Wednesday, June 15, 2016

Financial Choice

If you're interested in policy rather than politics, the package of legislative proposals coming out of Congress are a lot more interesting than the Presidential race at the moment. Speaker Paul Ryan is rolling out "A Better Way" package and Rep. Jeb Hensarling has just announced a "financial CHOICE act" to fundamentally reform Dodd-Frank. (Most quotes are from Jeb Hensarling's speech at the Economic Club of New York. See also  NYT coverage.)

These efforts will, I think, become much more important later on. The presidential race will decide whether this agenda can survive the instant veto that it faces now.  (This is a non-partisan comment. Hilary Clinton could likely assure a landslide by announcing she will work with Paul Ryan to craft and pass it.)

In any case, it defines a clear program that may be the focus of economic policy under a presidency of either party. And I think that's healthy as well.  We are still living in the shadows of Franklin Roosevelt's 100 days, and an increasingly imperial presidency. But the current need is not for a flurry of new legislation and executive orders to address a crisis. We need a steady clean-up of the legal and regulatory mess of the last few decades. For that project, it may be better for policy leadership to come from Congress, and by careful and patient drafting of actual legislation.

The legislation is still being drafted, which is why it would be lovely if more of the media and blogosphere were paying attention rather than to the latest antics of the presidential candidates. The congressional staff writing these things are paying attention and the proposals can be refined!

Today, a look at the Financial CHOICE act.

More capital, and the carrot of less regulation
...there is a growing consensus surrounding the idea of a tradeoff between heightened capital levels and a substantially lower regulatory burden....[We] will relieve financial institutions from regulations that create more burden than benefit in exchange for meeting higher, yet simple, capital requirements...Think of it as a market-based, equity financed Dodd-Frank off- ramp... the option remains with the bank.

How to measure capital? This is a hard nut.
...banks that maintain a simple leverage ratio of at least 10 percent and, at the time of the election, have a composite CAMELS rating of 1 or 2 may elect to be functionally exempt from the post-Dodd-Frank supervisory regime, the Basel III capital and liquidity standards, and a number of other regulatory burdens that pre-date Dodd-Frank. 
This is an element worthy of more discussion. Leverage ratios have problems too, as they do not distinguish the riskiness of assets.  CAMELS ratings have their own problems.

As blog readers know, I think we can keep going well beyond 10% capital. I'd like to see steady incentives for more and more capital, rather than an arbitrary threshold.  My current thinking leads to reducing subsidies for debt, a fee on short term debt, and using ratios of market value of equity to debt. Or a schedule of regulatory reductions: so much for 10% capital, more for 20% capital, do what you want at 100%. But we're in danger here of repeating a Libertarian party sort of fight whether there should be drivers' licenses in Nirvana, so let's leave this as an open question for refinement.

It seems natural to ask for more capital on riskier assets, but a beautiful paragraph on risk-weights explains why that doesn't work.
Risk-weighting is simply not as effective. First, it is far too complex, requiring millions of calculations to measure capital adequacy. Second, it confers a competitive advantage on those large financial institutions that have the resources to navigate its mind-numbing complexity. Third, regulators have managed to get the risk weights tragically wrong, for example, treating toxic mortgage-backed securities and Greek sovereign debt as essentially risk-free. One myopic globally imposed view of risk is itself risky. Finally, risk-weighting places regulators in the position of micro-managing financial institutions, which politicizes credit allocation. Witness the World Bank recently advertising its zero risk rating under the Basel Accords for their “green bonds.”
The regulatory carrot: A bank with enough capital
would be deemed “well capitalized” for prompt corrective action purposes; It would no longer be subject to Basel Committee capital or liquidity requirements as implemented by the U.S. banking regulators;  It would be able to make capital distributions freely; and would additionally be able to consummate transactions without being subject to the regulatory challenge of increasing risk to the stability of our banking or financial system, or on grounds related to capital or liquidity standards of concentrations of deposits or assets. 
... no Federal rule establishing “heightened prudential standards” of the type provided for in Dodd-Frank would apply to qualifying banking organizations, including the living will requirement...In short, a strongly capitalized qualifying bank will be enabled to remove government bureaucrats from its boardroom and lend and invest freely.
From the executive summary,
Exempt banking organizations that have made a qualifying capital election from any federal law, rule, or regulation that permits a banking agency to consider risk “to the stability of the United States banking or financial system,” added to various federal banking laws by Section 604 of the Dodd-Frank Act, when reviewing an application to consummate a transaction or commence an activity.
A linguistic note: Not once in this speech, except while quoting others, does Rep. Hensarling use the phrase "to hold" capital. Every instance is "raise" capital. And explicitly, 
equity capital can be put to work no differently than debt or deposits. It is not money put under a mattress.
And as to the ballyhooed impossibility of raising capital, 
U.S. banks have raised hundreds of billions in new capital
Who says nobody in Congress understands finance!

Bankruptcy; no more "designation"  

The centerpiece of Dodd-Frank is the FSOC (Financial Stability Oversight Council's) ability to "designate" a firm as "systemically important," and then to "resolve" it, in place of bankruptcy.  This will go.
...bankruptcy, not bailouts. Recently the House passed the bipartisan Financial Institution Bankruptcy Act, which creates a new subchapter of the Bankruptcy Code tailored to specifically address the failure of a large, complex financial institution.....
The speech goes on with several good reasons bankruptcy is better than resolution.  I hear cheering from John Taylor's office already.
 Retroactively repeal the authority of the Financial Stability Oversight Council (FSOC) to designate firms as systematically important financial institutions (SIFIs) 
Fed Lending
...we impose on the Fed Bagehot’s famous dictum: lend freely, but only to solvent institutions, only against sound collateral, and only at interest rates high enough to dissuade those who are not genuinely in need. 
I'm a little leery of this one. Dictums are not analysis. If you want to stop a run, you have to lend pretty freely. Private institutions like a clearinghouse to do that once existed, but they have been put out of business by the Fed.  Nobody knows who is solvent vs. illiquid; the point of a run is that collateral that was "sound" yesterday is not today.  And if you want to stop a run, who cares if it's insolvent or illiquid? The Fed doesn't need quickly salable collateral, being super senior in bankruptcy is enough.  Bagehot's dictum is a great way to run a hedge fund. It's not necessarily the right way to run a central bank.

I worry that we are headed for the worst of all worlds -- people expect bailouts and free fed lending, but the government is legally constrained from doing so. All the moral hazard and none of the crisis mop. If we're going to go in this direction, it has to be crystal clear to people running banks that the government will not be able to step in next time, even stretching laws, and they'd better set things up carefully ahead of time. I'm afraid people are not going to believe any legal restrictions.

Rule of Law

Some of the most interesting parts of this proposal really belong together in "restoring the rule of law to regulation." That's a big project that I hear simmering in much of this Congressional planning. And, based on the daily news (for example the latest on the FCC takeover of the internet) not a minute too soon.


The "Consumer Financial Protection Bureau" is out of control.
fundamentally reforming the CFPB......task it with the dual mission of consumer protection and competitive markets, with a cost-benefit analysis of rules performed by an Office of Economic Analysis. 
 Replace the current single director with a bipartisan, five-member commission which is subject to congressional oversight and appropriations. 
... Repeal authority to ban bank products or services it deems “abusive” and its authority to prohibit arbitration. ... Repeal indirect auto lending guidance.
Federal Reserve 

One of the most thought-provoking proposals splits the Federal Reserve's regulatory power from its monetary policy power. It puts bank regulation, like all regulation, in the rule-of-law framework that is supposed to exist for regulation: cost-benefit analysis, Administrative Procedures Act, Congressional oversight, and so forth. Various quotes: 
Require that the different sets of conditions under which stress tests are evaluated subject to notice and comment period. 
... makes sure every financial regulation passes a rigorous cost-benefit test... 
We will put all the financial regulatory agencies on budget. The bare minimum level of accountability to “We the People” is to have their elected representatives in Congress control the power of the purse, as inscribed in our Constitution. 
But, wisely,
protects the Federal Reserve’s independence in conducting monetary policy by leaving that function off-budget. The Fed’s prudential regulatory and financial supervision activities, however, will now be subject to the normal and transparent congressional appropriations process.
...due process rights. Too many citizens have been “shook down” or abused by their government. Thus we will provide an immediate right of removal to federal court for respondents in administrative proceedings.  We will ensure that disciplinary proceedings are public, that all fines imposed by regulatory agencies are sent to the Treasury for deficit reduction, that regulatory entities created by Congress are subject to full congressional oversight, and that other due process rights are strengthened.
There is a curious section on increasing the SEC's power:
the Financial CHOICE Act will impose the toughest penalties in history for financial fraud, self- dealing and deception.
We will double the cap for the most serious securities law violations and will allow for triple monetary fines when penalties are tied to illegal profits. We will give the SEC new authority to impose sanctions more closely linked to investor losses – and increase punishments even more for repeat offenders. We will increase the maximum criminal fines for both individuals and firms that engage in insider trading.
I'm not aware of a big problem in the SEC (and DOJ) not being able to ruin people's lives adequately, or extort large enough settlements from banks. Perhaps this is an olive branch, which won't hurt much.

Broader project

A sense of the broader project to restore rule of law in regulation.
Dodd-Frank gives FSOC the ability to designate companies as Too Big to Fail if it “determines that material financial distress” at the company “could pose a threat to the financial stability of the United States.” But nowhere in Dodd-Frank, or anywhere else in the U.S. Code for that matter, are these terms defined. So by defining these vague terms in any fashion that pleases them, this “super-group” of regulators can exert ultimate functional control over almost any large financial firm in our economy, and do so with utter disregard for due process. This is not the rule of law; it is the rule of rulers, and it’s an anathema to a free and democratic society.... 
Next, we repeal the Chevron doctrine requiring the judiciary to give deference to financial regulatory agencies’ interpretation of the law. The doctrine is unfair and an affront to due process and justice. 
I've gone on long enough. Legislation needs a public comment mechanism too, as this is  a big package, which though on a very good track can surely be refined a bit.


  1. John,

    "We need a steady clean-up of the legal and regulatory mess of the last few decades. For that project, it may be better for policy leadership to come from Congress, and by careful and patient drafting of actual legislation."

    Okay, put the private banking system and the Federal Reserve out of business by going back to fiat currency issued by the Treasury and have Congress just set the quantity of dollars in circulation.

    No need to worry about bank debt / equity ratios, capital requirements, and all that nonsense. Suddenly, we can now trust Congress to do the right thing. Except the polls say otherwise:

    June 2016 - U. S. Congress - 80% disapproval rating

    One final comment from above:

    "We are still living in the shadows of Franklin Roosevelt's 100 days, and an increasingly imperial presidency."

    The only reason Roosevelt was able to pass so much legislation was that the Democrats had a significant majority in Congress. Don't expect that situation again.

    1. Confirmation:

      "...Democratic voters have never been more concentrated in big urban areas than they are now. In 2012, President Obama won by 126 electoral votes while carrying just 22 percent of America’s counties — even fewer than losing Democratic nominee Michael Dukakis’s 26 percent in 1988. That means Democrats are wasting more votes than ever in safe congressional districts they already hold..."

  2. 1) 10% capital is ridiculous. Most banks have more than that today. Getting rid of all regulations for that is a free lunch for banks.

    2) And surprise, surprise - he is being financed by the banks!

    3) What exactly is the evidence that all these financial regulations are so bad for the economy?

    4) " notice and comment " period on the stress tests -> great, let's create a two-year delay. With financial innovation, it's a huge problem that all new guidances take forever to be approved.

    5) One key reason financial regulation doesn't work well in the US is fragmentation. Too many agencies, none of which has clear responsibility and powers. Surprise - not a word about that.

    6) Overall the bill seems just like a free-for-all for banks.

    1. Deutsche Bank has 20 billion market value of equity and some 2 trillion total assets - they'd love to get to your ridiculous 10% equity capital. Recently they've taken to gallows humor, picturing themselves in Dante's lowest pit of hell alongside others charging interest Dante never thought of negative rates, mind you, maybe that's the way to salvation.

  3. This project seems to be a self indulgent distraction for Congress. They should get on with finalizing a budget and putting forward a formal plan for ObamaCare before starting on these new projects.

  4. Prof. Cochrane - nobody said it's impossible to raise equity capital, only that its cost is very high relative to debt. You recall of course the part of MM on higher equity ratios making both equity and debt less risky and therefore less expensive?

    It may not be risk of default that is increasing, but rather the price of risk itself (a calculation similar to the excessive bond premium calculations. Truly I hope you'll address this point. Thank you.

  5. John,

    I am less sanguine on the penalty enhancements, see my Forbes piece here:



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