has provided an independent and empirical foundation for public policy. In May 2009, the Committee released a comprehensive report entitled The Global Financial Crisis: A Plan for Regulatory Reform, which contains fifty-seven recommendations for making the U.S. financial regulatory structure more integrated, more effective, and more protective of investors in the wake of the financial crisis of 2008.[3] Since then, the Committee has continued to make recommendations for regulatory reform of major areas of the U.S. financial system.

The Dodd-Frank Act requires that state nonmember banks and state savings associations supervised by the FDIC, with total consolidated assets in excess of $10 billion (Covered Banks), conduct annual stress tests and report the results to the FDIC and to the Federal Reserve. The FDIC must establish methodologies for the stress tests and the form and content of the report the Covered Banks will submit. Covered Banks will also be required to publish a summary of their stress test results.[4] The FDIC has not yet published specific requirements for the stress tests or for the reports, but expects to do so in the future.[5]

We note the Federal Reserve and the Office of the Comptroller of the Currency (OCC) have also each proposed their own rules on stress tests.[6] The Dodd-Frank Act calls for the FDIC and OCC to work in coordination with the Federal Reserve and to issue “consistent and comparable regulations” to implement the stress test requirements.[7] The Proposed Rules acknowledge that certain banks may be subject to multiple stress tests, both at their parent company level and at the level of subsidiary financial companies, including Covered Banks. The FDIC says: “To avoid unnecessary complexity or duplication of effort associated with this requirement, the [FDIC] intends to coordinate with the other primary federal financial regulatory agencies, to the extent needed. For example, the [FDIC] will aim to coordinate, as appropriate, with the other primary federal financial regulatory agencies in providing scenarios to be used by multiple entities within a holding company structure when meeting the requirements of the stress tests described in the proposed rule.”[8] The OCC suggested that there may be certain situations where a consolidated set of stress tests may be appropriate.[9]

We commend the FDIC for its attention to the need to coordinate with the Federal Reserve and the OCC. The FDIC should take into account comments submitted to the Federal Reserve and the OCC during their comment periods. We believe such coordination is critical, particularly where single firms will be subject to more than one stress test requirement. Ideally, the tests required by each agency should be as close to identical as possible. If there are differences in approach, there should be a clearly articulated reason for the difference. The Federal Advisory Council, in its comments to the Federal Reserve on the Federal Reserve Proposed Rules, noted: “Aligning stress-test procedures and assumptions across the Federal Reserve, OCC, and FDIC will ensure that holding companies and bank subsidiaries are subject to a consistent set of requirements. There are also opportunities to leverage existing regulatory data repositories where available and to coordinate with the FDIC with respect to how stress tests are leveraged with required resolution and recovery plans.”[10]

As the Committee noted in our comment letter to the Federal Reserve,[11] we would expect that stress-testing requirements under the Federal Reserve Proposed Rules, the Federal Reserve’s capital planning requirements and the Comprehensive Capital Analysis and Review (CCAR) be conducted once and be identical. We would thus encourage the FDIC similarly to follow this single model in its own stress tests. Further, we note that the Committee is currently undertaking to review bank stress test requirements, and expects to issue more specific recommendations regarding the content and reporting of these tests in the future.

In addition, unlike the Federal Reserve’s supervisory stress tests, company-run stress tests will not be standardized, and thus comparison of results across companies may not be possible. The Proposed Rules include minimum public summary disclosure requirements for these tests.[12] We would encourage the FDIC to provide companies with a standardized template for disclosure that would enable better understanding by the capital markets and the public.

Finally, we note that cost-benefit analysis is critical in light of the ruling this past July by the U.S. Court of Appeals for the D.C. Circuit in Bus. Roundtable v. Sec. and Exch. Comm’n.[13] While the FDIC has asked for comment on the anticipated costs associated with data collection and developing methodologies for stress testing on Covered Banks,[14] the Proposed Rules provide no cost-benefit analysis (other than a summary of the hourly paperwork burden and a conclusion that the Proposed Rules will not have a significant economic impact on small businesses).[15] We also note that the FDIC is more likely to be the primary federal regulator for institutions that are on the smaller end of the spectrum of those required to implement stress tests. The cost-benefit considerations of these institutions may be different in kind and relative impact from those of larger institutions, and these differences should be considered carefully when finalizing the Proposed Rules. If the Proposed Rules are to withstand judicial scrutiny, robust analysis of the broader impact of these rules must be undertaken.

Thank you for considering our comments. Please do not hesitate to contact us at (617) 384-5364 if we can be of any further assistance.

Respectfully submitted,

R. Glenn Hubbard, Co-chair

John L. Thornton, Co-chair

Hal S. Scott, Director

[1] Annual Stress Test, 77 Fed. Reg. 3166 (proposed Jan. 23, 2012) [hereinafter Proposed Rules].

[2] Dodd-Frank Wall Street Reform and Consumer Protection Act § 165(i), Pub. L. No. 111-203 (2010) [hereinafter Dodd-Frank Act].

[3] Comm. on Capital Mkts. Reg., The Global Financial Crisis: A Plan For Regulatory Reform (May 2009), http://www.capmktsreg.org/research.html.

[4] Dodd-Frank Act § 165(i)(2)(C)(iv).

[5] Proposed Rules at 3,167.

[6] See Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed. Reg. 594 (proposed Jan. 5, 2012) [hereinafter Federal Reserve Proposed Rules]; Annual Stress Test, 77 Fed. Reg. 3408 (proposed Jan. 24, 2012) [hereinafter OCC Proposed Rules].

[7] Dodd-Frank Act § 165(i)(2)(C).

[8] Proposed Rules at 3,168.

[9] OCC Proposed Rules at 3,412.

[10] Memorandum from the Fed. Advisory Council to the Bd. of Governors of the Fed. Reserve Sys. (Feb. 3, 2012), http://www.federalreserve.gov/SECRS/2012/February/20120228/R-1438/R-1438_022412_105569_535302029000_1.pdf.

[11] Letter from the Comm. on Capital Mkts. Reg. to Jennifer J. Johnson, Secretary, Bd. of Governors of the Fed. Reserve Sys. (Apr. 30, 2012).

[12] Proposed Rules at 3,169.

[13] Bus. Roundtable v. Sec. & Exch. Comm’n, 647 F.3d 1144, 1148 (D.C. Cir. 2011).

[14] Proposed Rules at 3,169.

[15] Id. at 3,170.

Tagged FDIC, Stress Test

The Committee releases its OCC annual stress test letter

Posted by jgrygiel on April 30, 2012 | Comments Off

Re: Annual Stress Test, 77 Fed. Reg. 3408 (Docket ID OCC – 2011 – 0029, RIN 1557 – AD58).

Dear Comptroller Walsh:

The Committee on Capital Markets Regulation (Committee) appreciates the opportunity to comment on the Office of the Comptroller of the Currency’s (OCC) proposed rule regarding annual stress tests[1] (Proposed Rules) under § 165(i) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[2]

Since 2005, the Committee, composed of 33 members, has been dedicated to improving the regulation of U.S. capital markets. Our research has provided an independent and empirical foundation for public policy. In May 2009, the Committee released a comprehensive report entitled The Global Financial Crisis: A Plan for Regulatory Reform, which contains fifty-seven recommendations for making the U.S. financial regulatory structure more integrated, more effective, and more protective of investors in the wake of the financial crisis of 2008.[3] Since then, the Committee has continued to make recommendations for regulatory reform of major areas of the U.S. financial system.

The Dodd-Frank Act requires that national banks and federal savings associations supervised by the OCC, with total consolidated assets in excess of $10 billion (Covered Institutions), conduct annual stress tests and report the results to the OCC and to the Federal Reserve. The OCC must establish methodolgies for the stress tests and the form and content of the report the Covered Institutions will submit. Covered Institutions will also be required to publish a summary of their stress test results.[4] The OCC has not yet published specific requirements for the stress tests or for the reports, but expects to do so in the future.[5]

We note the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) have also each proposed their own rules on stress tests.[6] The Dodd-Frank Act calls for the OCC and FDIC to work in coordination with the Federal Reserve and to issue “consistent and comparable regulations” to implement the stress test requirements.[7] The Proposed Rules acknowledge that certain banks may be subject to multiple stress tests, both at their parent company level and at the level of subsidiary financial companies, including Covered Institutions. The OCC states: “The OCC recognizes the possibility that different covered institutions within a given parent institution may be required to conduct stress tests using different scenarios, if the scenarios required by their respective primary federal financial regulators are different. In this regard, the OCC intends to coordinate with the Board and the FDIC on the development of the three scenarios that will be specified each year under these regulations. The OCC anticipates making every effort to avoid differences in the scenarios required by each primary federal financial regulator under the regulations implementing section 165(i)(2), and understands the Board and the FDIC to be in agreement.”[8] The OCC has also suggested that there may be certain situations where a consolidated set of stress tests may be appropriate.[9]

We commend the OCC for its attention to the need to coordinate with the Federal Reserve and the FDIC. The OCC should take into account comments submitted to the Federal Reserve and the FDIC during their comment periods. We believe such coordination is critical, particularly where single firms will be subject to more than one stress test requirement. Ideally, the tests required by each agency should be as close to identical as possible. If there are differences in approach, there should be a clearly articulated reason for the difference. The Federal Advisory Council, in its comments to the Federal Reserve on the Federal Reserve Proposed Rules, noted: “Aligning stress-test procedures and assumptions across the Federal Reserve, OCC, and FDIC will ensure that holding companies and bank subsidiaries are subject to a consistent set of requirements. There are also opportunities to leverage existing regulatory data repositories where available….”[10]

As the Committee noted in our comment letter to the Federal Reserve,[11] we would expect that stress-testing requirements under the Federal Reserve Proposed Rules, the Federal Reserve’s capital planning requirements and the Comprehensive Capital Analysis and Review (CCAR) be conducted once and be identical. We would thus encourage the OCC similarly to follow this single model in its own stress tests. Further, we note that the Committee is currently undertaking to review bank stress test requirements, and expects to issue more specific recommendations regarding the content and reporting of these tests in the future.

In addition, unlike the Federal Reserve’s supervisory stress tests, company-run stress tests will not be standardized, and thus comparison of results across companies may not be possible. The Proposed Rules include minimum public summary disclosure requirements for these tests.[12] We would encourage the OCC to provide companies with a standardized template for disclosure that would enable better understanding by the capital markets and the public.

Finally, we note that cost-benefit analysis is critical in light of the ruling this past July by the U.S. Court of Appeals for the D.C. Circuit in Bus. Roundtable v. Sec. and Exch. Comm’n.[13] While the OCC has asked for comment on the anticipated costs associated with data collection and developing methodologies for stress testing on Covered Institutions,[14] the Proposed Rules provide no cost-benefit analysis (other than a summary of the hourly paperwork burden and a conclusion that the Proposed Rules will not have a significant economic impact on small businesses).[15] We also note that the OCC is more likely to be the primary federal regulator for institutions that are on the smaller end of the spectrum of those required to implement stress tests. The cost-benefit considerations of these institutions may be different in kind and relative impact from those of larger institutions, and these differences should be considered carefully when finalizing the Proposed Rules. If the Proposed Rules are to withstand judicial scrutiny, robust analysis of the broader impact of these rules must be undertaken.

Thank you for considering our comments. Please do not hesitate to contact us at (617) 384-5364 if we can be of any further assistance

Respectfully submitted,

R. Glenn Hubbard, Co-chair

John L. Thornton, Co-chair

Hal S. Scott, Director

[1] Annual Stress Test, 77 Fed. Reg. 3,408 (proposed Jan. 24, 2012) [hereinafter Proposed Rules].

[2] Dodd-Frank Wall Street Reform and Consumer Protection Act § 165(i), Pub. L. No. 111-203 (2010) [hereinafter Dodd-Frank Act].

[3] Comm. On Capital Mkts. Reg., The Global Financial Crisis: A Plan For Regulatory Reform (May 2009), http://www.capmktsreg.org/research.html.

[4] Dodd-Frank Act § 165(i)(2)(C)(iv).

[5] Proposed Rules at 3,411.

[6] See Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed. Reg. 594 (proposed Jan. 5, 2012); Annual Stress Test, 77 Fed. Reg. 3,166 (proposed Jan. 23, 2012).

[7] Dodd-Frank Act § 165(i)(2)(C).

[8] Proposed Rules at 3,412.

[9] Id.

[11] Letter from the Comm. on Capital Mkts. Reg. to Jennifer J. Johnson, Secretary, Bd. of Governors of the Fed. Reserve Sys. (Apr. 30, 2012).

[12] Proposed Rules at 3,411.

[13] Bus. Roundtable v. Sec. & Exch. Comm’n, 647 F.3d 1144, 1148 (D.C. Cir. 2011).

[14] Proposed Rules at 3,411.

[15] Id. at 3,412-3,413.

Tagged OCC, Stress Test

The Committee releases a letter to the Federal Reserve regarding enhanced prudential standards and early remediation requirements for covered companies

Posted by jgrygiel on April 30, 2012 | Comments Off

Re: Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed. Reg. 594 (Docket No. 1438, RIN 7100 – A86).

Dear Ms. Johnson:

The Committee on Capital Markets Regulation (Committee) appreciates the opportunity to comment on the Federal Reserve Board’s (Federal Reserve) proposed rule regarding enhanced prudential standards and early remediation requirements for covered companies[1] (Proposed Rules) under § 165 and § 166 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[2]

The Dodd-Frank Act requires that the Federal Reserve establish prudential standards for: (i) nonbank financial holding companies as designated by the Financial Stability Oversight Council (FSOC) (Nonbank Covered Companies) and (ii) bank holding companies with greater than $50 billion in assets (Large BHCs, and together with Nonbank Covered Companies, Covered Companies).[4] These requirements are to include liquidity requirements, overall risk management requirements and credit exposure requirements, among others, in addition to any other enhanced prudential standards determined appropriate by the Federal Reserve.[5] Certain aspects of these requirements, for example, a requirement to conduct annual stress tests as well as a requirement to establish a risk committee, also apply to smaller banks, bank holding companies and savings and loan holding companies. The Dodd-Frank Act also requires the Federal Reserve, in consultation with the FSOC and the Federal Deposit Insurance Corporation (FDIC), to prescribe regulations for early remediation of Covered Companies.[6]

As an initial matter, we note that the Federal Reserve has acknowledged it intends to consult with other FSOC members regarding any prudential standards or other requirements it may impose that are “likely to have a significant impact on a functionally regulated subsidiary or depository institution subsidiary of a covered company.”[7] This coordination is critical, as entities that fall under the jurisdiction of multiple regulators could otherwise face potentially conflicting and/or duplicative regulation. We have seen, for example, three sets of proposed rules regarding stress tests, from the Office of Comptroller of the Currency (OCC), the FDIC and the Federal Reserve, and a single banking entity with multiple subsidiaries might be subject to all three sets of rules. The Federal Reserve acknowledges this concern and states: “To minimize any undue burden associated with multiple entities within one parent structure having to meet the proposed rule’s requirements, the Board intends to coordinate with the other federal financial regulatory agencies, as appropriate.”[8] We commend the Federal Reserve for its attention to the need for coordination. Ideally, the tests should be as close to identical as possible and the required timing of any reports, submissions or disclosure should be coordinated for different entities within the holding company structure. If there are differences in approach, there should be a clearly articulated reason for the difference. The Federal Advisory Council, in its comments to the Federal Reserve on the Proposed Rules, noted: “Aligning stress-test procedures and assumptions across the Federal Reserve, OCC, and FDIC will ensure that holding companies and bank subsidiaries are subject to a consistent set of requirements. There are also opportunities to leverage existing regulatory data repositories where available and to coordinate with the FDIC with respect to how stress tests are leveraged with required resolution and recovery plans.”[9]

In addition, the Proposed Rules would apply the same enhanced prudential standards to all Covered Companies, including both Large BHCs and Nonbank Covered Companies. The Federal Reserve acknowledges that Dodd-Frank requires they “take into account differences among bank holding companies covered by the rule and nonbank financial companies supervised by the Board,”[10] and that the Federal Reserve “may determine…to tailor the application of the enhanced standards to different companies on an individual basis or by category, taking into consideration their capital structure, riskiness, complexity, financial activities, size and any other risk-related factors that the [Federal Reserve] deems appropriate.”[11] However, the Federal Reserve proceeds to explain that while its Proposed Rules were “largely developed with large, complex bank holding companies in mind, some of the standards nonetheless provide sufficient flexibility to be readily implemented by covered companies that are not bank holding companies.”[12] We are concerned that the Federal Reserve has provided no indication of what the different standards might be, or when they might apply. It is critical that any such tailored enhanced prudential standards for Nonbank Covered Companies be proposed publicly, and that market participants have an opportunity to comment.

We will now address several specific concerns with the Proposed Rules.

Liquidity Requirements

The Federal Reserve proposes implementing its liquidity requirement proposals, which consist of both liquidity risk management requirements as well as quantitative liquidity requirements,[13] in two stages. The quantitative liquidity requirements will be implemented through future rulemakings as part of the new Basel III reforms, and could include a Liquidity Coverage Ratio and a Net Stable Funding Ratio.[14]

Regarding the liquidity risk management requirements, the Proposed Rules introduce a liquidity stress test requirement as well as a requirement that Covered Companies maintain a “liquidity buffer” of liquid assets to meet projected outflows under certain stress scenarios. The Proposed Rules also require Covered Companies to produce cash flow projections, to establish and monitor liquidity risk tolerances and to maintain contingency plans if normal funding sources are not available.[15]

The Proposed Rules outline the role of the Covered Company’s board of directors in the risk management process, which includes numerous specific duties such as establishing the Covered Company’s liquidity risk tolerance;[16] reviewing and approving (either directly or through the board’s risk committee) liquidity costs, benefits and risks of each significant new business line and significant new product before implementing or offering the product; at least annually reviewing all significant business lines and products for liquidity risk; reviewing and approving the Covered Company’s contingency funding plan (CFP) at least annually; and performing a series of additional reviews (either directly or through the risk committee), at least quarterly, regarding cash flow projections, stress testing, liquidity buffers, and other factors.[17] These extremely detailed requirements for extensive involvement by the board in granular business operations are problematic, and arise again in other provisions of the Proposed Rules (in particular the Risk Management provisions of the Proposed Rules). The enumerated risk management responsibilities will be very time-consuming, and compliance with the Proposed Rules could easily become a full-time job for board members. It would be an unfortunate result if such reviews became pro-forma and mere “window dressing” because boards were unable to devote adequate time to them alongside their other responsibilities. We encourage the Federal Reserve to consider whether certain of these responsibilities would be better placed with senior management, who are more intimately involved in the day to day operations of the Covered Companies and who can devote the proper level of time and attention to these matters.

The Proposed Rules also require that Covered Companies conduct liquidity stress testing at least monthly, in addition to performing ad hoc liquidity stress tests.[18] We believe that monthly may be too often, particularly for Covered Companies whose overall portfolio holdings do not change with the level of frequency, for example, of other firms that engage in significant investment banking activities. We encourage the Federal Reserve to re-consider the required frequency of these stress tests, and to propose different frequencies for Covered Companies as appropriate, based on their business models.

In addition to stress test requirements, the Proposed Rules also require Covered Companies continuously to maintain liquidity buffers of unencumbered, highly liquid assets that could cover projected cash outflows or impairment of existing funding sources for 30 days. We recognize that liquidity shortcomings pose perhaps more immediate risk than capital shortcomings. As an initial matter, although we support the idea of liquidity risk management, we would encourage the Federal Reserve to reconsider whether liquidity buffers can actually achieve the goal of preventing or curtailing irrational runs in the event of a crisis. We believe that it is the central bank’s role as lender of last resort, rather than a pre-existing liquidity buffer, which is critical to supporting liquidity in such situations. Furthermore, we suggest that the Federal Reserve should continue to analyze, with the international community, the liquidity proposals under Basel III in order to better understand the micro- and macro-economic effects of requiring these buffers over and above capital regulation. In addition, coordination of liquidity buffer regulation internationally will be necessary, and we urge the Federal Reserve to advocate the Proposed Rules’ more flexible approach to liquidity buffer regulation when engaging in international discussions on the final Basel III Rules. Only after this international process is concluded should the Federal Reserve determine the appropriate liquidity buffer regulations for Covered Companies.

Finally, turning to the specifics of the Proposed Rules, the rules set forth detailed guidance regarding the types of assets that may be included in the liquidity buffer, and requirements to discount the assets in times of market stress as well as requirements to hold diversified liquid assets. [19] The Federal Reserve asks what, if any, other assets should be included in the definition of highly liquid assets. We believe that this definition has been constructed too narrowly and should be broadened to include other sources of liquidity. Additional sources of liquid assets should be directly permitted under the Proposed Rules, rather than requiring an individual application to, and determination by, the Federal Reserve. These should, at a minimum, include qualifying foreign sovereign securities, securities or other obligations issued by multilateral development banks, securities or other obligations issued by central banks, highly liquid corporate debt and equity with appropriate haircuts for credit risk, loan payments received in 90 days and loans held-for-sale. Further, the Proposed Rules should be clarified to reflect that the Federal Reserve’s discount window credit will be available in times of severe stress, and to reflect other sources of liquidity like the Federal Home Loan Bank facilities.

Single-Counterparty Credit Limits

The Dodd-Frank Act requires that the Federal Reserve establish single-counterparty credit concentration limits to prohibit Covered Companies from having over 25% credit exposure to an individual counterparty. The Federal Reserve has the ability to lower this threshold if necessary.[20] The Federal Reserve has addressed this requirement through the Proposed Rules with a two-tier single-counterparty credit limit, imposing a general 25% limit on Covered Companies but also proposing a lower 10% counterparty limit for major Covered Companies, defined as Nonbank Covered Companies or Large BHC’s with over $500 billion in consolidated assets (Major Covered Companies).[21] Counterparties are also defined to include foreign sovereign entities.

We have several concerns with the Proposed Rules’ treatment of single-counterparty credit limits. First, the 10% limitation for Major Covered Companies could be especially problematic. The Federal Reserve has not provided any explanation as to why 10% is more appropriate than 25% exposure for Major Covered Companies, nor has it satisfied the requirement under Dodd-Frank to determine that such a lower limit is “necessary to mitigate risks to the financial stability of the United States.”[22] At the same time, the result of this strict limitation will be that affected firms must spread their exposures across more and smaller, potentially less stable counterparties. The Federal Reserve should explain how the 10% limitation was derived, confirm that the benefits of this lower limitation will not be offset by potentially increased risk and interconnections as Major Covered Companies are forced to spread their exposures across smaller counterparties, and more generally, support how these limits are “necessary.” In addition, after the transition to central clearing, the Proposed Rules seem to work at cross-purposes with the Title VII (and global) requirement for central clearing of derivatives, by generally applying to relationships with central clearing counterparties (CCPs). We would encourage the Federal Reserve to exempt Covered Companies’ exposures to CCPs until further regulation of the CCPs has been finalized, and the Federal Reserve has had the opportunity to study whether limits might be appropriate.

In addition, the Federal Reserve has measured credit concentration levels in an extremely narrow way. For example, provisions for collateral haircuts are very conservative, and in fact, more conservative than those under Basel II. The Federal Reserve has not provided any explanation as to how they derived these haircuts. In addition, the Proposed Rules have no provision for offsets when a Covered Company lends and receives the same equity, which is a common practice in banks’ current internal economic models. The effect of such a conservative calculation is that Covered Companies will likely face significant limitations in their ability to lend as a result of restrictions on the collateral they can accept. This impact will be most acutely felt in business lines that rely heavily on collateral, for example, in the securities lending, prime brokerage and repo businesses. Also, while the Federal Reserve’s approach to measuring credit exposure has the benefit of being simple and relatively easy to apply, it lacks critical nuances. As a result, the Federal Reserve’s approach to measuring credit exposure (particularly in relation to derivative exposure) will lead to determinations that are many multiples the size of the credit exposures currently identified under banks’ internal tests. The Federal Reserve should revise the Proposed Rules to take into account such nuances and to apply appropriate advanced models (as accepted and approved by the Federal Reserve under capital rules) to more accurately reflect exposure of Covered Companies to their counterparties.

Another significant issue is the application of the counterparty limitation to foreign sovereign debt. While the Proposed Rules provide an exemption for certain credit exposures to the U.S. government, there is no similar exemption for exposures to state or local governments or foreign sovereigns.[23] Foreign government debt can serve as a relatively safe form of collateral, and its widespread acceptance as collateral suggests that Covered Companies will find the limits particularly restrictive. In our current environment, given the greater need for capital, liquidity and collateral, Covered Companies will be considerably constrained in their business activities when such limits impact their direct exposures to foreign sovereigns, as well as both their acquisition of sovereign debt for their own collateral posting requirements and their receipt of sovereign debt as collateral from counterparties. To address the Federal Reserve’s concern about the risks posed by foreign sovereign debt, limitations could be imposed through haircuts rather than an absolute, overall quota. Note the counterparty limitations would also apply to deposits at foreign central banks, which may be required under local regulation. The Federal Reserve acknowledges this possibility and specifically asks whether credit exposures to foreign central banks, which are necessary to facilitate the operation of foreign banking business by Covered Companies, should be exempt.[24]

A further significant issue related to credit limits is the Proposed Rules’ lack of interpretation of the so-called Attribution Rule in the Dodd-Frank Act. The Attribution Rule says that “…any transaction by a [Covered Company] with any person is a transaction with a company, to the extent that the proceeds of the transaction are used for the benefit of, or transferred to, that company.” [25] The Federal Reserve acknowledges that too broad an interpretation of the Attribution Rule “would lead to inappropriate results and would create a daunting tracking exercise for covered companies.”[26] The Attribution Rule could be interpreted to require that when a Covered Company that extends a loan to a counterparty (for example, an operating business), the Covered Company must look through its counterparty and identify and track the ultimate recipients of those funds (for example, suppliers of parts to the counterparty). The Covered Company must measure its exposure to these end suppliers, although in the event of a default, the Covered Company would have no recourse against the suppliers. This look-through could go on indefinitely and would be extremely burdensome, while at the same time, it would serve limited value in measuring the credit exposures of the Covered Company. The Federal Reserve requests comments on whether additional regulatory clarity around the Attribution Rule would be appropriate; we believe such clarity is critical. In particular, we urge the Federal Reserve to interpret this provision so that it is used only to prevent clear evasions of the counterparty limits.

Stress Tests

The Dodd-Frank Act directs the Federal Reserve to implement rules regarding annual stress tests, in coordination with the appropriate primary Federal regulatory agencies and the Federal Insurance Office.[27] These capital-based stress tests are in addition to the liquidity stress tests discussed above. They are also separate from stress tests that are part of the Federal Reserve’s capital planning requirements, which were incorporated in the most recent Comprehensive Capital Analysis and Review (CCAR) issued last month. In the context of discussing the CCAR and how its capital plans will intersect with what is mandated by Dodd-Frank, the Federal Reserve has stated that stress tests mandated by Dodd-Frank “will be integrated into the ongoing assessments of BHC capital required by the capital plans rule. As set forth in the law, the Federal Reserve will be implementing the specific stress testing requirements of Dodd-Frank over the next year. The Federal Reserve expects that the stress tests required in Dodd-Frank will be an important component of the annual assessment of BHC capital plans.”[28] We would expect that stress-testing requirements under the capital planning rules, the CCAR and the Proposed Rules would be conducted once, would be identical, and would be permitted to satisfy all such requirements; if they are not, the Federal Reserve should clearly explain the reasoning for duplication.

The Proposed Rules include requirements for supervisory stress tests as well as company-run stress tests, both of which will be published. The Committee is currently undertaking to review bank stress test requirements, and expects to issue more specific recommendations regarding the content and reporting of these tests in the future. We support the Federal Reserve’s creation of the Model Validation Council, which will help to evaluate and improve the quality of the Federal Reserve’s stress testing models.[29]

With respect to supervisory stress tests, and specifically the recent CCAR results, we understand that many institutions have called for the Federal Reserve to provide greater transparency for Covered Companies as to the models and methodologies used by the Federal Reserve. At the same time, we recognize the countervailing concern that providing too much information about how stress tests are conducted, particularly before the tests are conducted, may permit subjects to “game” the process and conduct business in order to achieve favorable results under the Federal Reserve’s model. We believe this issue warrants further study, in particular, whether limited disclosure of the Federal Reserve’s models and methodologies following issuance of the CCAR results could satisfy market demand without presenting a significant gaming risk.

In addition, unlike the supervisory stress tests, the company-run stress tests will not be standardized, and thus comparison of results across companies may not be possible. The Proposed Rules include minimum public summary disclosure requirements for these company-run stress tests.[30] We would encourage the Federal Reserve to provide companies with a standardized template for disclosure that would enable better understanding by the capital markets and the public.

Early Remediation Requirements

The Dodd-Frank Act requires the Federal Reserve to promulgate regulations providing for early remediation of financial distress at Covered Companies.[31] The Proposed Rules suggest various triggers which would subject a Covered Company to each of four levels of remediation review: heightened supervisory review, initial remediation, recovery and recommended resolution. Among these triggers is leverage. We would encourage the Federal Reserve to reconsider the use of leverage ratios as a metric for determining when remediation is required. While leverage ratios may pose benefits in that they are easy to calculate, they may not serve as a true indicator of risk. In addition, the Federal Reserve should ensure that these trigger events are as specific as possible, as subjectivity in the triggers can create uncertainty that is harmful to the institution, the industry and the markets. The consequences of a Covered Company falling into a particular level of remediation review are significant, and there should be no opportunity for differential treatment among institutions based on vague standards. However, we would urge that the restrictions placed on the activities of a company put into remediation be tailored to the actual trigger or event that caused the company to enter remediation. Inapposite responses to the triggering event are likely to cause more harm to the institution, rather than assisting with its rehabilitation.

Thank you for considering our comments. Please do not hesitate to contact us at (617) 384-5364 if we can be of any further assistance

Respectfully submitted,

R. Glenn Hubbard, Co-chair

John L. Thornton, Co-chair

Hal S. Scott, Director

[1] Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed. Reg. 594 (proposed Jan. 5, 2012) [hereinafter Proposed Rules].

[2] Dodd-Frank Wall Street Reform and Consumer Protection Act §§ 165, 166, Pub. L. No. 111-203 (2010) [hereinafter Dodd-Frank Act].

[3] Comm. on Capital Mkts. Reg., The Global Financial Crisis: A Plan For Regulatory Reform (May 2009), http://www.capmktsreg.org/research.html.

[4] Dodd-Frank Act § 165(a)(1).

[5] Id.

[6] Id. § 166(a).

[7] Proposed Rules at 596.

[8] Id. at 632.

[9] Memorandum from the Fed. Advisory Council to the Bd. of Governors of the Fed. Reserve Sys. (Feb. 3, 2012), http://www.federalreserve.gov/SECRS/2012/February/20120228/R-1438/R-1438_022412_105569_535302029000_1.pdf.

[10] Proposed Rules at 596.

[11] Id. at 597.

[12] Id.

[13] Id. at 604.

[14] Id. at 600.

[15] Id. at 604.

[16] Id. at 605.

[17] Id. at 606.

[18] Id. at 607.

[19] Id. at 609.

[20] Dodd-Frank Act § 165(e).

[21] Proposed Rules at 613.

[22] Dodd-Frank Act § 165(e).

[23] Proposed Rules at 615.

[24] Id.

[25] Dodd-Frank Act § 165(e).

[26] Proposed Rules at 618.

[27] Dodd-Frank Act § 165(i).

[28] Bd. of Governors of the Fed. Reserve Sys., Comprehensive Capital Analysis and Review for 2012: Frequently Asked Questions (Nov. 22, 2011), http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20111122c1.pdf.

[29] Joshua Zumbrun, Fed Creates Council to Study Stress Tests of U.S. Banks, Bloomberg Businessweek, Apr. 20, 2012, http://www.businessweek.com/news/2012-04-20/fed-creates-council-to-study-stress-tests-of-u-dot-s-dot-banks.

[30] Proposed Rules at 633.

[31] Dodd-Frank Act §166.

Tagged Basel, Federal Reserve, Non-Bank Financial Companies, Prudential, Stress Test

Jacqueline McCabe testifies before the House Oversight and Government Reform Committee in a hearing entitled “The SEC’s Aversion to Cost-Benefit Analysis”

Posted by jgrygiel on April 17, 2012 | Comments Off

***Media Advisory***

COMMITTEE ON CAPITAL MARKETS REGULATION’S EXECUTIVE DIRECTOR FOR RESEARCH TESTIFIES THAT SOUND COST-BENEFIT ANALYSIS “MUST BE A PART” OF RULEMAKING

WASHINGTON, April 17 2012—Jacqueline C. McCabe, Executive Director for Research of the Committee on Capital Markets Regulation, testified before the TARP, Financial Services and Bailouts of Public and Private Programs Subcommittee of the House Oversight and Government Reform Committee today, warning that inadequate cost benefit analysis by regulators rulemaking under Dodd-Frank risks successful legal challenges and/or litigation delays which will cause economic harm.

Ms. McCabe recapped a recent study by the Committee on cost-benefit analysis in 192 orders, proposed rules and final rules issued by 15 government agencies pursuant to Dodd-Frank: “…we believe many of the rules under Dodd-Frank could be subject to successful challenge in court. It would be an unfortunate outcome if, after the Dodd-Frank rulemaking process has run its course for several years, important rules are invalidated because of inadequate analysis. Even if such rules are not eventually invalidated, prolonged uncertainty around their fate threatens to hamper economic activity.”

With regard to the recently issued SEC Internal Guidance on Economic Analysis in SEC Rulemakings she said that “We are pleased that the SEC has recognized the need to consider the overall economic impact of its rules, including both SEC rulemaking pursuant to Congressional mandates, as well as entirely discretionary SEC rulemaking… The SEC acknowledges that this approach will provide the most complete evaluation of a rule’s economic effect, particularly because in many cases it is difficult to distinguish between mandatory and discretionary aspects of a rule.”

She also addressed recent CFTC Internal Guidance, which is contrary to the SEC’s Internal Guidance on the issue of discretion: “The SEC’s approach to this issue of discretion stands in contrast to that taken by the CFTC. In staff guidance issued by the CFTC General Counsel and Chief Economist last May, the CFTC advised its staff that if rulemaking provisions under Dodd-Frank ‘merely replicate the statutory provisions the Commission is required to promulgate without the exercise of discretion, then cost-benefit considerations may not be a factor in the promulgation of the rule.’”

Ms. McCabe concluded that “…in calling for better cost-benefit analysis as part of the rulemaking process, we are not suggesting that the Dodd-Frank rulemaking process should be sidetracked or delayed. Many provisions of Dodd-Frank are crucial to ensuring the safety and soundness of our financial markets, and thus should be made effective as soon as possible.” However, “Rules needed to protect the financial system can be put in jeopardy by the failure to conduct a cost-benefit analysis that can withstand judicial scrutiny. We commend the new direction the SEC has taken on this issue and would hope other agencies would follow suit.”

# # #

The text of today’s letter appears below.

For further information please visit: http://capmktsreg.org/

Contact Information:

Jacqueline C. McCabe
617-384-5364
jmccabe@capmktsreg.org

Hal Scott
617-384-5364
hscott@law.harvard.edu Continue Reading…

Tagged Cost-Benefit Analysis, Dodd-Frank, Rulemaking, SEC, Volcker Rule

Financial Stability Board Roundtable Speech by Hal Scott: A Medium Term (5-10 Year) Vision for the Financial Stability Board

Posted by jgrygiel on April 13, 2012 | Comments Off

Committee Director Hal S. Scott gave the following speech in his capacity as the Co-Chairman of the Council on Global Financial Regulation.

Financial Stability Board Roundtable

Mexico City, April 13, 2012

A Medium Term (5-10 Year) Vision for the Financial Stability Board

Hal S. Scott, Nomura Professor of International Financial Systems,
Harvard Law School and Co-Chairman of the Council on Global Financial Regulation

Thank you for inviting me to speak to you today. I feel I am participating in a meeting of great importance to the future of the global financial system—to put the Financial Stability Board on an enduring organizational footing.

I am speaking in my capacity as the Co-Chairman of the Council on Global Financial Regulation. The Council was formed in 2010 with the objective of providing government officials and regulators with independent recommendations, analysis and commentary on issues relating to international financial regulatory coordination. The Council is composed of fifteen individuals, representing eleven different nationalities, who are experienced in financial regulatory matters and who have committed to act independently of any institutions with which they are or have been affiliated. None of the Council’s members presently hold any position in any governmental or financial regulatory body.

As you may know, this Council a year ago this month – in April 2011 – issued a report titled “Practical Measures for Strengthening International Financial Regulatory Coordination.” That Report focused in large part on the mandate, capacity and governance of the Financial Stability Board. We took that as our focus because of a belief that effective international coordination in the financial field is essential to healthy financial markets and global growth. Moreover, the Council in its Report took the view that the FSB should be a central and enduring part of the global financial institutional architecture. We offered what we believed were practical measures for strengthening the coordinating function of the FSB. Our thinking today remains in line with our April Report, but the Council has gone beyond it and in the spirit of offering constructive ideas for discussion is pleased to present today some additional thoughts with respect to development and implementation of standards. Our goal is less to be definitive, than to contribute ideas to a creative process of thinking as to the future of the Financial Stability Board.

The 2008 financial crisis made us painfully aware of the vulnerability of the global financial system. While the subprime crisis was centered in countries that experienced housing bubbles, the collapse of the bubble affected financial institutions globally that were exposed to declines in housing assets or that had financial exposures to institutions that did have housing asset exposure. While Asian and Latin American financial institutions were relatively unscathed, their economies were affected by the recessionary conditions that beset their Western trading partners. The G20 was relatively quick to realize that the financial crisis required not just a national but a coordinated global response. This was not only because of the widespread effects of the crisis and the interdependence of global financial institutions, but also to avoid regulatory inconsistencies, protectionist responses, gaps and arbitrage. The need for a coordinated global response was important background for the conversion of the Financial Stability Forum to the Financial Stability Board (FSB) in April 2009. As 2008 and its aftermath recede from memory and economic conditions stabilize, there is an unfortunate but understandable tendency for such coordination to yield to the more immediate interests of national policy makers and regulators, and local politics. This tendency needs to be resisted by further strengthening the role of the FSB.

I will discuss this morning my view that the FSB’s activities over the next five to ten years should have two main areas of focus. First, the FSB should monitor, identify and address national regulations that are in conflict with each other or with international standards set by international standard setting bodies, where such conflicts pose a significant risk to the financial system. At the moment, the regulation of derivatives and of proprietary trading by banks require particular attention in this regard.

Second, the FSB should identify high-risk regulatory gaps at the national and international level, for example, as they have done with shadow banking. The FSB must identify the relevant international organization that should address these regulatory gaps, or, where no existing organization can fill this role, itself coordinate the necessary national action. I will then turn to capacity issues of the FSB regarding organization, governance and funding.

Regulatory Inconsistency

Let me begin with the role of the FSB in dealing with regulatory inconsistency where the inconsistency creates a problem for the stability of the global financial system. The FSB must identify potential and existing regulatory divergences of this kind. This will require the FSB to institute a regular process to monitor G20 members’ regulations, as well as the standards set forth by international standard setting bodies. As the CGFR suggested in its April 2011 report, the FSB should encourage G20 member governments routinely to provide the FSB with proposed national financial regulatory measures that have cross-border implications, so that the FSB may coordinate a period of consultation among other G20 members prior to implementation. That process is intended to identify potential regulatory divergences before they come into effect and will facilitate collaboration between national authorities.

But the FSB must also play a role in identifying important inconsistent policies and regulations that are adopted, particularly if they create conflicts, and formulate plans for resolving them. The so-called regulatory dialogues, which perform this function bilaterally, need to be systematized and in many subject areas become multilateral. The FSB should maintain a thorough detailed database comparing key regulations and make this database open to the public. The FSB has taken steps in this direction, for example, by publishing on its website national and regional responses to a survey conducted by the FSB Implementation Monitoring Network regarding progress of these nations and regions toward implementing G20 recommendations. This information should be kept current, and should be presented in a manner that allows for easy comparison of regulations across jurisdictions.

Completeness of Implementation

Although not the main focus of my remarks, I should also mention that beyond monitoring inconsistent policy and regulation among countries, the FSB should also monitor the completeness of implementation of policies in areas where it has formulated an action program. This is necessary to make sure we can detect problems that go beyond looking only at “law on the books.” The CGFR has made two recommendations to make this process effective: the FSB should conduct or oversee a review of domestic laws which limit information-sharing across jurisdictions, and the FSB together with the International Monetary Fund (IMF) should develop a standardized framework for the G20 peer review process. The FSB’s Standing Committee on Standards Implementation has already developed such a framework for monitoring the implementation of international standards, which includes mechanisms for information gathering, evaluation and assessment and publication of results. Going forward the FSB and the IMF must clarify and formalize their respective responsibilities on multilateral surveillance.

The FSB should also strengthen and formalize the basis on which international standard setting bodies collaborate among themselves. Because these entities have distinct areas of technical competence, they are generally well-positioned to identify divergent cross-border regulations in a particular area. The FSB must work with these entities to coordinate their standards across sectors. These issues will be the topic of Olin Wethington’s address in the next panel.

Derivatives

The need to deal with significant inconsistencies is especially evident in the area of derivatives reform, which the G20 has identified as an area of priority. At the initiative of the FSB, a working group led by representatives of the Committee on Payment and Settlement Systems (CPSS), the International Organization of Securities Commissions (IOSCO) and the European Commission was formed in April 2010 to make recommendations on the implementation of the G20 derivatives reform. In October 2010, the FSB issued a report on “Implementing OTC Derivatives Market Reforms” which contained 21 recommendations regarding practical issues authorities might encounter in implementing the goals of the G20. The FSB issued its first implementation progress report in April 2011, where it expressed concern over whether many jurisdictions would meet the G20’s end-2012 deadline. The FSB issued a second report in October 2011, with an even more detailed assessment of progress. The FSB’s OTC Derivatives Working Group will continue to monitor implementation of derivatives reform as the end-2012 deadline approaches.

Unfortunately, divergence in derivatives regulation has begun to emerge, for example, in U.S. and E.U. regulation of clearinghouses. Both the U.S. and proposed E.U. regimes will permit their home-country institutions to participate in a foreign clearinghouse only if the regulation of that foreign clearinghouse is equivalent to that of the regulation of clearinghouses in the home country. These equivalence determinations are primarily designed to avoid regulatory arbitrage but the cure could be worse than the bite. It would be highly inefficient and risky, and perhaps even unworkable, to split central clearing of derivatives geographically. Where a trade has a U.S. and E.U. counterparty, where would the trade be cleared if equivalence were deemed lacking by both the U.S. and E.U.? Note that if one party found equivalence and the other did not, all trading would migrate to the location that did not find equivalence (since this venue would be acceptable to the party that found this location was equivalent). Such trading migration would likely not be acceptable, thus further underscoring the necessity of coordinated action.

The solution, of course, is to make sure each side finds equivalence, but this requires that there be minimum divergence in regulatory approach. Ensuring this outcome is complicated by different timetables for implementation of regulation, the U.S. being ahead of the E.U. This underscores the need for the FSB to encourage compatible timetables in implementation of regulation. And as for the substance, the FSB, or the OTC Derivatives Working Group as coordinated by the FSB, must be involved in the areas where the risk of divergence is highest, for example regarding margin requirements and other measures of protection for the clearinghouse, including capital requirements for members, ownership and governance restrictions, and clearinghouse access to a central bank discount window.

The U.S. and E.U. have also diverged in the proposed treatment of non-financial derivatives counterparties. The proposed European Market Infrastructure Regulation offers a more generous end-user exemption than the end-user exemption in the Dodd-Frank Act. The end-user exemption in the Dodd-Frank Act exempts only derivatives activity by a non-financial end-user for hedging purposes, whereas the E.U. proposal exempts any derivatives activity by a non-financial end-user up to a certain unhedged threshold. This threshold has yet to be determined. Thus it is likely that for a substantively similar derivatives transaction, non-financial end-users in the E.U. would not have to clear the transaction with a clearinghouse or report the transaction to trade repositories, while the same transaction in the U.S. would require both clearing and reporting. The FSB should have an active role in resolving these problems and others like it.

Unilateral Regulation Outside the G20 Framework

While significant inconsistencies in regulation can arise in the implementation of the G20 reform agenda, they can also arise when countries pursue reforms outside the agenda that impact the interest of other countries. This suggests that the FSB may need to play a role in restraining such action, even when undertaken by prominent members. Here I have in mind the impact of the Volcker Rule and Vickers Commission recommendations on the rest of the world.

The Volcker Rule bans proprietary trading and certain investments in hedge or private equity funds by U.S. banking organizations; this is not part of the G20 agenda nor has it so far been proposed or adopted by any other G20 member, to my knowledge. The Volcker Rule will not only limit the activities of U.S. banking organizations, it will also limit the activities of foreign banks operating in the U.S. In addition, it may prevent foreign banks outside the U.S. from investing in funds that are sold to U.S. residents. And most notably, it grants U.S. banking organizations an exemption for trading U.S. government but not foreign government debt, a discrimination that will be hard to fix by regulation. The Vickers Commission proposes splitting insured deposit retail banking activities and wholesale banking activities of U.K. banks into separate ring-fenced affiliates with the intent that the U.K. public safety net would cover only the retail bank. Unlike the Volcker Rule, the Vickers Commission proposal does not apply to foreign banks operating in the U.K. through branches although it has urged foreign supervisors to encourage their banks to operate in the U.K. in subsidiary rather than branch form. Nonetheless, the Vickers Commission could have substantial international repercussions. Suppose the U.K. wholesale bank were to fail with significant impact on foreign counterparties. Could or should the U.K., which was the home country supervisor of the failing wholesale bank, walk away from any financial responsibility just because the wholesale bank did not take insured deposits? The general point is that the FSB may have to police countries adopting policies outside the G20 consensus that significantly impact other countries.

Regulatory Gaps

In addition to resolving significant inconsistencies, a second main focus for the FSB in the coming five to ten year period should be in addressing gaps in financial regulation that create potential sources of systemic risk, across nations and regions. The FSF, pre-cursor to the FSB, was created in 1997 in part to serve an early warning function in future economic crises. An important part of identifying potential future crises will be to understand where the regulatory shortcomings lie. In many instances, these gaps exist outside the traditional banking industry, the principal focus of the FSB.

Shadow Banking

Regulation of the shadow banking system is an important gap, which is currently being addressed by the FSB. The shadow banking system, which the FSB has broadly defined as “credit intermediation outside the regular banking system,” encompasses such diverse activities as money market funds, securitization, securities lending and repo transactions, among others. It introduces significant benefits to market participants as a source of funding and liquidity. At the same time though, it is subject to “runs” similar to traditional bank short-term funding, and can thus be a source of systemic risk—this was a major problem with respect to the money market funds during the crisis. In addition, as the G20 noted in its report last November, the relatively unregulated status of the shadow banking system can create opportunity for regulatory arbitrage. At the G20’s request, the FSB created a Task Force on Shadow Banking to help identify the role and risks of the shadow banking system, and to set out approaches for effective monitoring and to prepare, where necessary, additional regulatory measures to address risks posed by the system. The FSB issued a report in October of 2011 that sets forth 11 specific recommendations for monitoring and enhancing regulation of shadow banking and the G20 has called on the Task Force to draft rules and regulations for the shadow banking industry by year-end.

In addition to shadow banking, there are other areas where the G20 has suggested the FSB should address gaps in regulation. For example, the G20 identified the need to integrate financial consumer protection policies into regulatory and supervisory frameworks, and endorsed the FSB’s report on consumer finance protection and the high level principals the FSB developed along with the Organisation for Economic Co-operation and Development (OECD). The G20 has also called upon the FSB to undertake ongoing monitoring and reporting on compensation practices, to identify gaps in implementation of the FSB principals and standards on compensation. The FSB has also been tasked with developing principles on credit ratings and in coordinating the preparation of recommendations for a global legal entity identifier. Addressing gaps in regulation will be an important role of the FSB. In addressing these gaps, the FSB should set priorities, focusing on areas where the potential for systemic risk is the greatest.

Another serious area of concern is the supervision and resolution process for important financial organizations operating across borders. The FSB has been very active in stepping into the action gap in this area. Its “Key Attributes of Effective Resolution Regimes for Financial Institutions” sets forth the principal features that should be part of all national resolution regimes. The Key Attributes also include requirements for information sharing between national authorities, institution-specific cross-border crisis management groups and institution-specific cooperation agreements between home and host authorities. The Key Attributes were endorsed by the G20 in November 2011 and the 29 financial institutions designated as G-SIFIs by the FSB and the Basel Committee on Banking Supervision (BCBS) are required to meet the resolution planning requirements by the end of 2012.

Capacity of the FSB

I would now like to discuss some key issues relating to making the FSB a “fully enduring organization,” as the G20 formulated the objective at the Cannes Summit. It goes without saying that its endurance will require that it be successful in fulfilling its mission, parts of which I have already discussed.

With this objective in mind, the work of the Council in recent months has concentrated on exploring and considering the various possible frameworks which have been used for different international organizations and which may also be appropriate for the FSB. When I say “framework,” our attention and research has particularly focused on three features which are central to any organizational structure—(i) its legal identity and corporate capacity; (ii) its governance process; and (iii) the primary sources of funding for its operation and staffing.

I think it would be helpful to briefly summarize the Council’s research in which we have examined these three features in 13 different international organizations.

Legal Identity and Capacity

On the topic of legal identity and capacity, let’s begin with the FSB. The FSB is a unique body among the various international organizations which the Council has researched. At present, the FSB does not possess its own legal identity and its charter is essentially an informal memorandum of understanding for cooperation among its member signatories. In fact, Article 16 of the FSB Charter states that the document “is not intended to create any legal rights and obligations.” The FSB effectively operates as an arm or extension of the BIS, and its actions or decisions evolve from political consensus rather than legal or statutory powers.

In contrast, most other international organizations today fall into one of three categories.

First are organizations which employ a traditional corporate structure under the laws of a particular jurisdiction, typically where their head office is located. This has been the preferred approach of the multilateral development banks such as the European Bank for Reconstruction and Development (EBRD), the Asian Development Bank (ADB) and the African Development Bank (AfDB) as well as the Bank for International Settlements (BIS). And, although the shareholders of these organizations include governments or national monetary institutions, these entities typically have customary corporate constitutional documents and share capital structures.

The second category would include organizations which are established by inter-governmental agreement or treaty. In these cases, the relevant constitutional document under which the organization is formed generally states that the organization is granted legal identity and capacity by the governments which are party to the inter-governmental agreement or treaty. Hence, for example, Article IX of the Articles of Agreement of the IMF states that the Fund “shall possess full juridical personality including the capacity to contract, acquire and dispose of immovable and movable property and institute legal proceedings.” The IMF’s Articles goes on to require that signatory states take the necessary action “within their territories” to give effect to the organization’s legal identity. Other examples of these types of organizations include the World Bank, OECD, Association of Southeast Asian Nations (ASEAN), the International Labour Organization (ILO) and the World Trade Organization (WTO).

Finally, the third category of organization would involve a type of international association.” Two examples are the International Association of Insurance Supervisors (IAIS) and IOSCO. In both cases, the organizations have specific statutory authority for their existence in the jurisdiction in which they are located – in the case of the IAIS, under the Swiss Civil Code, and in the case of IOSCO under a Spanish law recognizing “public utility associations.”

It is important to note an over-arching principle in all three of these categories and which is a feature shared by all the organizations we examined. Specifically, in each case (with the exception of the IMF and the World Bank which were created by intergovernmental agreements), there is a legal basis for the identity and capacity of the entity which arises from the legal jurisdiction in which it is physically located. In this way, an organization can expect to have certainty under the laws of the place where it is physically located so that it can engage in its business with the rights and privileges as well as responsibilities of the laws governing commercial or related types of activities. This covers a wide range of matters including, for example, engaging in real or personal property transactions, staffing and employment, intellectual property protection and, if necessary, judicial review for the enforcement of rights or redress of grievances arising in the place where the organization is operating.

This legal basis and the certainty it can afford may arise under existing corporate law or under express statutory authority. In the case of Swiss-based organizations, this can also be accomplished under what is referred to as a “headquarter agreement” through which the Swiss Federal government recognizes the legal identity of the organization and confers certain immunities and privileges under the Federal “Host State Act” (Federal Act on Privileges, Immunities and Facilities of 22 June 2007).

In terms of the future of the FSB, of these various options, the easiest path would be for the FSB to establish itself as a separate legal entity in Switzerland – a jurisdiction with the experience and precedent for hosting international organizations. The FSB Secretariat is already located in Switzerland and, as mentioned, Swiss law expressly offers a legal framework for giving an existing international organization a separate legal identity without the more difficult process of constituting a body through an international treaty or inter-governmental agreement. As mentioned, this can be accomplished under either existing statutory authority for associations as well as through “headquarter agreements” through which the legal identity of the FSB would be recognized. Both of these approaches should be explored with Swiss counsel and the staff of the FSB, taking into account the continuation of links with the BIS while keeping in mind the goal of optimizing the independence of the FSB not only vis-a-vis the BIS but in more general terms. Separation from the BIS will serve to differentiate its role from that of traditional central banks and thereby be capable of speaking to a wider audience and coordinating with a broader range of participants in financial regulatory matters.

Governance

Turning now to the topic of governance, the FSB presently has a distinct and informal approach, albeit with structures which are drawn from more formal governance methods found in public and private bodies. Specifically, the FSB’s present governance structure consists of the Plenary, a Steering Committee, a Chairperson and the FSB Secretariat. The Plenary, whose representatives are governors of central banks and other international institutions, is the decision-making body of the FSB and its decisions are taken informally by consensus. The Plenary, with the help of standing committees and working groups approves the work program of the FSB, decides its membership and adopts reports, standards and recommendations. The Steering Committee, whose composition is decided by the Plenary, meets at least four times each year and provides operational guidance between the Plenary meetings to carry forward the directions of the FSB. The Chairperson, the principal spokesperson of the FSB, is appointed by the Plenary from FSB members for a term of three years renewable once. Finally, the Secretariat is directed by the Secretary General who is appointed by the Plenary at the proposal of the Chairperson. The Secretariat supports the activities of the FSB, ensures the effective communication to Members and manages the financial, material and human resources allocated to the FSB.

The other international organizations we have examined share what are broadly similar governance structures which are similar to private corporations. In brief, member states or institutions are represented by a board of directors or governors or a council which meets and take decisions at annual or bi-annual meetings or conferences. A secretariat or executive board with permanent members oversees the day-to-day work of the organization and is often assisted by a number of committees and sub-committees. At the head of each organization is typically a managing director, director-general or president, often assisted by deputy managing directors or vice-presidents.

In terms of voting, there are three distinguishable voting procedures employed by the organizations we have reviewed: consensus; simple majority; and higher majority. The constitutional documents of the IMF, the BIS, the ILO, the IAIS, the EBRD, the ADB and the AfDB all include provisions for voting generally to be carried out on a simple majority basis, but prescribe higher levels of majority for certain matters, often relating to the constitution of the organization itself or for capital funding issues. For example, the statutes of the BIS require a two-thirds majority to authorize any increase or reduction of share capital, the cancellation of shares, the election of its Board of Governors or any amendments to the Statutes themselves.

Notwithstanding formal voting procedures, decision-making in international organizations is also often an informal and consultative process in which decisions are taken in a consensual fashion with recourse to formal voting only where no consensus can be reached. This approach is at the heart of the present governance method at the FSB. However, as it evolves towards a more enduring organization, the Council believes that the FSB should introduce greater formality, regularity and transparency in it decision-making process. These features are hallmarks of well-run public and private organizations which enjoy the support of their members or shareholders, and their introduction in the context of a more enduring status for the FSB should enhance the credibility of the organization’s decision-making process.

Funding

In completing my overview of other international organizations, I should also speak briefly about funding. The FSB, under its present structure, is an extension of the BIS and has funding arrangements which are dependent on budgetary allocations from the BIS. In considering the alternatives, the international organizations we investigated obtain their funding from essentially two sources.

The first method is through voluntary contributions of members. All of the organizations we researched obtain a portion of their funding in this way. This can be structured either through the issuance of share capital or through a dues-based system, and the amount of contributions may be equal across all members (e.g. ASEAN) or vary according to the size of a member’s economy (e.g. OECD).

The second method is what can be loosely described as private or profit-based funding. This includes private capital raising methods such as bond issuances or borrowing facilities. And in the case of international organizations engaged in lending or other commercial activities, funding may be provided by the revenues generated by such activities.

Finally, the funding framework for the BIS also suggests a type of “endowment” method of funding as this institution has specific reserve funds which are funded by an annual percentage of the BIS’s net profits and thereby provides a supplemental source of revenue for the institution.

In the Council’s view, and as we have previously recommended, the FSB should develop a funding approach that transitions away from primary reliance on the BIS to a more independent and sustained approach – at the same time taking into consideration the benefits of a continued relationship with the BIS. The alternative approaches for funding an organization like the FSB with limited capacity for profit-making activity are narrow and, hence, most likely to depend on dues-based contributions from member organizations. The level of these contributions may also be set so as to provide for an “endowment” reserve fund, similar to the BIS, which could facilitate the independence and stability of the FSB’s funding resources. A difficult question will also be the share allocation among member organizations – specifically, whether dues based funding should be equal across all members or vary according to certain criteria related to the size of the member’s economy. As the initial budget of the FSB may be modest, a simpler equal-sharing approach among members may be most attractive at the outset.

Conclusion

As we have discussed, the FSB’s key mission should be to coordinate financial regulatory policies of the G20 that have the greatest importance to the stability of the global financial system. This requires making the FSB a more enduring organization. We have also considered the options to accomplish this, focusing on three central features of any organizational structure – legal identity and capacity, governance and funding. While each of these topics offers alternatives and complexities, I would like to conclude by noting that these three areas are inter-connected for our purposes today. Legal identity is the starting point. Effective governance requires a legal identity to be in place. Both are necessary for fund raising operations and professional staffing. In short, these three features will be at the heart of any enduring organization because, in our view, it is the prudent and effective combination of these features which will offer an organizational foundation to ensure the effectiveness, independence and objectivity of the FSB in its future work.

Thank you again for inviting me to speak to you today.

Tagged Clearinghouse, Derivatives, Financial Crisis, Volcker Rule

The Alternative to Shareholder Class Actions

Posted by jgrygiel on April 1, 2012 | Comments Off

The SEC blocks arbitration without any explanation.

Wall Street Journal
By Hal S. Scott and Leslie N. Silverman

Last month, the Securities and Exchange Commission rejected attempts by the Carlyle Group, and proposals by stockholders of Pfizer and Gannett, to mandate arbitration rather than litigation in disputes between investors and management. The SEC gave no explanation for its action on Carlyle (related to an upcoming public offering), and it said opaquely the Pfizer and Gannett proposals might violate the securities laws.

Arbitration has opponents inside the agency, of course, and among plaintiffs lawyers. They claim stockholders will receive less for management wrongdoing, and that this will lead to less deterrence of such wrongdoing. But this argument ignores some important facts. And it does not address the problem identified by the Committee on Capital Markets Regulation—that securities class-action litigation may be the most burdensome feature of U.S. capital markets.

From 2000 through 2011, the total value of all U.S. securities class-action settlements was approximately $64.4 billion, according to NERA Economic Consulting. These settlements do little to accomplish the class action’s traditional goals of compensation and deterrence.

Unlike mass tort litigation, securities class actions involve stockholders who are often both plaintiffs and investors in the defendant corporation. The suits are invariably settled before trial, generally for pennies on the dollar. Small investors recover so little they often do not bother to file for their money: 40%-60% of settlement funds generally go unclaimed, according to research prepared for the Committee on Capital Markets. Regardless, plaintiffs attorneys take up to 35% of the total settlement.

The lawsuits do little to deter wrongdoing. The stockholders funding a settlement generally have no knowledge of management misdeeds—they simply held the wrong stock at the wrong time. Managements—the actual wrongdoers and proper objects of deterrence—rarely pay a dime, as the corporation’s directors’ and officers’ insurance picks up the settlement cost.

Real deterrence comes from whistleblowers and the media, whose reports of fraud send share prices plunging. Deterrence also comes from the strongest public-enforcement system in the world—administered by the Department of Justice, the SEC and the state officials.

Securities class actions undercut the competitiveness of the U.S. capital markets. Plaintiffs attorneys have demonstrated a clear tendency to target the largest public companies, and because insurance firms will not provide settlement coverage over a few hundred million dollars, public companies face substantial risk. Further, foreign corporations are reluctant to list and trade here, while private U.S. corporations have grown wary of going public.

In 2011, 7% of U.S. companies that did go public did so abroad. They were no doubt motivated in part by the litigiousness they can avoid under the Supreme Court’s decision in Morrison v. National Australia Bank (2010), which does not permit securities claims by private plaintiffs for shares purchased or sold on a foreign exchange. Historically, it was almost unheard of for American companies to go public outside the U.S.

It does not have to be this way. Companies and their stockholders have recently begun exploring mechanisms by which disputes must be settled in individual, private arbitration, taking advantage of the lower costs and quicker results such arbitration affords. They are following the national policy in favor of arbitration embodied in the Federal Arbitration Act of 1925 and confirmed by the Supreme Court in AT&T Mobility v. Concepcion (2011), which struck down a California anti-arbitration law. Other important Supreme Court cases include Rodriguez de Quijas v. Shearson American Express (1989), which held that arbitration does not violate federal securities laws that prohibit waivers of substantive rights guaranteed by law, such as anti-fraud provisions.

Despite arbitration’s endorsement by Congress and the Supreme Court, the SEC has rebuffed efforts to substitute arbitration for securities class actions. So in the recent cases cited above, investors—prospective, in the case of Carlyle, and existing, in the case of Pfizer and Gannett—were deprived of the opportunity to decide upon the dispute-resolution procedure they preferred.

The SEC prides itself on ensuring that U.S. markets are transparent, but in ruling out arbitration it has said no without any explanation. The matter deserves a fair hearing.

Mr. Scott is a professor at Harvard Law School. Mr. Silverman is a partner in the law firm of Cleary Gottlieb Steen & Hamilton LLP. Mr. Scott is the director of the Committee on Capital Markets Regulation, on which Mr. Silverman is a member.

Tagged Arbitration, Corporate Governance

Monthly Archives: April 2012

The Committee releases its FDIC annual stress test letter

The Committee releases its OCC annual stress test letter

The Committee releases a letter to the Federal Reserve regarding enhanced prudential standards and early remediation requirements for covered companies

Liquidity Requirements

Single-Counterparty Credit Limits

Stress Tests

Early Remediation Requirements

Jacqueline McCabe testifies before the House Oversight and Government Reform Committee in a hearing entitled “The SEC’s Aversion to Cost-Benefit Analysis”

Financial Stability Board Roundtable Speech by Hal Scott: A Medium Term (5-10 Year) Vision for the Financial Stability Board

The Alternative to Shareholder Class Actions

The SEC blocks arbitration without any explanation.

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