Opinion

Stamping Nonbanks ‘SIFI’ Is Harmful and Needless

Posted by ccmrtemp on February 22, 2013   |   Comments Off

American Banker
By Hal S. Scott

The Financial Stability Oversight Council is about to decide which nonbanks with assets of $50 billion or more to designate as systemically important.  It should use this authority extremely sparingly because it is based on the flawed premise of connectedness.  

The Lehman Brothers failure is instructive. Lehman’s bankruptcy did not set off a chain reaction of failures of connected financial firms (those with direct exposure to one another). What it did set off was a contagious run on a wide spectrum of financial firms, with no significant exposure to Lehman, because short-term creditors were concerned that if Lehman could fail, other firms might well be next.  It was 1933 revisited, as nonbank firms’ short-term creditors were not insured.

Similarly, there was no legitimate basis for concern that the failure of AIG would cause the failure of its derivative counterparties, since the exposure of these parties was limited to a reasonable percentage of capital—and that exposure was protected by collateral and hedges, for example by credit default swaps written on AIG.

Nevertheless, the Dodd-Frank Act entrusted the FSOC with the responsibility of designating nonbanks as systemically important nonbank financial institutions subject to enhanced supervision by the Federal Reserve, most likely including some form of higher capital requirements.

Dodd-Frank also stripped away crucial tools for dealing with contagious runs on financial institutions, like emergency Federal Reserve lending (the central now needs Treasury approval), and public insurance and guarantees (which was increased and extended to the nonbank sector during the crisis, for a risk-based fee). These tools—coupled with central clearing and new policies designed to decrease banks’ reliance on short-term funding—would create an environment where banks and nonbanks, be they large or small, could with very limited exceptions be permitted to fail. Not only would there be no need for SIFI designation, there would also be no need to break up or limit the activities of large banks.  Neither would there be a need for onerous capital and liquidity requirements.

The only legitimate remaining concern would be TCTF—too-crucial-to-fail, where a financial institution played a critical role in the financial system, such as through clearing or valuation, and such function could neither continue in bankruptcy nor be quickly transferred to another institution.  The “living wills” requirement of Dodd-Frank can address this problem.

Even if the FSOC were to focus on the threat of connectedness, it is hard to see how any threat can come from firms that are not, in fact, exposed to the failure of other financial institutions. Take a traditional insurance company that has no significant derivatives exposure, as opposed to the AIG holding company, which did in 2008. A traditional insurance company does not have significant exposure to any particular counterparty, since its credit exposure is to a wide range of policyholders making premium payments.  Furthermore, a traditional insurance company is not exposed to contagion because its funding is not short-term.  There cannot be a run on traditional insurance companies. In short, they pose no systemic risk.

Not only is SIFI designation unnecessary to prevent systemic risk, its use may on the contrary prove harmful. First, the designation of nonbank SIFIs has the real potential to create a funding advantage for the designees, since the market may assume that the government regards SIFIs as too big to fail.

Such expectations also create a moral hazard problem.  Of course, mere designation as a SIFI does not guarantee public rescue, or even that such an institution would be resolved through the new Orderly Liquidation Authority created by Dodd-Frank, under which Treasury funds are made available to render make a resolution smoother than might otherwise be the case.  Nevertheless, the market may well regard SIFI designation as reducing creditor exposure, thus creating a significant funding advantage.

Indeed, studies of U.S. banks with assets over $100 billion have found that these banks have an annual funding advantage of 60 to 80 basis points over smaller U.S. banks, which amounts to an implicit government subsidy of $35 billion to $60 billion annually.

On the other hand, the consequence of SIFI designation will be enhanced supervision by the Federal Reserve, most likely with higher capital requirements. This will place SIFIs at a competitive disadvantage vis-à-vis non-SIFIs facing lower capital requirements.

Whether it results in SIFI funding advantages or SIFI regulatory disadvantages, SIFI designation could distort competition.

Let me be clear. Financial institutions need to be regulated and supervised for the risks they pose, and much more comprehensively and effectively than in the past. The 2008 crisis demonstrated the exposure of our financial system to contagious runs on the system, and we need to do a lot more to make sure contagion does not recur. But the answer is not SIFI regulation, which is unnecessary, costly to the economy, and will create competitive distortions.

(Hal S. Scott is a professor of international financial systems at Harvard Law School and the director of the Committee on Capital Markets Regulation. The opinions expressed are his own.)

To contact the writer of this article: Hal S. Scott at hscott@law.harvard.edu

A Financial-Reform Agenda for Obama’s Second Term

Posted by jgrygiel on January 13, 2013   |   Comments Off

Bloomberg View
By Hal S. Scott

Despite the exhausting pace of financial regulatory reform in President Barack Obama’s first term, further changes are needed to improve the stability of the financial system and to make the U.S. capital markets more efficient and competitive internationally.

First, we must return to our regulators the tools — taken away by the 2010 Dodd-Frank Act — that enabled the U.S. to survive the most pernicious aspect of the 2008 crisis: the contagion following the collapse of Lehman Brothers Holdings Inc. Had Dodd-Frank been enacted in 2008, the financial meltdown would have been even more devastating.

The Federal Reserve can no longer provide liquidity to nonbanks without the consent of the Treasury secretary. The Treasury can no longer guarantee money-market-fund investors against runs, and the Federal Deposit Insurance Corp. can no longer insure senior debt or increase insurance on deposit accounts without congressional approval.

These backstops are politically unpopular, and should only be deployed in extreme circumstances, but they should be available if needed.

We need to further safeguard the financial system from contagion by limiting the dependence of banks on short-term funding. We should also extend insurance coverage, with appropriate fees, for the short-term funding that remains within banks and in shadow banks, such as prime money-market funds. The cost of the insurance should be risk-based and paid by the insured institutions, just like deposit insurance.

At the same time, we should revise our approach to the too- big-to-fail problem, starting with a re-examination of whether the failure of a large bank poses a real systemic problem. The Lehman meltdown did not set off a chain reaction of bankruptcies caused by financial firms’ direct exposure to one another. True, the Reserve Primary Fund lost two basis points (0.02 percent) of value due to its investment in Lehman paper. Yet the run on money-market funds generally, and the credit crunch more broadly, resulted from the fear that short-term creditors of all financial institutions, with or without significant Lehman exposure, were at risk.

Derivative Counterparties

There is also substantial evidence that the failure of American International Group Inc. would not have bankrupted its derivative counterparties that were hedged or had collateral. And central clearing requirements for derivatives have further reduced this concern.

What we do need to worry about is the possibility that a particular financial institution’s failure could put at risk the performance of a crucial financial-system function, like the payment system or clearing. This can be addressed through Dodd- Frank’s living-will requirement, which permits regulators to promptly transfer crucial functions of insolvent institutions to solvent ones.

Seen through this lens, we can let large banks fail and stop imposing such high costs on their current operations. The Basel Committee on Banking Supervision has implemented two potentially high-cost policies premised on the idea that we cannot let large banks fail.

First, required equity capital for large banks has been effectively increased to 9.5 percent from 2 percent. If we are prepared to let large banks fail, such high costs are unnecessary. And they are certainly an imperfect antidote to contagion where even higher levels of capital would be quickly depleted through fire sales of assets, compounding the contagion.

In addition, new untested Basel liquidity requirements would force banks to hold enough high-quality liquid assets (which may not even be available) to withstand withdrawals of as much as 3 percent of insured deposits over 30 days, even though runs may last much longer. While the initial proposals have recently been relaxed in terms of the time frame for implementation and what qualifies as a high-quality liquid asset, these requirements are still very costly. Traditional central-bank last-resort lending to solvent institutions is cheaper than requiring banks to add to liquid assets. More important, it is the only effective way to deal with runs.

What’s more, we must restore the competitiveness of the U.S. capital markets, a priority for some U.S. officials before the crisis. From 1996 to 2006, the U.S. share of global initial public offerings by foreign companies was almost 29 percent and the percentage of U.S. companies choosing to go public overseas was a mere 1.3 percent. In 2011, these figures were 8.6 percent and 6.9 percent, respectively. The source of competition, as with all matters economic, is increasingly China.

The Jumpstart Our Business Startups Act of 2012, passed with bipartisan support, addressed U.S. competitiveness by lowering the cost of going public for small companies, the engines of economic growth. These reforms could be extended by making it more profitable for securities firms to make markets in these stocks, for example by relaxing the requirement that they be traded in penny increments, which would improve their liquidity and increase their attractiveness to investors. At the same time, we need to better understand the impact of high- frequency and off-exchange trading in all stocks.

Cost-Benefit

Finally, we need to ensure that all financial regulation is justified by cost-benefit analysis. While Obama has called on the independent agencies to do cost-benefit analysis, it has generally not been forthcoming, although recently the Securities and Exchange Commission has done a better job. The Committee on Capital Markets Regulation, the independent and nonpartisan research group that I direct, found that many of the rules issued under Dodd-Frank include no cost-benefit analysis. Very few considered meaningful economic effects, as opposed to paperwork costs and the like.

This failure exposes the rules to invalidation by courts, creating further uncertainty that negatively affects the economy. The president should require independent agencies to conduct cost-benefit analysis with the option of submitting their rules for review to the Office of Information and Regulatory Affairs within the U.S. Office of Management and Budget. This step, after all, is mandatory for government departments.

(Hal S. Scott is a professor of international financial systems at Harvard Law School and the director of the Committee on Capital Markets Regulation. The opinions expressed are his own.)

To contact the writer of this article: Hal S. Scott at hscott@law.harvard.edu

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Goldman Sachs did not violate the Volcker Rule (and $1 billion is a drop in the bucket anyway)

Posted by jgrygiel on January 11, 2013   |   Comments Off

Quartz
By Hal S. Scott

Here’s the secret about that secret Goldman Sachs team that made headlines this week: It’s not really doing anything wrong.

Bloomberg News reported that the investment bank is sidestepping the so-called Volcker rule by having a group within the firm, with $1 billion of assets under management, make risky “hedge fund” type investments.

Take this story with a large grain of salt. The Volcker Rule, enacted by Congress, prohibits proprietary trading but also permits market-making and long-term investment. Market-making is important to the economy because it supplies liquidity for investments.  Without liquidity issuers of debt and equity would have to pay more for their funds because investors with less liquid investments would face more risk.  Banks are also allowed to invest their excess funds in longer-term investments.  As for any investor, it is prudent to diversify a portfolio with investments of different types, with some investments more risky than others.

The problem comes in deciding what is proprietary trading rather than market-making or investing.  When it comes to market-making, regulators want to make sure the positions are temporary, that inventory is being accumulated to dispose of in relatively short order.  On the other hand, when it comes to investment, the same regulators want to make sure the position is for the longer term, not a position that is designed to profit by short-term price movements.  Of course, in both these permitted cases, the firm has its capital at risk, as it does in the case of proprietary trading.  So if you can only have relatively short positions for market making and relatively long positions for investment, the real impact of the Volcker rule is to prohibit intermediate investment, a very questionable policy.  And even some intermediate risk might be permitted if the financial institution can rebut the presumption, based on all the facts and circumstances, that its position was taken essentially to make a short-term profit.  And intermediate risk would also be allowed if incurred in connection with a third proprietary trading exemption for hedging, the issue in the JP Morgan whale case.

But there is no Volcker Rule at the moment. Its implementation through regulation is in proposal stage and the proposal is being thoroughly revised in response to a raft of commentary—so there is nothing Goldman violated.  Secondly, the proposed rule allows long-term investments, those over 60 days, risky or not, because such longer term investments are not regarded as being in a “trading account.” Third, $1 billion sounds like a lot of money but it is a drop in the bucket of Goldman’s $950 billion in assets at the end of third quarter 2012.  Goldman has stated that the investments in question were long-term, so Goldman was just complying with the proposed rule, and really not risking that much of its money.

Much more troublesome than the story, however, is the rule itself. Once in effect, its only net impact might be to ban positions of intermediate term in some but not all cases.

Hal S. Scott is Harvard Law School’s director of the Program on International Financial Systems (PIFS) and director of the Committee on Capital Markets Regulation (CCMR). He is an independent director of Lazard Ltd. and a past governor of the American Stock Exchange.

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The Global (Not Euro-Zone) Crisis

Posted by jgrygiel on August 15, 2012   |   Comments Off

Published in the New York Times Global Edition
By Hal S. Scott

Europe’s failure twice plunged the world into war. In today’s globalized economic world, Europe’s failure to resolve its financial crisis could plunge the world into economic chaos. This is a global crisis — not a euro-zone crisis — and we must take international action to deal with it.

One fundamental parallel with the two world wars is the tension between Germany and other European states. While successfully integrated into Europe, Germany remains the Continent’s most powerful economic force, with higher productivity and economic growth rates and lower inflation than the other major European countries, including France, Italy, Spain and Britain. In the periods leading up to the world wars, Germany’s neighbors rightly feared and deeply resented German military power. Today, they fear German economic power even while they plead with Germany to come to their aid.

Germany can only go so far in bailing out Europe. The cost of recapitalizing European banks (despite overly optimistic stress tests), including those in Germany, is estimated to be €420 billion under an adverse scenario, just for non-performing loans. The cost of marking down — let alone writing off — sovereign debt would be much greater. As of last November, 20 of the largest banks in the European Union carried $4.2 trillion in PIIGS (Portugal, Ireland, Italy, Greece, Spain) sovereign debt, about seven times the amount of their $620 billion in equity.

The amount of potential budget support for countries with unsustainable debt is also substantial, up to €1.4 trillion for 2012 and 2013, excluding any support for Greece. This does not count losses of the European Central Bank from its operations to bring down the yield on new sovereign debt issuance.

Bailing out Europe is beyond the practical capacity of Germany, whose G.D.P. is approximately €2.6 trillion, a level that is far from assured as Europe crumbles around it.

Just as importantly, Germany faces severe political constraints on rescuing Europe. The German government is fortunate that the pro-European Social Democrat opposition party has not attacked its economic support for Europe. But Chancellor Angela Merkel faces deep divisions within her own party, fueled by the constant negative drumbeat of the Bundesbank. If Germany does too much for Europe it could sink Merkel. If Germany does too little for Europe, it could cause deep resentment from those it refused to help.

Too big a reparation burden on Germany after World War I contributed to the rise of the Nazis; in contrast, after World War II, we used the international approach of the Marshall Plan to rebuild Europe. Instead of placing another impossible burden on Germany, we must again take international action.

Various solutions to Europe’s problems that do not depend entirely on Germany are being considered in Europe while the rest of the world gives counsel from the sidelines, but these proposed solutions are insufficient and uncertain. Debt can be restructured, as with Greece, but this makes future borrowing more expensive, negatively impacts bank capital and risks contagion. Moreover, this does not address the root cause of the crisis — uncompetitive economies and overspending. Banks can raise some additional capital, but not nearly enough. Austerity measures are politically difficult to sustain and, for those who believe in stimulus, counter-productive for economic growth.

The European Central Bank can finance countries unable to borrow at affordable rates but this raises the specter of inflation and increases the debt burden of the sovereigns they are financing.

The option of using exchange-rate adjustment, by abandoning the euro straightjacket of immutable fixed exchange rates, is beset by operational problems. The effective re-denomination of debt and temporary capital controls would require international approval.

More fundamentally, it is feared that even a partial euro-zone breakup could be the start of the end of the European Union, a major step backward from decades of integration.

What is needed is an international approach, led by the United States, China and Japan, channeled through the International Monetary Fund, and perhaps considered at an international conference — Bretton Woods II.

Such a conference would examine the need for revision of current international exchange-rate arrangements, focused on but not limited to the euro. It might require that all monetary unions with incomplete fiscal consolidation have a mechanism to adjust individual members’ exchange rates, like the Exchange Rate Mechanism, not the euro. It could discuss how to restrain the growth of unsustainable debt, perhaps increasing creditor rights and imposing limits on international market access and support from central banks. It could also address measures to stimulate the global economy.

Nothing can be done by the United States and China until the transition to newly chosen governments is complete, and time is needed for participants to formulate international solutions. Nonetheless, there should be a call today for a conference in 2013, with the reasonable hope that the European Central Bank can provide necessary liquidity in the interim.

Hal S. Scott is professor of international financial systems at Harvard Law School and the director of the Committee on Capital Markets Regulation.

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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.

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Little to celebrate on Dodd-Frank’s birthday

Posted by jgrygiel on July 19, 2011   |   Comments Off

Financial Times
By Hal S. Scott

America’s Dodd-Frank act is one year old on Thursday. The act made some useful corrections in the regulation of American financial markets, but it has failed to respond effectively to the root causes of the financial crisis and its impact on the global financial system. In the short term, it has hindered economic recovery. Worse, in the longer term, it has actually made future crises more likely, while potentially damaging the international competitiveness of America’s financial institutions.

The crisis resulted from a housing bubble fuelled by loose monetary policy and excessive risky lending by over leveraged banks, encouraged by pro-housing financial regulation. Yet Dodd-Frank did not rectify the low underwriting standards of Fannie Mae and Freddie Mac, and failed to reverse the low levels of capital that Basel has required banks to hold for mortgages. Its creation of a Financial Stability Oversight Council to monitor systemic risk—a ten-headed hydra of largely independent agencies—will not be effective.

As the crisis developed, plunging housing prices created a contagious liquidity problem, only headed off by heroic policies of the Federal Reserve, the Federal Deposit Insurance Corporation and the US Treasury. Yet Dodd-Frank has now crippled the ability of these same agencies to respond in the same way to future crises. The Fed can no longer lend to individual companies, as it did to AIG. More importantly it can no longer establish emergency liquidity facilities without the written agreement of the secretary of the Treasury, who may in the future be a hostage to America’s new “anti-bail-out” consensus.

The FDIC, meanwhile, can no longer guarantee deposits above a new $250,000 limit after the end of 2012, or guarantee senior debt, without a joint resolution of Congress. Due to earlier legislation relating to the financial crisis, the Treasury also can no longer use its economic stabilisation fund to guarantee money market funds. As a result, at a whiff of a new crisis, liquidity will dry up in a flash.

Dodd-Frank did at least insist that systemically important financial institutions hold more capital, while banks hold at least as much capital as required under the original Basel I requirements. Yet the most important reforms on increased capital were left to the Basel Committee, whose record is weak. While Basel III has required more capital, there remains the more difficult (if not impossible job) of setting accurate risk weights against which to measure this capital.

One of the great myths of Dodd-Frank is that the new orderly liquidation authority of the FDIC to resolve non-banks will avert future crises. But if important financial institutions are taken over by the FDIC, it is already too late—runs will already be in progress; at best losses can be minimised in resolution. Worse, Dodd-Frank takes away from FDIC its previous power to keep troubled banks alive through open-bank assistance and makes it difficult to preference short-term creditors in any resolution, powers that may be needed to curb runs.

Dodd-Frank does make some needed corrections in regulation by requiring central clearing of over-the-counter derivatives, more disclosure to investors in securitised loans, more transparency about rating agency methodology and more emphasis on consumer protection. Yet the introduction of these so-called Volcker rules were in truth uncalled for. The crisis had nothing to do with proprietary trading or investment in private funds. Prohibiting these activities deprives US banks of diversification opportunities, and makes them uncompetitive with foreign banks.

This massive revamp of American regulation creates uncertainty for now, and, with Basel III, significant costs in the future, with uncertain benefit. The political debate that produced it was shaped by the popular desire to avoid bail-outs of irresponsible financial institutions. The record shows, however, that these bail-outs worked, and were profitable for taxpayers. Any future shortfalls could be met by taxes on financial institutions or, in the case of deposit insurance, by an increase in premiums. Taxpayers need not be put at risk. In the future bubble-induced crises will, unfortunately, continue. Yet, following the new rules introduced a year ago, containing them will sadly now be more difficult than ever.

The writer is professor of international financial systems at Harvard Law School and director of the committee on capital markets regulation

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U.S. Capital Markets Need an Overhaul

Posted by jgrygiel on April 20, 2011   |   Comments Off

Private offerings are overregulated, and the U.S. share of foreign IPOs is way down.

Wall Street Journal
By Hal S. Scott

Securities and Exchange Commission Chair Mary Schapiro recently informed the House Committee on Oversight and Government Reform that the SEC is reviewing ideas to reduce the regulatory burdens on small-business capital formation. This should translate into a review of how we regulate offerings in private and public markets. Both need major fixes.

Private offerings, such as those to qualified investors or to large institutions under Rule 144A, do not trigger the mandatory disclosure rules applicable to public offerings. Nor are privately held corporations subject to burdensome public market regulation like Section 404 of the Sarbanes-Oxley Act (requiring internal control audits), which in 2009 cost the average publicly held company more than $2 million in direct costs alone, according to the SEC’s own survey.

These advantages help explain why many U.S. companies prefer to remain private, and why in 2010 79.3% of the funds raised in the U.S. by foreign companies in global initial public offerings were raised through the private Rule 144A market.

But there are serious limitations on the use of private markets that need reforming. First, companies can remain private only if they have fewer than 500 shareholders. Shareholder limits impair the liquidity of private-company shares and in turn depress their price.

While transactions in private company shares grew to $4.6 billion last year, this is a drop in the bucket compared to the $1.1 trillion of New York Stock Exchange Group trading volume in NYSE-listed stocks in March 2011 alone. The 500-shareholder limit could be increased significantly, or even eliminated, without endangering investor protection because only qualified investors or large institutions can own these shares.

Short of this, the SEC could make clear that a fund composed of multiple investors counts as one holder of record. The SEC should also allow companies not to count their employees’ holdings to avoid discouraging employers from giving their employees stock.

Second, the SEC’s rules on private offerings do not permit general solicitation of investors. This prohibits widespread direct mail or ads in general media. This limitation has long been criticized by securities professionals, most recently in 2006 by the SEC’s own Advisory Committee. As long as there are limits on who can actually buy shares, what is the harm in broad marketing?

In her letter to Congress, Ms. Schapiro says such limitations have been supported “on the grounds that it helps prevent securities fraud by, for example, making it more difficult for fraudsters to attract investors or unscrupulous issuers to condition the market.” The logic is hard to fathom since fraudsters by their very nature will not observe SEC marketing limitations.

This general solicitation prohibition was at issue in Goldman’s Facebook offering last year. Reportedly, Goldman was concerned that the general media attention that resulted from unauthorized disclosure of its marketing to highly qualified investor clients would risk violation of the general-solicitation ban. As a result, Goldman withdrew the offer in the U.S. and instead made it abroad.

While Ms. Schapiro carefully stated in her letter to Congress that at no time did the SEC staff “advise or instruct” Facebook or Goldman that the U.S. offering was improper, she did not deny that the SEC was intensively investigating the matter. At the very least, the SEC should clarify that general media attention, as contrasted with general media marketing, does not violate its solicitation rules.

In her review of ideas to facilitate capital formation by small companies, Ms. Schapiro should not just focus on the private market. Even with relaxation of the number of shareholders and the ban on solicitation, this market will still be dwarfed by the public markets. While the direct-ownership share of U.S. equities by individual investors has greatly diminished (in 2009 it was about 38% compared to about 92% in 1950), it is still important.

Our public markets are increasingly unattractive to foreign issuers, those who have a real choice as to whether to use our markets—unlike large U.S. public companies that are generally trapped here. The U.S. share of global IPOs by foreign companies was 14.2% in 2010, compared to 28.7% from 1996-2006. When the SEC relaxed its requirements for deregistration in 2007, 13.7% of SEC-reporting foreign companies headed for the exits, and they continue to do so.

The SEC review should also focus on how our unique securities class-action litigation system is contributing to this undesirable trend. In 2010, company payouts funded by shareholders amounted to more than $3 billion, and in previous years it’s been as high as $17 billion. That’s no way to attract foreign companies to U.S. markets.

Mr. Scott is professor of international financial systems at Harvard Law School and the director of the Committee on Capital Markets Regulation.

Reprinted from The Wall Street Journal © 2011 Dow Jones & Company. All rights reserved.

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Geithner’s Hollow ‘Speed’ Pledge to Business

Posted by jgrygiel on August 5, 2010   |   Comments Off

To reduce uncertainty, the Treasury secretary says Dodd-Frank regulations will be implemented quickly. That can’t and won’t happen.

Wall Street Journal
By Glenn Hubbard and Hal Scott

Businesses must know the rules of the game before risking their capital. And so, in his speech at New York University’s Stern School of Business on Aug. 2, Treasury Secretary Tim Geithner assured his audience that the massive regulatory reforms of the new Dodd-Frank legislation would be implemented quickly to remove the drag of uncertainty on the economy.” First we have an obligation of speed,” he said, and asked to be held accountable if his pledge was not honored.

We might as well hold him accountable now, because his promise is impossible to fulfill. His plea to business—”Don’t wait for Washington to draft every rule before you start changing how you do business”—will and should fall on deaf ears. There are four main reasons Mr. Geithner’s pledge is hollow.

First, Dodd-Frank failed to consolidate and rationalize the regulatory structure. Indeed, the new law makes matters worse by creating new regulators, an unwieldy Financial Stability Oversight Council (10 members who act on a two-thirds vote), the Consumer Financial Protection Bureau, and the Office of National Insurance. But an increasingly balkanized regulatory structure means separate timetables and priorities and jurisdictional clashes among the separate agencies—more uncertainty.

Second, Mr. Geithner’s pledge ignores the basic legal requirement for deliberative and rational regulatory implementation. He argued that the “frustrating, glacial pace” of rule writing must change, all the while promising that the regulatory agencies will consult broadly and draft rules that will be published and available for comment.

The Administrative Procedure Act requires notice and comment on new rules, and, importantly, that these rules have a rational basis. The courts have interpreted this requirement to include a cost-benefit test. For example, in Chamber of Commerce v. SEC, the D.C. Circuit Court of Appeals twice struck down, in 2005 and 2006, an SEC rule requiring mutual funds to have boards comprised of at least 75% independent directors and an independent chairman. The court ruled that the agency failed to adequately analyze its costs and benefits. Dodd-Frank specifically calls for an economic cost determination for any recommendations to regulators made by the Financial Stability Oversight Council. So the reality is formulating new rules will take a long time.

Third, uncertainty springs from the new law itself, through the creation of the Consumer Financial Protection Bureau, an agency with a budget of roughly $500 million per year that has yet to be created. This agency has broad jurisdiction over the entire financial system—it could ban products or cap fees. Michael Barr, the Treasury department’s assistant secretary for financial institutions and a leading candidate to head the new agency, has advocated having only “plain vanilla” products without specifiying what these might be; further uncertainty.

Mr. Geithner opined that when the new Financial Stability Oversight Council first meets in September (a month from now) it “will establish an integrated road map for the first stages of reform.” This road map will not, however, include the plans of the consumer bureau.

Fourth, Mr. Geithner’s “obligation of speed” ignores the international process for setting capital requirements for financial institutions. These requirements have a major impact on the activities in which financial institutions engage. They operate like a tax, and if they reduce the profitability of a financial product or service, then institutions will gravitate to other businesses.

Without knowing what such “taxes” will be, businesses are naturally reluctant to invest. But capital requirements are not set by the Treasury; they are instead effectively set by the Basel Committee on Banking Supervision, a group of regulators from 27 countries. While the United States participates in the group, it does not control its actions.

Over the past 22 years, this group has promulgated two generations of capital requirements, Basel I and II, which performed badly during the crisis. Indeed, U.S. banking regulators have yet to implement Basel II, the delay springing from concern about its design and impact. The committee is now at work on Basel III capital requirements, together with new liquidity rules. Formulation of these rules is still in progress and their implementation is years away. Many financial specialists question whether the process will deliver an efficient and effective set of rules and requirements.

Despite the Geithner pledge to “move as quickly as possible to bring clarity to the new rules of finance,” the implementation of Dodd-Frank will take considerable time and leave a pall of uncertainty hanging over business decisions. The vagueness of the statute, necessitating gap-filling regulation, is the result of the desire in Congress to enact massive reforms quickly and its need to put together a fragile majority to do so. It would have been easier if the administration had advocated, and the Congress had designed, a more efficient regulatory structure to implement its reforms. Having narrowed the options to the slow lane, Mr. Geithner now urges the fast lane.

Mr. Hubbard, dean and professor of finance and economics at Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. He is co-chair of the Committee on Capital Markets Regulation. Mr. Scott, a professor of international finance at Harvard Law School, is director of the committee.

Reprinted from The Wall Street Journal © 2010 Dow Jones & Company. All rights reserved.

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Do We Really Need a Systemic Regulator?

Posted by jgrygiel on December 11, 2009   |   Comments Off

Based on what we now know about AIG, it’s unclear ‘too big to fail’ institutions are in fact too big to fail.

Wall Street Journal
By Hal S. Scott

The principal assumption underlying the financial regulatory reform legislation working its way through Congress is that certain financial institutions are “too big to fail” because of the severe consequences of “interconnectedness”—a word that entered our lexicon during the financial crisis.

The problem is presented as follows: There are major financial institutions that are systemically important because their failure can, due to interconnectedness, bring down other large financial institutions. A chain reaction of such failures is unacceptable since it would disrupt our economic system. The chain reaction must be stopped after the fact by the use of taxpayer-funded bailouts that avoid the kinds of losses for investors or counterparties that would normally occur in bankruptcy. Finally, taxpayers need to be protected by new regulations designed to protect against the failure of these major institutions.

But how severe is the threat from interconnectedness? Last month’s report by the Special Inspector General for the Troubled Asset Relief Program (Sigtarp) on AIG is illuminating. While the report’s focus is on whether Goldman Sachs unduly profited from the Fed’s rescue of AIG, more significant is its discussion of why AIG even received an $85 billion rescue. It does not appear to be because counterparties would have failed as a result. According to the report, Goldman had adequate collateral to protect itself against an AIG default. Indeed, the collateral was cash whose value would not have been decreased by a “rush to the exits.” There is no reason to assume other counterparties did not follow similar collateral practices.

Viewed in this light, FDIC Chair Sheila Bair’s proposal to increase the losses secured counterparties must bear in case of a financial institution’s failure seems misguided. Counterparties whose exposure to credit losses is fully backed by collateral are after all “secured.” Treating them as if they were unsecured—forcing them to take a “haircut”—in the case of a financial institution’s failure would only increase the risks of chain reactions.

An amendment to the House bill (“The Wall Street Reform and Consumer Protection Act”) very likely to be adopted today fortunately exempts most derivative contracts from haircuts. But it fails to exempt all short-term repurchase agreements (“repos”). Short-term repos are normally fully secured; if lenders know they will have to take a haircut they will be less likely to extend credit to financial institutions most in need.

Sigtarp further reports that the Fed and the U.S. Treasury were actually more concerned with $88 billion of AIG investor and debt-holder losses: $10 billion on loans by state and local governments; $40 billion for workers in 401(k) plans; and $38 billion for retirement plans. Certainly, these losses would be “connected” to an AIG default. But they did not involve the threat of a chain reaction of financial institution failures. The auto company bailouts also had little to do with the fear of devastation to the financial system.

If large losses by institutional investors and other stakeholders are the real reason why we are concerned with interconnectedness and “systemic risk,” then we would have to regulate all large global corporations, not just financial ones, whose failures could trigger similar losses—an impossible task.

The Sigtarp report does mention concern with losses to money market funds, principal holders of $20 billion in AIG commercial paper. It is certainly possible that an AIG default right on top of the Lehman bankruptcy could have led to more money-market funds falling below $1 per share and have intensified the irrational run on funds generally. The answer to the run problem was not to rescue AIG but rather for the government to use, as it did, its lender of last resort powers to stem the runs.

Clearly we need to know far more about the facts of interconnectedness. As a starting point, Congress should require Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner to give the American people a complete account, with supporting documentation, of why the Fed and Treasury thought it was important to rescue AIG. This account should include a detailed analysis of counterparty exposure to the extent this is claimed to have played a significant role in their decision.

If it turns out that there are no severe consequences to the financial system from interconnectedness, then do we really need to control the risk of large financial institutions by imposing heightened capital or new liquidity requirements? Indeed, why would we need a systemic-risk regulator at all? Congress, as part of its reform legislation, should mandate the creation of a new expert commission designed to fully investigate the extent and consequences of interconnectedness before any new regulation of systemically important institutions is actually adopted.

Without real adverse consequences from interconnectedness, the too-big-to-fail problem becomes much more manageable. Public money might still have to be injected into a failed institution to avoid a sudden economic disruption, but this would only be after losses were fully imposed on the private sector without fear of a chain reaction. Thus, we could avoid the untenable situation of private gains and public losses that we have persuaded ourselves we are faced with today.

Mr. Scott is professor of international financial systems at Harvard Law School and the director of the Committee on Capital Markets Regulation.

Reprinted from The Wall Street Journal © 2009 Dow Jones & Company. All rights reserved.

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Markets Are the Best Judge of Bank Capital

Posted by jgrygiel on September 23, 2009   |   Comments Off

Financial Times
By Andrew Kuritzkes and Hal Scott

Leaders of the Group of 20 summit begin their summit in Pittsburgh on Thursday determined to increase the resilience of a financial sector that was brought to its knees last autumn. To this end, the G20 finance ministers, together with the Basel Committee on Banking Supervision, the international body that sets bank capital rules, have called for banks’ mandated minimum capital ratios to be raised and for large banks to hold even more capital. This is an understandable reaction to the financial crisis. But do regulators really know how much capital the banking system needs?

The current regulatory capital framework, established by the Basel Committee, provides no empirically justified answer. The Basel framework’s core regulatory capital requirement – that banks hold a minimum of 8 per cent Tier I plus Tier II capital relative to risk-weighted assets – has been in place for more than 20 years. While the recent 10-year effort to update the Basel accord refined the complex risk weights that are at the core of the regulatory framework, the Basel Committee intentionally “calibrated” the system to ensure the total amount of required capital would not be increased. The regulators thus failed to address the fundamental question of whether this historical amount of capital was sufficient to protect individual banks or the system as a whole.

Not surprisingly, given the lack of a solid foundation, regulatory capital requirements have not acted as a binding constraint on the amount of capital banks actually hold. In 2007, before the crisis, the regulatory capital ratio for the top 20 US banks (accounting for almost two-thirds of US banking assets) averaged 11.7 per cent. This was nearly 50 per cent above the minimum regulatory requirement of 8 per cent, and 17 per cent above the “well capitalised” standard of 10 per cent.

Large institutions that became distressed during the crisis maintained even greater capital buffers relative to regulatory minimums. The five largest US financial institutions subject to Basel capital rules that either failed or were forced into government-assisted mergers in 2008 – Bear Stearns, Washington Mutual, Lehman Brothers, Wachovia and Merrill Lynch – had regulatory capital ratios ranging from 12.3 per cent to 16.1 per cent as of their last quarterly disclosures before they were effectively shut down. The capital levels of these five banks were between 50 per cent and 100 per cent above the minimums and 23 per cent to 61 per cent higher than the well-capitalised standard. The strong implication is that capital levels for most banks – and especially for large institutions that raise systemic risk concerns – are set by market expectations, not regulatory rules.

Raising regulatory capital requirements to a level where they could become a genuine constraint leads to trade-offs. For a given level of risk, higher capital requirements would mandate a larger capital “cushion” to absorb losses and so provide greater protection against bank failure. However, to the extent that capital requirements are imperfectly linked to bank risk-taking, higher capital requirements could lead banks to seek a greater return on the additional capital. The higher requirements would also tend to drive financing out of the banking sector into less regulated sectors such as insurance or hedge funds. Indeed, we already have seen a great deal of both these phenomena during the financial crisis.

Given the evidence that market expectations play a more important role than regulatory minimums in setting bank capital levels, we should find ways to strengthen market discipline. Arguably, one of the most effective policy responses during the crisis was the Federal Reserve’s stress-testing of the 19 largest US banks – a clear departure from the Basel framework. The Fed’s release of stress test results, an unprecedented disclosure of a regulatory examination, steadied the market. It helped to stem the free-fall in bank share prices and paved the way for banks to raise about $87bn of capital in the market.

Indeed, a key lesson from the credit crisis is that, regardless of the level at which the minimum is set, regulatory capital, by itself, is not sufficient to prevent large banks from failing. We need to complement regulation with more effective market discipline. This requires better information, which could perhaps be provided by regular stress tests. It also demands a more credible resolution regime to ensure that equity and debt investors in all banks, even those considered systemically important, will suffer adverse consequences from bank failures.

Andrew Kuritzkes is a partner of Oliver Wyman, the management consulting firm. Hal Scott is professor of international financial systems at Harvard Law School. Mr Kuritzkes is a senior adviser to and Mr Scott is the director of the Committee on Capital Markets Regulation

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