BPInsights: July 27, 2018

BPInsights: July 27, 2018

BPInsights

Top of the Agenda

What Kevin Costner Can Teach Us About Bank Profits and Regulation

Suppose someone said to you, “Kevin Costner is such a great actor, he should be Secretary of Defense.” How would you respond? Would you fight the premise – what about Waterworld, Robin Hood, The Bodyguard, The Postman, etc.? Or would you move straight to the illogic – why would a great actor be qualified to run the Pentagon? We have faced a similar conundrum with the argument, “Banks are highly profitable, so any review of banking regulation is inappropriate.” Should we challenge the (false) notion that banks are highly profitable, or note that it is quite possible for a profitable industry to be badly regulated (or for an unprofitable industry to be well regulated)? We have spent some time on both, in our most recent analysis as well as in a previous blog. But today is a Waterworld, premise-fighting day. We think it’s important to understand the state of bank profits, and how they relate to regulation and bank safety and soundness.

Of Note

CFTC Defends Derivatives from Vatican’s Moral Reproach

We highlight with admiration a letter from CFTC Chairman Giancarlo and Chief Economist Tuckman to the Vatican. It is one thing to speak truth to power, but to do it with such élan, and even humor, is remarkable. The letter, a response to the Vatican’s May Bollettino decrying the use of derivatives, cites derivatives’ social utility as a means of transferring the risk of variable production costs away from those unable to afford them, and of lowering worldwide costs in agricultural markets. “In many ways,” they write, “the greatest beneficiaries of global derivatives activities may well be the world’s hungriest and most vulnerable.”

AEI’s Pethokoukis Argues that Presidential Criticisms of the Fed Are Problematic

President Trump’s escalating criticisms of the Fed are problematic, James Pethokoukis argues in a July 20 post on AEI’s public policy blog, citing the economic volatility associated with a 1970s executive branch disputes with the Fed. He writes, “If you value economic stability, then you probably don’t want the president using political pressure to influence the U.S. central bank. It can get really ugly.”

Vice Chairman Quarles Sworn in for Second Term as Member of Federal Reserve Board of Governors

Following confirmation last week, Vice Chairman Quarles was sworn in for a full term as governor this week. It is remarkable to note, given his manifest qualifications and two prior confirmations by voice vote, that 33 Senators found a reason to vote against him. Here is a list.

CFTC Nears Full Strength as Dan Berkovitz Coasts Through Nomination Hearing

For the first time in four years, the Commodity Futures Trading Commission moved a step closer to having a full commission with Dan Berkovitz, a partner at WilmerHale and former CFTC general counsel, getting almost no pushback at a Senate confirmation hearing, according to a WSJ article.

Nine Democratic Senators Call on Otting to Rescind CRA Bulletin

Senate Banking Committee Ranking Member Brown and eight other Democratic senators sent Comptroller Otting a letter asking him to rescind the OCC’s recent bulletin on Community Reinvestment Act (CRA) performance evaluations. Otting recently defended the bulletin, which streamlined policies to promote consistency and effectiveness of CRA performance evaluations, in testimony before the House Financial Services Committee. Democrats are fearful that the bulletin marks the beginning of a process to water down compliance with the CRA.

Amazon in Financial Services: Payments, Cards, Loans, and soon Checking and Insurance?

For almost a decade, pundits have predicted Amazon would move into banking. Although Amazon currently has numerous investments in fintechs and also offers payments, credit card, and consumer and small business loan products, it has yet to move formally into the deposit-taking banking space. Will that change? A report from CB Insights notes that the company already has patents for prepaid cards and for a method that can link bank account information. However, the report notes that “Amazon isn’t building a traditional bank that serves everyone. Instead, Amazon has taken the core components of a modern banking experience and tweaked them to suit Amazon customers (both merchants and consumers).”

International Market Turbulence Highlights Dangers of Post-Crisis Liquidity Declines

Recent episodes of severe market stress abroad are making it increasingly difficult to ignore the danger of declining market liquidity. As a July 24 Wall Street Journal article notes: “Liquidity, a measure of the capacity to trade securities without significantly affecting the price, has been a growing concern since the financial crisis. Traders say it has generally weakened across markets including stocks, bonds, and commodities as the large banks that once kept these markets running have pulled back in response to limits on their risk-taking. But recent episodes of extreme market stress in Italy and emerging markets have highlighted just how quickly trading conditions can deteriorate, exacerbating concerns that markets are becoming more vulnerable to a shock as central banks slow the stimulus they have supplied for a decade … For years, central banks helped paper over the decline in market liquidity that occurred when post-crisis regulation made it harder for banks to trade bonds. The current challenge coincides with central banks withdrawing their long-time support for fixed-income markets.”

We think it is fair to say that market participants have been raising these concerns for years, and that the general response of the regulatory community was initially to deny there was an issue, then to say that it was not clear there was an issue, and then to say that they were studying the issue. (At least one large asset manager took a similar tack, perhaps out of concern that it would prompt higher liquidity requirements for funds holding increasingly illiquid securities.) While capital and liquidity regulations are not the sole cause of the problem, we continue to believe that they are a large enough contributor for their effects on market liquidity to be considered (as opposed to ignored) as a cost of these regulations. Presumably, these concerns motivated proposed changes to the Volcker rule and the recent Fed/OCC proposal on the leverage ratio — which punishes market making in low-risk securities — and perhaps the growing evidence of trouble in these markets will prompt a wider review. (Hint: the otherworldly global market shock in CCAR.) That review could include study of whether liquidity moving away from the bond market to the derivatives market, as described in the article, has financial stability consequences. (We will confess to not knowing the answer, though it seems troubling for an underlying instrument to have less liquidity than a market derived from that instrument.) Certainly, everyone is now on notice that the problems here are not hypothetical.

BPI News

Blog

The LCR, Interest Rate Dynamics, and Monetary Policy Implementation

In a BPI blog published Wednesday, BPI Chief Economist Bill Nelson analyzes the potential repercussions of the liquidity coverage ratio (LCR), a key liquidity requirement established as part of post-crisis regulatory reforms. The need for large commercial banks and their holding companies to satisfy the LCR, Nelson argues, creates foreseeable consequences for market interest rates and presents challenges for monetary policy implementation. Actions by banks to comply with the LCR will push short-term interest rates lower and deposit rates and medium-term interest rate higher. As the Fed reduces the size of its securities portfolio, demand by banks for excess reserves to comply with the LCR may push market rates temporarily near or above the interest rate the Fed pays on excess reserves (IOER), with pressures increasing at quarter ends. The Fed could ease these pressures by ceasing to require banks to hold part of their liquidity buffers as excess reserves, by allowing banks to include required reserves in their buffers, or by establishing voluntary required reserves that can be included in the buffers.

BITS

BITS Hosts Cybersecurity Board Governance Roundtable

On Wednesday, BITS hosted a roundtable discussion on improving cybersecurity risk management discussions with the banks’ boards of director. This meeting, which brought together CIOs, CISOs, and operational risk officers, focused on crisis preparedness; the use of threat intelligence information to inform decision making; the integration of cyber and operational resiliency; and how firms are building their board briefings and using metrics. One of the top recommendations from this session was the importance of the having the firm’s cyber, operations, legal, and communications teams work together to plan for a response, develop response playbooks, and test the firm’s execution of the plan on a regular basis. The group also discussed how best practice around when to notify the public of a data breach has shifted over time and how the firms that err on the side of transparency and rapid notification fare better than those who wait to provide notice. The key themes and findings from the discussion will be published in a forthcoming white paper.

BPI Events

BPI & TCH Annual Conference 2018

Registration is now open for the 2018 BPI & TCH Annual Conference, the premier gathering for senior financial services executives, regulators, policymakers, and academics focused on the changing regulatory landscape and the future of payments. Register Today!
November 26-28, 2018, The Pierre, NYC

Industry News

Agency News

DOJ’s Cyber-Digital Taskforce Highlights Virtual Currencies as Illicit Finance Risk and GDPR as Potential Impediment to Law Enforcement Efforts

Recently, the Justice Department released its Report of the Attorney General’s Cyber Digital Task Force, which highlights the illicit finance risks posed by virtual currencies and the potential impediments the EU’s General Data Protection Regulation (GDPR) may pose to law enforcement efforts. On virtual currencies, it states that “criminals often launder their virtual currency by mixing one user’s money with multiple other users,’ or sending their virtual currency through a convoluted series of transactions.” On the GDPR, the report provides several examples of ways in which the regulation could be interpreted to impede law enforcement efforts, notably stating that “[a]bsent official guidance, companies with significant EU business may become reluctant to participate in mandatory data transfers to U.S. law enforcement and regulatory authorities” and that DOJ “must continue to collaborate with European authorities and stakeholders to carefully monitor the GDPR’s impacts.”

UK Government Moves Toward Temporary Permissions and Recognition Regimes for EU-Based Firms

The UK’s Government and Treasury have published drafts of the statutory instruments that, pending Parliamentary approval, would establish temporary recognition- and permissions-regimes for Eureopean Economic Area banks operating in the UK, a Bank of England publication explains. The regimes would serve to “allow firms, including CCPs, who wish to continue carrying out business in the UK in the longer term to operate in the UK for a limited period after withdrawal while they seek authorization or recognition from UK regulators.”

Implementation Monitoring of PFMI: Fifth Level-1 Update

The Committee on Payments and Market Infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO) this week issued a progress report on implementation of Principles for financial market infrastructures (PFMI). PFMI extablishes international standards for payment, clearing and settlement systems, and the report found 21 of the 28 jurisdictions have completed the implementation of measures for all FMI types, compared to 20 when the last report was published last year.

Capitol Hill

McConnell Files Cloture on Clean Four-Month Reauthorization of NFIP

On Thursday, Senate Majority Leader McConnell filed cloture on a clean four-month reauthorization of the National Flood Insurance Program (NFIP), setting up a vote next week. The House has already passed the bill. Without reauthorization legislation, the NFIP would lapse Tuesday, July 31. We support measures to avoid a lapse, as the NFIP helps facilitate flood insurance for properties in high-risk flood zones where lenders often require coverage to make loans.

Next Week in Washington

  • The House is now in recess until after Labor Day and the Senate Banking Committee will not hold scheduled hearings next week.

Seminars, Conferences & Events

DHS National Cybersecurity Summit

Tuesday, July 31 8:00 a.m. – 2:00 p.m.
Alexander Hamilton Custom House
1 Bowling Green
New York, NY 10004

 

Main Street Matters: Small Business Financing

Wednesday, August 1 10:00 a.m. – 11:30 a.m.
Bipartisan Policy Center
1225 I (Eye) St NW, Suite 1000
Washington, DC, 20005

Research Rundown

Bank Underground Blog: What a Difference a Day Makes (Roberts-Sklar)

The authors estimate the distribution of financial market prices, yields, and returns using observations from the May 2018 bond price spike. Ultimately, they refute the usefulness of VaR models in measuring a short period of bond activity.

The Transatlantic Economy Ten Years after the Crisis: Macro-Financial Scenarios and Policy Responses (Bertoldi et al.)

This working paper shows empirically that high accounting profitability prior to a crisis helps explain the cross-sectional variation in banks’ stock returns during the crisis. The impact is stronger if pre-crisis profits are driven predominantly by noninterest income or such profits are paid out in the form of dividends or management compensation.