AT TODAY’S HOUSE FINANCIAL SERVICES SUBCOMMITTEE HEARING, lawmakers discussed new capital requirements under the Dodd-Frank Act with industry stakeholders. The hearing focused on H.R. 3128, sponsored by Rep. Michael Grimm (R-N.Y.), which would amend the Dodd-Frank Act with regard to the retroactive date for provisions under the Collins Amendment.  

Question and Answer 

Rep. James Renacci (R-Ohio) asked the panelists how banks would seek to replace the Tier 1 capital that would be lost by the phase out of Trust Preferred Securities (TRUPS). 

Daniel McCardell, Senior Vice President and Head of Regulatory Affairs for the Clearing House, said the Association’s member banks are working toward full compliance with the Dodd-Frank Act and noted how firms are looking toward new forms of capital, such as common equity, to meet the new requirements. Richard Ward, Chief Regulatory Officer of Emigrant Bank, added that any difficult compliance timeframes for complying with the TRUPS phase out may potentially result in an impairment of lending as his firm seeks to raise capital. 

Rep. Carolyn Maloney (D-N.Y.) asked how a change in the grandfathered status of firms as it relates to the Collins Amendment would affect banks. 

McCardell noted that the core issues with the Collins Amendments is the three year transition schedule and the 10 year transition schedule for the TRUPS phase out under the Basel III framework. He said these requirements must be reconciled. 

Testimony 

In his opening statement, Richard Wald focused his testimony on H.R. 3128. He noted that the Dodd-Frank Act eliminated Tier 1 capital treatment for TRUPS for all institutions with $15 billion or more in assets, however, TRUPS issued by institutions with less than $15 billion in assets (as of December 31, 2009, which was moved retroactively from May 19, 2010 to December 31, 2009) were allowed to continue counting TRUPS as Tier 1 capital. Wald said the cut off date of December 31, 2009 is inconsistent with the other "cut-off" dates in the Collins Amendments and would prevent Emigrant from using TRUPS as Tier 1 Capital, costing his bank $300 million to comply and significantly reducing Emigrant's ability to lend to the community it serves.  

In his opening statement, Daniel McCardell expressed concern that some of the capital-related regulatory reforms could “ultimately work at cross purposes to the goals of protecting the financial system against systemic meltdowns” while enabling the financial system to “play its necessary role in fostering economic and job growth.” He said that the policy concern that gave rise to the Collins Amendment’s Basel I-based minimum capital floor – namely, that the Basel II approach could require too little capital – has been “separately and more appropriately addressed by other regulatory reforms.” McCardell said, if implemented, the Collins Amendment would add “needless” complexity to capital planning and would place U.S. institutions at a competitive disadvantage compared to their international peers. In closing, McCardell urged members to consider the trade-offs between higher capital standards and the risk of reducing economic and job growth. 

For testimony and a webcast of the hearing, please click here.  

AT TODAY’S HOUSE FINANCIAL SERVICES COMMITTEE HEARING, lawmakers discussed the settlement practices of the U.S. financial regulators. Chairman Spencer Bachus (R-Ala.) said neither admit nor deny settlements avoid the costly expense and uncertainty inherent to lengthy trial proceedings. In addition, such a policy allows harmed investors to receive proceeds from a settlement much faster than a long, drawn-out court case. 

Turning to the Securities and Exchange Commission (SEC) v. Citigroup case, which could potentially affect regulators’ use of neither admit nor deny settlements, Bachus said “on balance, the appellate court’s analysis was the correct one. A policy that requires judges to micromanage federal agencies’ enforcement authority and requiring the government to engage in lengthy and expensive trials would not serve the bests interests of taxpayers or investors.”  

Bachus added that it “makes more sense to leave the judgment of whether to try a case or attempt to settle largely to the agency’s discretion rather than shifting that responsibility to federal judges.” 

Rep. Maxine Waters (D-Calif.) said she was concerned with the “frequent use” of the neither admit nor deny settlements. She said “settlements should never be viewed as another cost of doing business… When no wrongdoing is admitted, it encourages repeat offenses.” She also told the panel she understands the SEC is constrained and “outgunned in terms of resources,” adding “I will continue to fight for the SEC to have the resources it needs.” 

Waters also stated her concern with market service and consent orders which the Office of the Comptroller of the Currency (OCC) and the Federal Reserve Board entered into with 14 banks. “I am eagerly anticipating the results of a [Government Accountability Office] study that I requested on this topic,” she said. 

Rep. Carolyn Maloney (D-N.Y.) believed an admission of guilt is more likely to be a deterrent and is sympathetic to Judge Jed Rakoff’s view in the SEC v. Citigroup case. Turning to the SEC’s budget, Maloney said it is “not enough to fund lengthy legal battles” and settlements “offer the only available route for the SEC to take.” 

Rep. Robert Dold (R-Ill.) said “a legal standard that requires wrongdoing admissions from defendants as a condition of settling regulatory proceedings will diminish the number of settlements to something very close to zero.” 

Panel I Testimony 

The witnesses on panel one included Scott Alvarez, General Counsel of the Board of Governors of the Federal Reserve System; Robert Khuzami, Director of the Division of Enforcement at the SEC; Richard Osterman, Deputy General Counsel of the Litigation and Resolutions Branch at the Federal Deposit Insurance Corporation (FDIC); and Daniel Stipano, Deputy Chief Counsel at the OCC. 

In their testimonies, the witnesses described the enforcement tools within their respective agencies and the processes for carrying out various enforcement actions. 

Alvarez said “the vast majority of enforcement actions are resolved upon consent.” In addition, Alvarez said “it has not been our practice to require formal admissions of misconduct” as this “would have deleterious effects on our supervisory efforts” by impeding and delaying corrective action and potentially harming the financial institution and market. Over the last decade, only 11 of the roughly 1,000 enforcement actions were not resolved by consent. 

Khuzami said “the fact is that requiring admissions as a condition of settlement would likely result in longer delays before victims are compensated, dilution of the deterrent impact of sanctions imposed because of the passage of time, and the expenditure of significant SEC resources that could instead be spent stopping the next fraud.” 

Turning to the SEC v. Citigroup case, Khuzami said it is “not clear what an admission would add and whether it would be worth the cost of delay and resources.”  

In cases arising out of the financial crisis, Khuzami said the SEC has filed actions against 102 individuals and entities, naming 55 CEOs, CFOs, and other senior corporate officers, and obtained orders for $2 billion. 

Osterman said the vast majority of FDIC’s cases are solved through settlements without admission of liability. Requiring this policy “may have the unintended consequence of frustrating its goals,” delaying prompt relief and corrective action, he said. 

Stipano said prompt and effective action “is critical.” In the vast majority of cases, Stipano said OCC actions are resolved by consent, adding “permitting the bank of individual to neither admit nor deny wrongdoing allows the OCC to get an enforceable order in place at an early stage of the proceeding, and encourages compliance with the enforcement action and immediate correction of any deficiencies that need to be addressed.”  

Panel I Q&A 

The witnesses on the first panel defended the neither admit nor deny policy and reiterated points made in their respective testimonies that without it, protracted litigation would cause lengthy delays in compensating harmed investors, and would stall corrective actions that would protect the institution and the marketplace.  

In response to questions from Dold, panelists reiterated that a substantial portion of their cases are settled before trial and if a policy was put in place that required institutions and individuals to admit wrongdoing, the number of settlement agreements would fall significantly. Panelists said such a policy would lead to lengthy delays, would require agencies to request more staff to work on additional litigation matters and would lead to decreased settlement payments to harmed investors. 

Rep. Blaine Luetkemeyer (R-Mo.) asked whether the witnesses believed they had enough tools to “go after the bad guys.” All of the panelists said they did. 

Bachus asked Khuzami to detail the factors behind an SEC decision to settle an enforcement action. Khuzami said it comes down to the question of “can we get everything we can reasonably hope to get,” if we had gone to trial. If that standard is not met, only then will the SEC prepare to go to trial, Khuzami said. He added, “we’re fully prepared to litigate and we’re doing more of it.” 

Referring to recent news reports, Garret focused on money market funds and asked Alvarez whether the Federal Reserve, through FSOC, would step in for the SEC, if the SEC fails to act, “and exert its authority over the industry individually, or designate the entire industry as systemically important.” He added that “regulating money market funds would be one way to put money market funds effectively out of business and then have the funds in that segment of the economy flow from them… to the banking institutions, which would be a way for them to backfill some of the banks that are out there, which would be a way to provide for additional capital for them to make them more safe and sound, which is what you’ve been saying, rightly so, is the responsibility of the Fed.” He asked Alvarez if that is the approach the Federal Reserve takes to regulation. 

Alvarez said the FSOC has made it clear that money market funds are an “area that requires attention.” He added that the SEC is moving forward on taking steps to improve the safety soundness, and strength of money market mutual funds. “We all await the SEC’s action on that. That is as far as the Federal Reserve has made any statement or participation at this point,” he said.  

Outside of Dodd-Frank, Garrett also asked Alvarez about the premium capture cash reserve account (PCCRA). Specifically, Garrett said if implemented, it would put capital on the sideline and freeze up the securitization markets, “which are already frozen,” in addition to keeping the federal government on the hook as far as providing financing for the housing marketplace. After referencing two letters authored by Bachus and Garrett, which were sent to the Federal Reserve on this issue, Garrett asked Alvarez whether the Federal Reserve has done a cost-benefit analysis on the issue. 

Alvarez said “we are in the process of doing an analysis” and “we are working on this as best we can.” There is currently no estimate on when the analysis will be completed, but Alvarez expects it to be released before the rule comes out. 

Rep. Bill Posey (R-Fla.) was the only Republican to really distinguish himself from the rest of the Republican lawmakers in attendance. Posey said a “minor fine” is unlikely to change behavior. “I don’t see anybody going to jail. All the criminal activity we have seen from Wall Street, I just see a real lack of accountability and prosecution.” He asked the panel to submit how many referrals to the Department of Justice each regulatory agency has made concerning criminal prosecutions for wrongdoing, how many convictions have occurred, how many stipulated settlements have been entered into and the amounts of those settlements and damages that each settlement was pertaining to. 

He also asked the panel whether they have investigated compensation committees who have awarded multi-million dollar bonuses to those “at the helm of a sinking ship.” Further, Posey said “I want to see wrongdoers go to prison… and it’s an obligation of yours to see that this happens” in order to change current behavior. 

A number of Democrat lawmakers touched on the budget cuts to the various financial regulatory agencies. In response to a question from Maloney on whether the SEC would be able to initiate more action if the agency had independent funding authority, Khuzami said such authority “would help us greatly,” allowing the SEC to investigate and litigate more and hire additional trial lawyers.  

In response to a follow up question, Khuzami stated his support for SEC Chairman Mary Schapiro’s comments that the SEC be given the legislative authority to increase its penalties on individuals and firms, adding “those remedies would help us a great deal.” 

Waters questioned Khuzami on whether the Residential Mortgage-Backed Securities Working Group had enough resources to carry out its mission and whether he was concerned that the task force has yet to appoint an executive director, and when could the Committee expect an announcement of an appointment. She added, “we anxiously await what they’re going to be able to accomplish.” 

Khuzami said “we have a significant amount of resources” and pointed to the fact that five agencies make up and contribute to the task force. Khuzami also said the working group is preparing a draft to respond to Waters’ letter inquiring about the new working group. He also said most of the investigative work was not being conducted by the task force, itself, but from within the agencies that make up the task force. 

Rep. Brad Miller (D-N.C.) asked Khuzami whether anyone at the SEC has been able to review the settlements the SEC has entered into, noting the Federal Housing Finance Agency’s (FHFA) critical report on how the settlement between Freddie Mac and Bank of America “was settled too cheaply and for the wrong reasons.” 

Khuzami said the SEC currently has a vacant inspectors general position. He said there has not been an overall review of the settlements, but noted that there is a “great deal” of scrutiny and review of each settlement. 

Panel II Testimony 

In his testimony, William Galvin, Secretary of the Commonwealth of Massachusetts, said permitting a firm “to enter into a settlement where it pays a fine, but neither admits or denies that it has done anything wrong, permits that firm to avoid basic culpability for its actions.” He added, “if we intend to reform the worst practices in the financial industry, then the firms that have violated the law must acknowledge that what they have done is wrong.” 

Regarding the SEC v. Citigroup case, Galvin said as an executive agency “the SEC must be able to decide which matters to investigate, which cases to litigate, which charges to bring, and the terms of any settlements.” 

In his testimony, Richard Painter, Professor of Law at the University of Minnesota Law School, said he agrees with the Second Circuit’s opinion in the SEC v. Citigroup case, saying the SEC “needs discretion to decide how limited enforcement resources should be used in a way that maximizes investor protection” and “federal courts should not define the way the SEC litigates and settles cases.” 

Painter also said “for the SEC to litigate and lose a case with potential weaknesses can wreak havoc on the enforcement regime.  The outcome may encourage wrongdoing by others who will see the S.E.C.’s loss as an opportunity to violate the same or related provisions of law with apparent impunity.”   

In his testimony, Kenneth Rosen, Professor of Law at the University of Alabama School of Law, discussed the flexibility behind the SEC’s current use of the neither admit nor deny policy and the SEC v. Citigroup case. Rosen also said the time is now “for a comprehensive and vigorous dialogue on issues like limited resource allocation prioritization as it relates to enforcement.” As financial instruments and markets become more complex, Rosen said coordination amongst all levels of government drawn into the battle against financial irregularities “will be critical.” 

Panel II Q&A 

Rep. Barney Frank (D-Mass.) asked if it would be beneficial for the SEC to bring forward a large, and potentially expensive, case that the agency is confident it could win in order to set an example that the agency is willing to pursue wrongdoings no matter the cost.  

The panelists agreed that the SEC should pursue strong cases and suggested the SEC be able to retain some of the revenue it collects from settlements. 

Frank cautioned against this approach, noting his concern about the incentives that may derive from authorizing an enforcement agency with the ability to levy fines and then spend those fines. 

Frank noted provisions in the Dodd-Frank Act that require all financial regulators to ensure compensation procedures and practices include claw back measures. He wondered whether regulators can use this authority to ensure firms include claw back provisions in their compensation packages that require individuals who are responsible for a large firm to pay for some of that loss.  

For more on the hearing, please click here. 

The House Financial Services Subcommittee on International Monetary Policy and Trade held a hearing to examine the market access opportunities for financial services firms in China. The hearing was timely considering last Friday’s announcement by Treasury on the progress made during the fourth meeting of the U.S.-China Strategic and Economic Dialogue (S&ED). 

David Strongin, SIFMA’s Managing Director for International Policy, testified at the hearing. 

In his opening statement, Subcommittee Chairman Gary Miller (R-Calif.) called for a level playing field in China, saying it is in both the U.S. and China’s interest. He added that while China “might be meeting the letter of the World Trade Organization (WTO) obligation, U.S. firms have complained that China is not meeting the spirit of those obligations.”  

Referring to past dialogues with China, Miller said “while we make commitments, they only make comments,” and stressed the need to hold them accountable for changes they have agreed to. 

Ranking Member Carolyn McCarthy (D-N.Y.) echoed Miller’s statement and said that while the S&ED is not a binding agreement, it is important to follow through and enforce the agreement.  

Panel I Testimony 

In her opening statement, Treasury Under Secretary Lael Brainard said she believed the administration has made important progress on economic, trade and financial issues following the fourth S&ED.  

“We secured commitments that will expand market access and help level the playing field for U.S. companies in China,” she said, and China agreed to take concrete steps to shift away from exports and relying more heavily on its own domestic consumption for growth.”  

Brainard stressed that “a more open and market-based financial system is also central to achieving more balanced Chinese growth and a more level playing field …  China's financial sector, which remains dominated by government-owned banks and subject to extensive government controls on the price and quantity of credit, generates massive distortions that filter through the whole economy.  That is a problem for China, and for us.” 

Brainard reviewed the commitments made at the S&ED but did not expand into any detail on the timing of their implementation.  

She characterized financial sector commitments as “tangible, significant gains that will benefit the United States… But they are not enough.” 

Panel I Q&A 

Rep. Robert Dold (R-Ill.) asked what is being done to decrease regulatory barriers and restrictions for U.S. business. Brainard said they are pushing to raise issues associated with equity ownership restrictions and investment allocations across the board and are looking to further revisions to China’s investment catalogue.  

Rep. David Scott (D-Ga.) asked whether China is impressed by our financial resilience since 2008.  Brainard said they have “heightened interest” in having our firms participate in their society and are pushing their financial institutions to implement the same safe guards, such as capital buffers and surcharges.  

Scott argued that, because of China’s large debt holdings, it is difficult to understand why China has such restrictive policies in place.  Brainard said firms are “just now starting to increase their investment” and noted that U.S. firms still have a larger amount of branches and subsidiaries in China that there are Chinese branches in the U.S. 

Rep. Don Manzulllo (R-Ill.) expressed concern about the Federal Reserve’s approval of licenses for three Chinese banks earlier this week. Brainard said that while foreign institutions must undergo a review by the Federal Reserve, the U.S. does not impose equity cap restrictions.  

Manzullo said it is problematic to allow full access to the U.S. market for Chinese firms but not requiring the same for U.S. firms in China. Brainard reiterated that there was some progress made to raise equity caps and argued that the move is an important step forward that will “expand meaningfully beyond their WTO commitments.” 

Rep. Bill Huizenga (R-Mich.) agreed with Manzullo and said negations with China are “like the U.S. taking two steps forward, China taking one step forward and declaring a tie.” 

With respect to the Fed’s decisions, Brainard said she believe the approval of licenses was made on “the basis of prudential requirements.” 

Panel II Testimony 

In his testimony, Robert Nichols, Chairman of Engage China Coalition and President and CEO of the Financial Services Forum, said the modernization of China’s underdeveloped financial system is “one of the most fundamental and important reforms necessary for the United States.” A more developed and sophisticated financial sector brings more efficient, effective, and diverse capital formation and increases the means and expertise for mitigating risk and weathering any economic difficulties and adjustments, he said. Nichols added that a shift to a more consumption-based Chinese economy requires “a more modern and sophisticated financial sector.” 

Nichols identified a number of U.S. financial sector challenges in China, including a limit on investments in Chinese financial institutions to a capped minority interest. The limitations “are among the most restrictive of any large emerging market nation and stand in the way of a level playing field for financial service providers.” Other barriers include arbitrary limitations of permitted products and services, discriminatory regulatory treatment, and restrictions on licensing and corporate form. 

Despite the challenges, Nichols said the Chinese leadership “recognizes the connection between faster financial reform and a more consumption-based economy,” and detailed a number of recent speeches by Chinese political and economic leaders, including the U.S.-China Strategic & Economic Dialogue (S&ED) talks that took place last week. Those talks produced “additional progress” including allowing foreign investors to take up to 49 percent equity stakes in domestic securities joint ventures, agreeing to allow investors from the US and other economies to establish joint venture brokerages to trade commodity and financial futures, and China reaffirming its intention to promote a more market-based interest rates.  

Nichols said future talks both within and outside of S&ED should focus on the “critical importance” of opening up the Chinese financial sector to promote the services and consumption-led economic growth that China’s leaders seek; increased market access for foreign financial services firms; the discriminatory national treatment towards foreign firms; regulator and procedural transparency, and further expansion of QFII and Qualified Domestic Institutional Investor (QDII) programs, amongst other issues. 

In his testimony, David Strongin, Managing Director at the Securities Industry and Financial Markets Association (SIFMA), said SIFMA “has long supported more open, fair and transparent markets, and liberalization of the national treatment of financial services in U.S. multilateral and bilateral trade forums.” 

Strongin identified five key and inter-connected industry priorities to ensure a more level playing field including: 1) Permit 100 percent ownership and right to establish in corporate form of choice; 2) Allow same scope of business; 3) Further develop QFII/QDII programs; 4) Improve bond market depth/liquidity/efficiency; and 5) Promote regulatory transparency. 

SIFMA highlighted the “most notable outcomes” from the S&ED including increased equity caps from 33 percent to 49 percent for securities joint-ventures (JVs), reduction of the “seasoning period” to two years, increased QFII quotas, and a commitment to continue the Bilateral Investment Treaty (BIT) discussions. SIFMA also made recommendations under each of these notable outcomes for U.S. policymakers to continue to pursue during future discussions. 

In closing, Strongin said in light of the Committee’s central role in ensuring the timely implementation of China’s current S&ED commitments, whilst pursing a level playing field for U.S. firms, SIFMA offered two recommendations: 1) An annual report from the Treasury to Congress demonstrating China’s implementation of commitments agreed to at each S&ED; and 2) Increasing the frequency of the economic portion of the dialogue to twice per year. 

In his testimony, Clay Lowery, Vice President at Rock Creek Global Advisers LLC, said the time is right to further open China’s market to foreign financial firms “because such liberalization is an essential part of China’s broader effort to rebalance its economy.” Lowery noted the challenges to this including entrenched interests (both private and public), Chinese firms’ unwillingness to compete, potentially captured regulatory entities, or “just pure politics and inertia at local levels” that will work to maintain the status quo. 

Lowery said “it is becoming in China’s interest” to allow foreign firms with decades of experience to compete and offer their services. Other recent important steps include the recent U.S.-China decision to resume BIT negotiations, adding that the Committee “should bring the same intensity and oversight to pushing for strong deliverables at the S&ED and in BIT negotiations as Members of Congress have shown on exchange rate issues.”  

Lowery said the Trans-Pacific Parternship talks currently being held in Dallas “are very positive for the U.S.” and will “truly help our competitiveness in the region” while bringing “even more pressure on China to rebalance its economy and allow for greater market access.” 

In his testimony, Nicholas Lardy, Senior Fellow at the Peterson Institute for International Economics, said the current disappointment expressed by foreign firms in not being able to expand their financial sector presence in China stems from three factors: 1) The bilateral negotiations for China’s entry into the World Trade Organization (WTO) saw the U.S. fail to press “very hard” for market opening in financial services; 2) Both U.S. and Chinese negotiators are constrained in their ability to make reciprocal concessions so further market opening measures flowing from recent dialogues “has been painfully slow; and 3) The U.S. argument that China would benefit from further unilateral opening of its market to U.S. and other foreign financial services firms “is far less compelling today than it was prior to 2008.” 

Lardy went on to discuss factors behind the limited role of foreign financial institutions in China, the limited access of foreign firms to the domestic insurance market, and whether the recent SE&D talks “will be sufficient to erode the dominance of the securities market in China by indigenous firms.” 

Panel II Q&A 

Miller discussed the 2010 Organization for Economic Co-operation and Development (OECD) financial markets restrictiveness index and asked how the pace of growth for financial services can be accelerated when Chinese officials “just talk” instead of entering into firm commitments. 

Nichols said there is a “huge group” of Chinese citizens that do not have access to the financial marketplace. He added that “it is in their best interest to change their economy.” However, Nichols reiterated that “we’re not satisfied… there’s much more to do to get them to open their markets.” 

Strongin told the subcommittee not to “discount the importance of continued outside pressure,” including the S&ED discussions, the BIT negotiations, and the subcommittee’s commitment to the issue. “They all provide us with both pressure and some leverage,” he said. 

In a follow up question, Miller asked whether the S&ED meetings are helping to move China in the right direction.  

Strongin said “from a securities industry perspective they’ve been helpful and moved the ball forward, but not nearly enough.”  

On a question asked by Miller concerning Federal Reserve licenses, Nichols said “we’re not satisfied… it’s not a level playing field.” He added that the reason the Federal Reserve granted the branch licenses to the Chinese banks is due to the fact that the home country supervision has improved, which is “actually a good thing.” Miller agreed and said “we need to aggressively encourage [China] to do the right thing.” 

Rep. Andre Carson (D-Ind.) asked the panel to what extent China’s capital reserve requirements are a barrier to U.S. firms seeking access to the banking sector. 

Lardy said he did not see it as a barrier, but said “the fact that they rely so heavily on the required reserve ratio reflects the fact that they don’t have market determined interest rates for the most part.” He added that this is a “very quantity controlled mechanism rather than a price-oriented mechanism.” 

Strongin said the key is to focus on ownership restrictions. “Whether you go through insurance, banking, securities and other types of financial products, it always starts with the inability to run your business the way you want to run it.”  

For more on the hearing, please click here. 

AT TODAY’S HOUSE FINANCIAL SERVICES SUBCOMMITEE on Financial Institutions and Consumer Credit hearing, lawmakers discussed the impacts systemically important financial institution (SIFI) designations would have on individual firms and the marketplace. Officials from the Federal Reserve and the Treasury Department testified as well as a panel of industry stakeholders and academics. 

The Dodd-Frank Act authorized the newly-established council of regulators, the Financial Stability Oversight Council (FSOC), with the power to designate firms that pose a threat to the financial system as a SIFI and subject those firms to heightened prudential and supervisory powers.  

In their opening statements, lawmakers on both sides of the aisle voiced concern over large financial firms that are perceived by the market as “too big to fail.”  

Rep. Scott Garrett (R-N.J.) called the entire SIFI debate a “charade” and suggested that discussions should center on how to end too big to fail and the moral hazard it poses. 

Rep. Ed Royce (R-Calif.) said Section 165 of Dodd-Frank, which subjects certain nonbank financial firms to heightened regulatory standards, will “publicly stamp” institutions as systemic which in turn will send a message to the markets that “Washington will never allow these firms to fail.” With regard to the impending designations, Royce stated his hope that regulators “cast the smallest possible net and designate only the firms that everyone agrees are too big to fail,” but said the overall approach was the wrong direction. 

Rep. David Scott (D-Ga.) cautioned that new regulation must be implemented appropriately to ensure that the “forces that generate the capital, that disburse the capital, that lend and keep this economy going” are not put in “straight jacket.”   

Testimony 

In his opening statement, Lance Auer, Deputy Assistant Treasury Secretary for Financial Institutions, outlined the three stage process for SIFI designations. Auer said stage one is not intended to identify nonbank financial companies for a final determination. He noted how  a nonbank financial firm will warrant further evaluation beyond stage one if it has at least $50 billion in assets and: $20 billion of total debt outstanding; 15 to 1 leverage ratio; and 10 percent ratio of short-term debt to total consolidated assets, among other things. Companies that reach stage two will be analyzed based on a six-category framework. Based on this analysis, the FSOC will contact only the firms that it believes merit further consideration in stage three. According to Auer, the objective of the stage 3 analysis is to assess whether a nonbank financial company meets one of the statutory standards for a determination or “whether the company’s material financial distress, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the company, could pose a threat to U.S. financial stability.” Auer emphasized that “every designation decision will be firm-specific, and every firm will receive robust due process protections, including the opportunity for judicial review of any final designation.” 

In his opening statement, Michael Gibson, Director of the Division of Banking Supervision and Regulation at the Federal Reserve, provided an overview of the Federal Reserve’s work to date on the designation and supervision of nonbank financial companies that could pose a threat to financial stability. Gibson referred to the Federal Reserve’s proposed rules that would apply the same set of enhanced prudential standards to covered companies that are bank holding companies and nonbank financial companies designated by the FSOC, and said the Fed may “tailor the application of the enhanced standards to different companies on an individual basis or by category, taking into consideration each company’s capital structure, riskiness, complexity, financial activities, size, and any other risk-related factors that the Federal Reserve deems appropriate.” He said that once the FSOC designates one or more nonbank financial firms, the Fed is “committed to thoroughly assessing the business model, capital structure, and risk profile of each designated company and tailoring the application of the enhanced standards to each company on an individual basis or by category, as appropriate.” 

In his opening statement, Thomas Quaadman, Vice President of the Center for Capital Markets Competitiveness at the U.S. Chamber of Commerce, noted that with regard to the designation process, the Federal Reserve and the FSOC are not following the structure Congress passed into law. Quaadman recommended the FSOC increase transparency with regard to its proceedings on legislative matters and noted how the FSOC did not provide a cost-benefit analysis in the rulemaking process to allow stakeholders to determine the impacts of the proposed regulations.  

In his opening statement, William Wheeler, President, Americas, for MetLife, discussed why regulated insurance activities generally do not pose systemic risk and why naming only a few insurance companies as SIFIs would “needlessly upset the competitive landscape in the insurance sector.” Wheeler also discussed why prudential regulation must be tailored to MetLife’s unique asset and liability characteristics in the event it is designated as a SIFI.  

Question and Answer

Subcommittee Chairman Shelley Moore Capito (R-W.Va.) asked the regulators how they will assess differences in the industry business models with regard to the designation process. 

Auer said the FSOC developed a three stage framework for the designation process. The first stage uses uniform quantitative thresholds to screen out “the large number of firms that the council is unlikely to consider for further evaluation.” The next two stages will take an “individualized look at each particular nonbank financial company under consideration to look at all of its activities, all of its businesses, the types of business it is in, the types of activities it engages in” so that the FSOC can take into account the specific factors of that firm in coming up with a final determination. 

Gibson stated the Fed’s intent in its proposal for enhanced prudential standards to tailor the standards to the characteristics of the companies that are designated by the FSOC. “We understand that there are some nonbank companies for which the bank-like standards that we've proposed would likely be a bad fit. And we have committed to looking at that when those companies are designated and doing what we can to tailor the standards,” Gibson said.  

Rep. Carolyn Maloney (D-N.Y.) asked for more clarity regarding the designation criteria and specifically asked how much interconnectedness makes a firm a SIFI.  

Auer reiterated the FSOC’s designation process and said interconnectedness is one factor of many that the Council will take into consideration. He said interconnectedness will be assessed on a firm-by-firm basis.  

Maloney asked Gibson whether the Federal Reserve’s prudential standards proposal for SIFIs will be modified to adapt to the distinct profile of non-bank SIFIs. 

Gibson said the Fed is currently reviewing comments from its proposed rule released last December. He said he could not predict where the final rule will come out but did state that the Federal Reserve is “committed, after the companies are designated, to take a look at the need for tailoring the standards.” 

Maloney also asked for clarity regarding the timing of the designations and when the Federal Reserve will develop prudential standards for nonbank financial firms.  

Auer said the Treasury Secretary hopes the FSOC will begin the first of its designations “sometime this year.” Gibson said the Fed is still reviewing comments from its proposed rule.  

Full Committee Chairman Spencer Bachus (R-Ala.) asked if there was any recognition that the proposed standards do not appear to fit asset managers, money markets, captive finance companies or insurance companies. 

Gibson noted that with regard to certain non-bank financial firms, such as asset management and captive finance companies, the Federal Reserve would “certainly have to look at the need to tailor the standards that are in the proposed rule to the specific characteristics of those companies. And as you point out, an asset management company is very different from a bank because the assets it's managing are not on its own balance sheet. They're held in custody for customers, so that's an important difference.” 

“We have experience with asset management companies because there are large bank holding companies that are significant participants in asset management. But we don't have the experience of writing capital and other prudential standards for a company that only engages in asset management. And that is what we would need to tailor. If and when those companies are designated, we would tailor the standards,” Gibson said.  

Rep. James Renacci (R-Ohio) noted the confusion stemming from what it means for a nonbank financial company to be engaged in a financial activity under Title I of Dodd-Frank and asked whether the confusion will be resolved before the designation process is underway. 

Gibson said the Federal Reserve issued a supplemental proposal last month to clarify certain aspects of that definition but said the FSOC does not believe they have to wait until the Federal Reserve’s final rule to designate companies. He said the Fed “defined as financial in nature activities that are referenced in certain sections of the law that defines what activities are permissible for a bank holding company. And by referring to that section of the law we're incorporating the existing definitions of what is a financial activity into this definition of nonbank financial company.” 

Scott asked if the FSOC has conducted a thorough cost benefit analysis on the designation of nonbanks as systemically important, specifically with regard to asset managers.  

Auer said the “FSOC member agencies are obviously very concerned about the costs and benefits of their actions” but that the rule was designed to provide greater clarity about the Council’s designation process. 

Scott asked if the FSOC has considered any adverse effects of the designation, specifically noting that asset managers do not invest with their own balance sheets, and asked where the process will end and whether other nonbank industries will be considered systemic as well. 

Auer said the designation process will be undertaken on a firm-by-firm basis. Auer said asset management firms would unlikely be designated to the degree that such firms have their activities in custody and on behalf of customers and, as a result, do not pose a threat to financial stability.   

Rep. Michael Grimm (R-N.Y.) asked if asset managers have been involved in the Office of Financial Research (OFR) study to date and if there is a formal process for conducting the due diligence for asset managers. 

Auer said the OFR has “begun the process of talking with people in the asset management industry and will continue to do so.”  He said any “asset management firm or any entity that wants to meet with the council staff or member agency staff about the designations process is welcome to contact any council member agency and we will try -- or the OFR -- will try and set up meetings for that firm.” 

Grimm responded by noting that when a client changes an asset manager that does not mean that the portfolio is immediately liquidated and stated his hope that “the FSOC is looking at that and that there certainly would be adverse effects. I wish they would certainly consider that.” 

Rep. John Carney (D-Del.) asked for more clarity regarding the designation process.  

Auer said the FSOC’s final rule took effect this month and that the member agencies and the OFR are currently collecting data to assess which firms will pass the stage one threshold. He said stage two is designed around a six-factor framework that relate to the “probability that a firm might get into distress,” including leverage, liquidity, lack of substitutes, interconnectedness, size, and existing regulatory scrutiny. Auer said firms will be notified in stage three that they are under consideration by the FSOC. The firm will then have the to opportunity to provide information or arguments to the Council in support or opposition to the designation. If the FSOC decides to vote for a designation, the firm can then request a hearing in front of the Council. If the Council decides to approve the designation then the firm can appeal to the federal system.  

Rep. Patrick McHenry (R-N.C.) asked if the Federal Reserve conducted cost-benefit analysis on its counterparty credit limit proposal.  

Gibson said the Federal Reserve looks at the costs and benefits of every rule and that it is still gathering information on the particular counterparty credit limits that were proposed and the alternatives that were suggested by the commenters. 

During the second panel, Renacci asked Wheeler how SIFI designations for certain insurance firms would affect the insurance sector. 

Wheeler said such firms will be seen as “insurance firms you do not want to buy stock in.” He noted how these firms would be subject to higher capital requires, which would increase costs, and posited that the marketplace would punish those firms.  

For testimony and a webcast of the hearing, please click here. 

AT TODAY’S CFTC OPEN MEETING, one final rulemaking was considered and approved: 

• Final Rule on Core Principles and Other Requirements for Designated Contract Markets (DCMs). 

Prior to the Open Meeting, the Commission approved a proposed amendment to a previous order providing temporary relief from certain swaps regulation, proposing to extend the temporary relief from the last extension date (July 16, 2012) to December 31, 2012.  

In his opening remarks, Chairman Gary Gensler provided a preview of future Commission activity, noting that the Commission will “turn shortly” to the products definition final rule and will “soon complete” a final rule establishing data recordkeeping and reporting requirements for pre-enactment and transition swaps or “historical swaps.” Gensler also said he anticipates “seeking public comment in the near term on an exemptive order regarding certain contracts traded on regional transmission organizations as well as an interpretative guidance on the cross-border application of the swaps provisions of Dodd-Frank.” Final rules regarding swap execution facilities (SEFs) may be taken up in July. In addition, Gensler announced that the CFTC will be holding a roundtable on the Volcker Rule in late May.  

Regarding the final DCM rule, Gensler highlighted coordination between the Commission and the Office of Information and Regulatory Affairs (OIRA) in drafting the cost-benefit analysis.     

Commissioner Jill Sommers noted her general support of the DCM final rule. However, Sommers raised concerns that her office had not yet seen any term sheets, comment summaries or working drafts of cross-border or capital and margin releases.  She pointed out that it is likely that swap dealer registration would be required before these issues are clarified, which will prove problematic for market participants, further noting the SEC approach (i.e., not requiring registration until all substantive rules are finalized) is the better approach. 

Commissioner Scott O’Malia stated his support for the final DCM rule (including collaborations with OIRA) and the exemptive order. He noted that market participants continue to seek guidance regarding the timing of the CFTC’s rules and referenced a timetable he created of when he understands the Commission expects to vote on the remaining Dodd-Frank-related rules, orders and guidance. “I have developed this list and timetable based on my knowledge and through conversation with Commission staff,” O’Malia said. He said the timetable will be posted on the CFTC’s website and urged the public to comment on the list, specifically asking interested parties to answer whether: the Commission’s 2012 year-end deadline of completing Dodd-Frank rulemaking is achievable; and the sequencing of these rules, order and guidance is appropriate.  

Final Rule on Core Principles and Other Requirements for Designated Contact Markets (DCMs) – Vote (5-0) 

The final rule implements Section 735 of the Dodd-Frank Act which codifies rules, guidance and acceptable practices applicable to DCMs and DCM applicants. Among other things, the final rule eliminates the accelerated approval procedures for DCM applications and instead requires that all applications be reviewed under the 180 day statutory review period.  

The final rule also adopts rules governing the dual registration of a Board of Trade as both a DCM and SEF. A Board of Trade that is designated as a DCM may operate provided it separately registers pursuant to the SEF registration requirements and complies, on an ongoing basis, with the SEF rules and core principles. Any Board of Trade intending to be dually registered may use the same electronic trading system for listing and executing swaps provided they make it clear to market participants whether the electronic trading of swaps is taking place on a SEF or DCM platform.  

With regard to rules requiring a DCM to establish and enforce rule compliance, the regulations codify existing practices, including those requiring automated trade surveillance systems and real-time market monitoring. The rules also require a DCM to obtain consent from their members and market participants to the DCM jurisdiction prior to granting access to it markets.  

With regard to Core Principle 9, which requires that DCMs provide a competitive open market and mechanism for executing transactions, the final rule states that more time is needed before finalizing this provision and recommends the Commission take it up when it considers the final SEF rulemaking. According to staff, the additional time would “allow the Commission to consider the available alternatives for contracts that may not comply with the proposed centralized market trading requirements as well as any related implementation of the rules pertaining to off exchange transactions including exchange of derivatives for related position transactions.”  The original proposal for Core Principle 9 would have required that 85 percent of total trading volume of contracts on DCMs must consist of centralized trading or be mandatorily de-listed. 

The rules require DCMs to establish and enforce trade risk controls to prevent market disruption, including market restrictions that pause or halt trading in the event of extraordinary price movements that may result in distorted prices or trigger market disruption.  

The rules require DCMs to adopt rules establishing minimum financial standards for both member futures commission merchants (FCMs) and introducing brokers and non-intermediated participants. DCMs will also be required to conduct ongoing financial surveillance of the risk created by FCM customer positions’ on DCMs. DCMs must also have rules prescribing minimum capital requirements for intermediated brokers. In addition, the FCM would have primary responsibility for overall risk management, but the DCM would be required to establish an automated risk management system permitting a FCM to set appropriate risk limits for each customer with direct access to the contract market.  

The final rule takes effect 60 days after its publication in the Federal Register. 

Fact Sheet 

Q&A 

Question and Answer 

Sommers asked staff to explain if entities with multiple registrations share costs and what evaluations will be conducted to ensure there is no double counting. 

Staff said such an entity would have to demonstrate that it has sufficient resources to operate the single combined entity and would thus be able to share certain costs. As an example, staff said that “if you have a corporate entity that operates both a derivatives clearing organization (DCO) and DCM, and they have an employee that works for both, we don't contemplate that we would require that corporate entity to count that full salary of that employee both for the DCO and then again for the DCM, but rather would be able to share the cost.” 

O’Malia asked what DCMs must do to comply with Core Principle 9 before the SEF rules are finalized. 

Staff noted that DCMs today are currently complying with each of the core principles and that they should use their “reasonable discretion” in determining the method in doing that. Staff said that “we anticipate DCMs would continue to do that for Core Principle 9 in the way they have complied over the last eleven months until final rules are adopted.” 

Commissioner Chilton asked whether the Commission could propose an alternative to the “85% requirement” of Core Principle 9, and then finalize the rule without soliciting further comment.  

Staff noted that only where a variation to a proposed rule is found to be a “logical outgrowth” would that be possible; otherwise, the opportunity for public comment would be necessary. 

For opening statements and materials from the meeting, please click here.  

AT TODAY’S HOUSE FINANCIAL SERVICES SUBCOMMITTEE HEARING, representatives from community banks and credit unions discussed the effects of post-crisis regulation on their institutions. 

In her opening remarks, Chairman Shelly Moore Capito (R-W. Va.) said Dodd-Frank related regulations are putting an increasing amount of pressure on small banking institutions. “If we do not take steps to preserve the vitality of community banks, communities across the nation will be adversely affected,” Capito said. In closing, she implored regulators and members of Congress to pay more attention to the cumulative effect of new regulations and start eliminating, or updating, old and outdated regulations.  

Full Committee Chairman Spencer Bachus (R-Ala.) echoed Capito’s remarks and pledged to repeal any Dodd-Frank rules that are negatively affecting community banks and credit unions. 

Ranking Member Carolyn Maloney (D-N.Y.) said she is sympathetic to the cost of regulatory compliance, but said smaller institutions must take into account the cost of “under-regulation.” In closing, Maloney noted similar banking industry pushback on Depression-era reforms, and said regulation after the last global financial crisis spurred 70 years of economic growth. 

In their opening statements, William Grant, testifying on behalf of the American Bankers Association (ABA), and Samuel Vallandingham, testifying on behalf of the Independent Community Bankers of America (ICBA), said the cumulative impact of new regulations and the proliferation of non-bank and non-taxed competitors is threatening the existence of community banks. Both cited Dodd-Frank as the main reason compliance costs are rising, noting that the cost of regulatory compliance is expected to be $50 billion cumulatively, which is two-and-a-half times  greater, as a share of operating expenses, for small banks than for large banks. In closing, Grant and Vallandingham said the amount of regulation and the resulting legal risk is pushing community banks out of their traditional lines-of-business, including mortgage lending.   

Ed Templeton, testifying on behalf of the National Association of Federal Credit Unions (NAFCU), and Terry West, testifying on behalf of the Credit Union National Association (CUNA), said credit unions face a crisis of “creeping complexity” with respect to regulatory burdens. 

“The greatest challenge facing many credit unions is the cumulative impact of the rapidly growing number of regulatory burdens in the wake of the financial crisis,” said Templeton. While any one single regulation may not be particularly burdensome, the layering of new regulation on top of old and outdated regulation can completely overwhelm small financial service providers like credit unions.” 

Templeton and West both expressed concern about the mandates of the Consumer Financial Protection Bureau (CFPB) and the debit interchange rule, and urged the committee to monitor the CFPB as they consider issuing more rules that will affect their business. West added that every dollar a credit union spends on compliance related costs, is a dollar that could have gone towards lending or another financial product for consumers. 

In his opening statement, Adam Levitin, Professor of Law at Georgetown University, said community banks and credit unions have been steadily losing market share to large banks due to financial deregulation, arguing that intrinsic characteristics are to blame for the current struggles of community banks, not overregulation. Further, Levitin said members should be working towards eliminating too-big-to-fail, noting that if mega-banks are “slimmed down” community banking will become viable once again. In closing, Levitin pointed out that the large majority of the regulations that the community banks and credit unions are complaining about have nothing to do with Dodd-Frank or the CFPB and criticized small banking institutions for “getting caught up in ideological regulatory agendas.” 

In his opening remarks, Mike Calhoun, President of the Center for Responsible Lending (CRL), focused his testimony on lending and credit availability. He said CRL supports a qualified mortgage (QM) definition that encompasses the vast bulk of the market, establishes bright lines that provide lenders with certainty about whether a mortgage can be designated as a qualified mortgage, is consistent with the standards for a qualified residential mortgage (QRM), and determines that qualified mortgage status is a rebuttable presumption and not a safe harbor from any future liability. Calhoun said such a definition will permit smaller institutions to make and sell loans to all of their creditworthy customers, while eliminating the legal risk that has crippled community bank and credit union lending.  

Question and Answer 

Several members asked the witnesses to articulate how the current regulatory atmosphere is hurting their businesses. The witnesses said they are being harmed by the rate of regulatory changes, regulatory uncertainty, and the cumulative effect of the new and old regulation.  

Rep. David Scott (D-Ga.) asked the witnesses to identify the most burdensome Dodd-Frank provisions. 

Vallandingham said that while community banks and credit unions are exempted from many Dodd-Frank related rules, oftentimes those exemptions do not apply because the rules “become best practices and we [credit unions] are forced to comply.” Grant said the municipal advisor rule will have a “particularly chilling effect” on registered tellers and customer service providers if implemented. He also said he urges regulators to be very careful when crafting the QM definition because if it is too restrictive it will prevent small institutions from lending to large segments of their customer bases.  

Capito and Vice Chairman James Renacci (R-Ohio) asked Grant and Vallandingham if old or outdated regulations are being repealed or updated. Grant and Vallandingham said they have not heard of any older regulations being updated or repealed as new rules are implemented. When asked what specific regulations they wanted to see updated, Vallandingham said Regulation E and check clearing regulation need to be updated in light of technological innovation and changes in accepted best practices.  

Maloney asked Grant if he agrees with her that regulating the non-bank financial sector has been positive for community banks. Grant said the community banking industry appreciates that Dodd-Frank has allowed for the regulation of non-bank financial firms, but expressed concern that the CFPB’s broad interpretation of its Dodd-Frank mandates will affect community banking products and services that the prudential regulators have already deemed safe. Following up, Rep. Jeb Hensarling (R-Texas) asked Grant to detail the effect that forthcoming CFPB rulemakings are having on community banks’ credit availability. Grant said it is already curtailing lending and several community banks are thinking about ending their mortgage lending business.  

Rep. Blaine Luetkemeyer (R-Mo.) followed up on Grant’s response to Hensarling, asking why community banks would stop lending to their customers. Grant said community banks feel that the regulatory and legal risk outweighs the commoditized pricing that you find in mortgages today. Vallandingham added that increasing compliance costs and uncertainty over QM and QRM definitions are also reasons why community banks are exiting the lending business.     

Rep. John Carney (D-Del.) asked Levitin to expand on his assertion that smaller financial institutions would be better off if the largest banks were forced to become smaller. “Large banks need to go on a diet,” Levitin said, urging members to incentivize their reduction in size though excessive taxation of large financial institutions and burdensome capital requirements. Grant expressed his support for the elimination of too-big-to-fail banks, but noted that the U.S. needs banks of all sizes. “If we [the U.S.] tear down large banks, foreign banks will swoop in and take their place,” he said. 

For testimony and a webcast of the hearing, please click here. 

AT TODAY’S SENATE BANKING SUBCOMMITEE HEARING, lawmakers discussed the concentration of banking activities and the implications of such changes in the banking sector. The hearing consisted of three panels featuring former Federal Reserve Chairman Paul Volcker, Federal Deposit Insurance Corporation (FDIC) Board member Thomas Hoenig, Federal Reserve official Randall Kroszner, and a panel of industry representatives.  

Subcommittee Chairman Sherrod Brown (D-Ohio) began the hearing by noting his intention of reintroducing the “SAFE Banking Act” which would impose a  cap on any bank holding company’s share of the total insured deposits in the U.S. and would reduce the maximum amount of non-deposit liabilities at financial firms, among other things. 

Testimony 

In his opening statement, Paul Volcker noted that the greatest structural challenges facing the financial system is the perception of “too big to fail.” He said provisions in the Dodd-Frank Act deal with this issue, including the Volcker Rule. Volcker pointed to other issues that need to be addressed such as reform of the government sponsored enterprises (GSEs) and encouraging more private sector participation in housing finance activities, and reforming money market mutual funds (MMFs). Volcker noted how MMFs are vulnerable to runs in times of stress and said they need to be harnessed “in a manner that recognizes both their structural importance in diverting funds from regulated banks and their destabilizing potential.” He suggested MMFs be treated as ordinary mutual funds, “with redemption values reflecting day by day market price fluctuations.” Volcker also called for a member of the Federal Reserve to be designated as Vice Chairman for Supervision, a position that has not been filled nearly two years after its authorization.  

Thomas Hoenig, FDIC Board member, submitted his paper “Restructuring the Banking System to Improve Safety and Soundness” from May 2011 as his statement for the record. The paper was written when Hoenig served as President and CEO of the Federal Reserve Bank of Kansas City and outlines proposals to “reintroduce accountability” by restricting bank activities.  

Randall Kroszner, Member-Designate of the Federal Reserve Board, submitted his paper on “Stability, Growth and Regulatory Reform” from April 2012 as his statement for the record. The paper discusses the value of financial innovation and the effects regulatory reform efforts have on the financial system. 

In his opening statement, Tom Frost, Chairman Emeritus of Frost National Bank, discussed how the banking business has evolved into two different cultures – one that is transactions-based and one that is based on customer relationships. He suggested these cultures be separated and that government support should not be given to hedging and speculative services.  

In his opening statement, Marc Jarsulic, Chief Economist for Better Markets, Inc., discussed how high leverage , proprietary trading, and dependence on unstable short term financing made large financial firms vulnerable during the financial crisis. Jarsulic suggested the Volcker Rule place “meaningful leverage and liquidity requirements on bank broker dealers” and lower the permitted leverage. He also suggested the repo market be designated and supervised by the Financial Stability Oversight Council in order to enact effective regulation of the shadow banking system.  

In his opening statement, James Roselle, Associate General Counsel for Northern Trust Corporation, highlighted specific provisions in the proposed Volcker Rule that may have negative impacts on firms that Congress did not intend for the rule to cover. Those concerns include “the overly broad definition of “covered fund” and the impact that so-called “Super 23A prohibitions will have on custody-related transactions; the proposed inclusion of foreign exchange swaps and forwards in the proprietary trading restrictions; and the unnecessary and onerous proposed compliance requirements.” 

In his opening statement, Anthony Carfang, Partner at Treasury Strategies, Inc., who testified on behalf of the U.S. Chamber of Commerce, discussed regulatory reform provisions that may have negative effects on capital raising methods for businesses. Carfang noted that “artificial and arbitrary caps on the financial industry, or the Volcker Rule (as currently proposed), or additional money market regulation will not reduce systemic risk.” He said such regulation will force “non-financial companies that are the engines of our economy to retrench, enhance their cash positions and face a much tougher time raising the capital needed to operate, grow and create jobs.” 

Panel I Q&A 

Brown addressed the issue of moral hazard with regard to large financial institutions and asked Volcker what regulators can do to send the message to markets that such firms will not be propped up by the government if they get into trouble. 

Volcker said provisions in Dodd-Frank will assist in the orderly liquidation of a large firm, including authorizing the FDIC with powers of conservatorship and requiring banks to establish living wills. He also noted that the biggest global banks tend be centered in the U.K. and stressed the importance of regulatory consistency with that jurisdiction. 

Sen. Bob Corker (R-Tenn.) asked Volcker to clarify his intention with the Dodd-Frank provision that is named after him, the Volcker Rule, with regard to specifically focusing on banning proprietary trading activities. Corker noted that there have been attempts by regulators, in implementing the rule, to do away with market making and asked how market making and proprietary trading can be differentiated.  

Volcker confirmed that his intention with the rule was to focus on proprietary trading. He said it is important for the management of banks, including the directors, to understand what the law says and to enhance the controls on banks’ trading desks to ensure the law is followed. He said traders at market making desks should not be taking proprietary risks under the guise of market making and that these differences can be identified by a number of metrics, including the size and volatility of trades. Volcker said that through these metrics supervisors should be able to identify signs of proprietary trading and subsequently raise appropriate questions to confirm whether this is the case.  

Corker also asked whether identifying market making activities that make a profit for a firm as proprietary trading is regulatory overreach and if it is a legitimate thing for banks to be involved in holding small amounts of inventory that are held for their customers’ use.  

Volcker agreed with Corker’s assertion of regulatory overreach and said profits can be made from market making. With regard to holding a small inventory, Volcker questioned why firms wanting to be prepared for market making don’t hold a short position “because the customer may want to sell. So they ought to have a balanced position, it seems to me, and if the position is very unbalanced it raises questions.” 

Sen. Jeff Merkley (D-Ore.) noted certain criticisms of the Volcker Rule and asked Volcker whether he believed the provision would result in decreased liquidity. 

Volcker said decreased liquidity would not necessarily lead to a problem and noted how markets were very liquid right before the crisis which led to some “unconstructive behavior” in the banking sector. He specifically pointed to the multitude of investment vehicles used to securitize mortgages and noted proposals in Europe to tax transactions to make the markets less liquid. Volcker said enough liquidity should exist to buy and sell reasonably but not to the point where a long-term security can be purchased and sold within “10 minutes” of each other and with “no risk.” 

Sen. Mike Johanns (R-Neb.) voiced his concern with the complexity of the Volcker Rule and whether it may lead to more consolidation in the banking sector. 

Volcker said prohibitions in the Volcker Rule will only apply to 6-8 institutions and that these firms are very sophisticated with strict controls over their trading desks. He said transactions do not have to be traced in real time and that regulators should “describe generally” the characteristics of proprietary trading.  

Volcker said that with the reputation of a bank’s management at stake, they will make a good faith effort to stay within the framework of the rule’s restrictions.  

Merkley noted that regulators may not be prepared to finalize the rule by its statutory effective date in July and asked whether they should still move forward and attempt to complete the rule by the summer. 

Volcker said regulators are aiming to complete the rule by July and that they recognize that over the two year conformance period, they may want to change things in the provision. He did refer to interpretations of the Federal Reserve’s clarifying guidance on the conformance period that suggested firms can continue to engage in proprietary trading during that period, and stated that no proprietary trading can take place after the rule’s effective date in July 2012.  

Panel II Q&A 

Brown asked what growth and consolidation has meant in terms of the ability to effectively manage and monitor large financial firms.  

Kroszner said “in principle” such firms are not too big to manage. He noted that more transparency would make it easier for regulators to monitor banking activities but noted that risks the rules are intended to address do not disappear, but may move to less regulated areas like the shadow banking sector. He said careful cost benefit analysis should be undertaken to identify any government subsidies that benefit certain types of firms over others and then to subsequently eliminate those subsidies.  

Corker asked whether Hoenig believed Dodd-Frank makes the financial system less safe.  

Hoenig referred to his proposal to take certain high risk activities and “move them out to the market where they can fail” which would then resolve any size and concentration issues among large financial firms. He said removing such activities would allow regional and community banks to compete on a more level playing field with the large banks. 

Panel III Q&A 

Brown asked Frost and Roselle, as banking practitioners, whether large banks are too big to manage.   

Frost said a difference in cultures – one that is transactions-based and profit driven vs. one that is focused on building relationships with customers - make large banks impossible to manage. Frost said the Dodd-Frank Act failed to address this issue and that there needs to be a separation of cultures; where the customer-focused business can receive government safety nets while the transactions-based business would be allowed to fail.  

Corker asked Roselle’s thoughts on Frost’s idea of separating banking activities in such a manner. 

Roselle said it would be a mistake to establish an artificial separation and that banking services should be allowed to evolve through natural market forces. As an example, Roselle noted how Northern Trust evolved from a predominately wealth management firm to a custodian bank based on client demand. He also noted that enacting such a separation would not reduce risk and may actually drive activities to less regulated environments.  

For testimony and webcast of the hearing, please click here.