Patomak CEO’s take on the Treasury capital markets report: a positive step toward reform, some weaknesses still need to be addressed
The Department of Treasury’s newly released 220-page report on reforming capital markets regulation should give investors, consumers, workers, small businesses, and the financial industry alike reason for optimism. After eight years of anemic economic growth, due largely to increased barriers to small business financing and accelerating regulatory complexity, the report sets forth a pragmatic approach to improving capital formation, expanding investor choice, and simplifying regulations.
The report was issued in response to a February Executive Order that requires Treasury to identify policies that could advance, or conflict with, the President’s “Core Principles” on financial regulation. These Core Principles include making regulation efficient, empowering American investors, ending taxpayer-funded bailouts, and improving the regulatory process. The report’s recommendations regarding expanding access to capital, securitization, and regulatory processes neatly align with the President’s objectives. Implementing many of these policies would fuel economic growth. Although the report’s recommendations on derivatives and equity market structure also largely go in the right direction, some are misguided or rather weak and need to be better supported or re-worked altogether. Unfortunately, the report’s section on so-called “financial market utilities” (FMUs) accepts failed regulatory approaches that are antithetical to the Core Principles. Despite shortcomings, overall, the report offers a positive and needed direction for reform.
Moving forward, Treasury has more work to do to determine how best to overhaul U.S. financial markets polices that conflict with the President’s Core Principles. For example, Dodd-Frank’s Financial Stability Oversight Council (FSOC) has virtually unchecked power to designate FMUs and other nonbank financial institutions (such as insurance companies and asset managers) as “systemically important” – an anti-competitive and costly “too-big-to-fail” label that brings about moral hazard and adds next to nothing to make the financial system more “stable.” Another of Dodd-Frank’s controversial provisions that conflicts with the President’s Core Principles is Orderly Liquidation Authority (OLA), which enables taxpayer bailouts of financial firms and is hardly orderly – its extrajudicial process places nonbank resolution in the hands of a bank regulator and its “single point of entry” strategy is based on unworkable assumptions.
Hopefully, needed reforms related to these issues will be endorsed in upcoming Treasury reports on asset management, insurance, FSOC, and OLA. Treasury should announce that it will drop its ongoing appeal of the strong March 2016 MetLife v. FSOC court ruling that limits one of FSOC’s sweeping designation powers. The decision to appeal is a holdover policy stance from the Obama Administration and many, such as Sen. Toomey (R-PA), have urged Treasury Secretary Steven Mnuchin to call the lawyers off. Treasury should also endorse Congress’s effort to rein in FSOC’s full suite of designation powers and end taxpayer-funded OLA bailouts. In the meantime, Treasury should overhaul guardrails on FSOC’s designation powers to require thorough ex ante economic analyses and do away with firm-specific designation.
An overview of some of the capital market report’s most positive components, and of policy areas still requiring Treasury’s attention, are listed below.
- Expanding access to capital. Treasury appropriately recognizes the huge decline in public companies and initial public offerings (IPOs) since the 1990s, and makes clear how shrinking access to public markets has harmed the general public. The report is right to call for policies that will improve the vitality of and access to capital markets, such as: (i) developing policy responses to the harmful market effects of anti-competitive proxy advisory firms; (ii) revising the $2,000 holding requirement for shareholder proposals; (iii) allowing dispute resolution between companies and shareholders via arbitration; (iv) expanding the accredited investor threshold; (v) enabling Exchange Act reporting companies to be Regulation A eligible; and (vi) implementing reforms to improve the market for Tier 2 offerings, such as increasing the offering limit to $75 million. The report also appropriately reinforces the importance of the materiality standard for corporate disclosures and recommends repealing provisions of the Dodd-Frank Act that require the disclosure of immaterial information related to conflict minerals, mine safety, resource extraction, and CEO pay ratios.
- Market structure. Friday’s report illustrates how the SEC’s 2005 Regulation NMS increased market complexity and harmed transparency – as Commissioner Cynthia Glassman and I warned would occur when we voted against the rule. Ill-defined broker best execution obligations and outdated regulations related to market data have resulted in substantial economic inefficiencies and distortions, with few benefits to show. The report rightly calls upon the SEC to consider amending Regulation NMS to increase competition. It also encourages a number of positive Regulation ATS reforms, including the elimination of unnecessary public disclosures of confidential information and the simplification of disclosures. To further improve market structure, Treasury makes the rather timid recommendation that the SEC “consider amending the Order Protection Rule to give protected quote status only to registered national securities exchanges that offer meaningful liquidity and opportunities for price improvement.” Such a Solomonic step would require continued discretionary line-drawing by the SEC, picking winners and losers, instead of an approach that would depart from the dirigiste philosophy of Regulation NMS by injecting more “market” into the capital markets. The current equities marketplace, which has benefited so much from technological innovation, is still subject to byzantine SEC rules, such as the system of “protected quotations,” which has led to atomization of the equities market, a dizzying array of order types, and inefficiencies for institutional trading and price discovery.
- Securitization. Treasury is right to call upon the SEC to simplify and improve the disclosure and reporting process for registered securitizations. It also appropriately advocates for regulators to “issue a broad qualified exemption for [collateralized loan obligation (CLO)] risk retention.” In 2013, CLOs provided nearly $300 billion in U.S. business financing, although issuances have declined in recent years due in part to regulatory pressures. Compared to mortgage-backed securitizations, CLOs performed quite well during the financial crisis, and are inherently less-risky given exposure only to senior, secured commercial loans. To alleviate unnecessary burdens on corporate borrowing, it makes sense for Treasury to recommend an exemption from Dodd-Frank’s risk retention standards for CLO managers who select loans that meet “qualified” standards set forth by regulators. Treasury also notes the impediments to securitization caused by bank regulators’ Liquidity Coverage Ratio (LCR), which precludes non-agency securitized products from being treated as Highly Qualified Liquid Assets (HQLA). However, rather than call for small tweaks to HQLA calculations, Treasury should reassess the efficacy of ill-conceived and costly Basel III bank liquidity regulations, and consider leading a push to abandon the LCR and its cousin the Net Stable Funding Ratio.
- Derivatives. Similarly, Friday’s report explains how, thanks to Basel III, U.S. bank rules inappropriately measure derivatives exposures through a so-called “current exposure method” (CEM), which over-estimates risk through prohibiting notional value measurements and requiring other overly-blunt approaches. Treasury is right to call for a more realistic approach to derivatives risk so that the CEM’s severe harm to derivatives market liquidity can be reversed; as the report explains, liquid derivatives markets are vitally important to the real economy. Treasury also appropriately recommends that the swap dealer de minimis registration threshold not fall below $8 billion. Moving forward, the CFTC should use swap data to make sure that this threshold is appropriately set. Treasury is also right to urge the SEC and CFTC to allow financial firms to comply with non-U.S. regulations in lieu of nearly-identical U.S. rules – poor CFTC cross-border coordination unnecessarily increased regulatory costs during the Obama years. Overall, the report’s derivatives-related recommendations go in the right direction, although some do not go far enough or are misguided. The report asks banking regulators to “consider providing” an exemption from certain initial margin requirements for uncleared swaps, which stem from costly Dodd-Frank rules and misguided international agreements. Instead, it should have called for stronger action, as these requirements discourage the utilization of uncleared swaps that can enable more precise risk management than standardized products. Most troubling, the report endorses unnecessary and inappropriate CFTC efforts to limit traders’ positions in certain commodities. The CFTC’s authority to do so was expanded by Dodd-Frank, but it is not required to act on this power, and its past attempt to do so was vacated in federal court. Indeed, as a leading derivatives markets economist explains, there is “no compelling theoretical or empirical case for limits on speculative derivatives positions.” The CFTC’s quest to define “excessive speculation” for purposes of this rule has wasted taxpayer resources.
- Financial market utilities. Needed policy reforms regarding FMUs are missing from Treasury’s capital markets report. It does not question the efficacy of the process by which the FSOC – a multi-regulator council created by Dodd-Frank – designates FMUs as “systemically important,” thus implicitly labeling these firms as “too-big-to-fail,” reducing competitiveness, and providing designated FMUs with access to Federal Reserve bailouts. Instead, Friday’s report calls on the Federal Reserve to explore reasons to expand Federal Reserve Bank account access for certain FMUs. The report also does not challenge the involvement of the FDIC in resolving FMUs through Dodd-Frank’s OLA, which as mentioned above, can force taxpayers to foot the bill for financial company bailouts. Hopefully, these stances are not signs of things to come in future Treasury reports on FSOC, OLA, and other areas of the financial system. Moving forward, Treasury should promote market stability by working to undo past FMU designations and reining in FSOC’s sweeping designation powers. Likewise, Treasury should endorse the Financial CHOICE Act’s plan to end FSOC designations, as well as its bankruptcy-oriented approach to resolving large, complex financial firms as a fairer, more effective replacement for OLA. In the meantime, Treasury should announce that it will charge a hefty penalty rate for obligations it purchases pursuant to OLA, in order to make sure taxpayers are not left on the hook.
- Regulatory processes. Treasury calls for sensible reforms to regulatory processes at the CFTC and SEC to curb excessive regulation-by-guidance and improve the quality of economic analyses produced during the rulemaking process. Reasonable policies endorsed by the Report include recommending that the CFTC and SEC: (i) enhance their use of cost-benefit analysis; (ii) avoid imposing new requirements via non-rulemaking processes such as no-action letters, interpretations, and other forms of guidance; (iii) conduct regular periodic, holistic reviews of the costs and benefits of existing regulations; and (iv) review existing guidance to determine potential sources of regulatory uncertainty and compliance costs. Similarly, what is good for the goose should be good for the gander: Treasury should require that the Financial Stability Oversight Council use rigorous enhanced economic analyses to inform its actions, and work to ensure that financial agencies – such as the Fed – with poor records of conducting economic analyses implement Treasury’s June 2017 recommendation to produce thorough ex ante cost-benefit analyses for major rulemakings.
Overall, despite some weaknesses, Treasury’s capital markets report is a welcome and substantial step towards undoing eight years of damage to capital formation and access caused during the past eight years by a mismanaged SEC, an unpredictable CFTC, and a misguided and unaccountable Federal Reserve.