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Sunday, February 26, 2017

The Overlooked Merits of Bank Disclosure


Author: David Schwartz J.D. CPA

  • What if banks were to get a capital benefit from investing in superior risk management technology – and if that benefit was disclosed to the market?
  • Should not the costs of risk management investments by FDIC-insured banks be partly repaid by taxpayers in the form of capital relief?
  • Why don’t capital rules allow a reduction in risk-weighted requirements, to help offset the lost revenue and encourage conservative risk management?
  • Dynamic metrics are far more relevant for understanding the levels of stability in securities finance than are static sizing and demographics alone.

 

European bankers are caught up in a debate over whether to disclose their full supervisory capital demands to market participants. That’s an issue because bank supervisors, under Pillar 2 of the Basel III accord, can set a bank’s regulatory capital “guidance” at a level higher than its Pillar 1 “requirements.” Bank analysts and investors can discount the securities of banks with relatively high guidance, assuming that supervisors have learned something negative in their confidential reviews. That’s the essence of Pillar 3: Market Discipline.
 
Financial reporters and investors are in favor of full disclosure for both capital requirements, as well as Pillar 2 guidelines. “Markets operate best with greater transparency,” asserted an editor in the January 31, 2017 issue of Global Capital. “There is simply no need for banks to let the size of their capital buffers become a subject for speculation when they have the option to publish all of their supervisory capital demands.”[1]
 
At least some legislators also support the release of more information underlying the regulatory capital metrics.  For example, Conservative Party MP Andrew Tyrie has urged the Bank of England to disclose more about the internal risk models of large UK banks.
 
“The market mechanism for imposing good behaviour on banks might work better, possibly much better. Its manifest shortcomings were brutally exposed in the crash,” argues Mr. Tyrie, whose views were cited in the Financial Times of June 7, 2016. [2] “The case for greater disclosure is now strengthened, not weakened, by the greatly increased intrusiveness and complexity of the supervisory process and of financial regulation.”
 
Regulators and supervisors have resisted calls for more disclosure of specifics. Bankers are uncertain, at least based on the disclosure evidence cited by the FT. That may be a function of the fact that Pillar 2 can only be capital accretive, not reductive.[3] Yet, bankers should be firm supporters of universal disclosure – for the reasons that we explain below.  
 

  • What if banks were to get a capital benefit from investing in superior risk management technology – and if that benefit was disclosed to the market?

 
There is no explicit credit in the regulatory capital accord for banks which offer superior risk-management services. Presumably, supervisors invoking Pillar 2 of the Basel Accord can take that into consideration, although at present they cannot adjust capital buffers below the minimum requirements. That’s not fair to banks that have invested heavily in systems to control their risk exposures.
 
Case Study: Securities Finance
Banks lend securities while offering indemnification against borrower default to their institutional and corporate customers. Currently, the weight of new capital regulations is forcing banks to price the indemnification beyond customers’ ability to pay.[4]  As a result, the availability of securities to lend is expected to drop by as much as 50% in the next five years, potentially leading to impaired pricing efficiency in markets and higher risks for investors.
 
If supervisors were willing to accept the relative strength of an agent bank’s risk management systems and if Pillar 2 could be used to reduce a superior risk manager’s capital requirements, then it could be argued that lender indemnification for some agent lending programs should be exempted from the capital regulations or fractionalized in some way. (Similar arguments with different metrics could help borrowers with their own regulations, especially the net stable funding ratio.) That would be a huge incentive for banks to invest in the best possible risk management technology.
 
There is a solid logical basis to argue for regulatory capital relief resulting from superior risk management technology. There is also strong evidence to believe that banks would seek that relief, rather than repeal of Dodd-Frank regulations, based on the enormous post-crisis investment that banks have made in risk management and compliance systems.
 
According to one senior banker, “Agent lenders have made great strides in mitigating the perceived risks in securities lending especially in terms of cash reinvestment where most of the problems occurred during the financial crisis.  We focus on liquidity, concentration risks, diversity, as well as appropriateness of haircuts, collateral type, the mix of collateral – it goes on and on.”
 
That level of risk management is a big investment for any bank. But it’s not being considered as an offset against such capital impositions as the counterparty concentration limit, the leverage ratio, or other metrics that force capital to be reserved against off-balance sheet risks. 
 

  • Should not the merits of risk management investments be disclosed and their costs partly repaid by taxpayers in the form of capital relief?

 
Supervisors should have the ability to reduce the capital requirements for banks with above-average risk management systems in their business lines.  What does that mean in specific terms? Let’s look at one example:
 


Discussion: In securities finance, agent banks currently hold collateral against the securities that are loaned out for their customers. The agents’ risk management systems mark the collateral to market prices each day, but the details of the process can differ among banks. Sometimes the differences are subtle, visible only when comparing contractual commitments among agent banks. Perhaps a benchmark should be devised to show those differences – not to rate the contracts of individual customers, certainly, but to reveal an average for the bank itself, which may be kept confidential by supervisors, and, for all banks, as an information release to the public market.[5] 


 
Initial haircuts on collateral in securities lending may be standard, depending on the form, but the point can vary at which additional margin is demanded of the borrowers. Conceivably, any bank which allows collateral margins to fall below 100%, all else equal, would be taking more risk to offer its default indemnity. However, that bank might be in an excellent position to judge the exposure to its counterparty, more so than a universal statistic. Conversely, banks might be seen to take less risk when maintaining margins above the average. That adds protection against a taxpayer bailout, ultimately, but such a policy is also likely to make loans of easy-to-borrow securities less attractive to borrowers.
 
(These examples are merely illustrative to help consider options “outside the box” for regulatory capital reform. It may be far too difficult to collect the required metrics, compute the benchmarks and then analyze the results to be practical. Yet there must be a better system than the one that currently has resulted in so many unintended consequences. )
                                                                                                  

  • Why don’t capital rules allow for a reduction in risk-weighted capital requirements, to help offset the lost revenue and encourage more conservative collateral management?

 
Customer income and bank fees will fall if borrowers consistently avoid banks which enforce tough collateral margins. Still, that income drop is a normal risk-return outcome, well understood by customers and their bank relationship managers.


Discussion: In another example from securities finance, the trading desks of agent lenders generally hold a loan buffer that prevents the distribution of the total inventory of available positions in a securities issue. That’s useful in the case of a loan recall, when the customer has sold its position and needs the borrowed securities back to make delivery.  The buffer allows the agent bank to substitute another lender’s position, thereby obviating the need to close out the loan and return the borrower’s collateral. Buffers are clearly risk mitigants, since excessive recalls by lenders during a crisis would force the return of cash collateral and possibly lead to fire sales of longer-dated instruments. The buffers protect the taxpayer, but there’s an obvious opportunity cost to the customer and the bank that holds a substantial buffer. Fear of cascading fire sales is at the heart of the securities finance regulation, but none of these dynamics are currently being considered either in the details of the capital regulations or in the data collection process itself.
 


At present, the data aggregation process of global supervisors is focused on levels and loans. There’s very little data on collateral management, buffer maintenance or other dynamic metrics. But now may be the time to change that, along with a revision of the capital regulations. Banks that disclose the efficiency of their investments in risk-mitigating technology should be granted not only a market premium on their securities, but also consideration in relation to their capital requirements (and guidelines).
 

  • Dynamic metrics are far more relevant for understanding the levels of stability in securities finance than are static sizing and demographics alone.

 
There’s no question that the time is right for an enlightened construct to revise/replace the current macroprudential framework. In a January 31, 2017 letter to Federal Reserve Board Chair Janet Yellen, the House Republicans announced “a comprehensive review of past agreements that unfairly penalized the American financial systems in areas as varied as bank capital, insurance, derivatives, systemic risk, and asset management.”

There's more than one way to approach systemic risk mitigation so why not try capital relief and disclosure?

 
 
[3] Although the limits of Pillar 2 are not entirely clear, the Prudential Regulation Authority of the Bank of England’s Statement of Policy, dated July 2015 and updated 2016, makes no mention of any methodology used to lower the capital requirements set in Pillar 1 computations.
[4] Advocates for the new capital charges contend that the market has not priced the risk properly to date. Opponents show a long history without losses and reply, ‘Yes, it has.’
[5] However, the bank could elect on its own to release the comparative results in responding to customer requests for proposals or in other forums, should it so desire.

 

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative. 

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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