On February 25, Gary Gensler appeared before the Senate Committee on Agriculture, Nutrition & Forestry at a hearing on his nomination to be Chairman of the CFTC. The hearing went well for Mr. Gensler, and it is very likely that he will be confirmed.
Not surprisingly, Gensler stated that his views had “evolved” concerning OTC derivatives, since he was a Treasury Under Secretary advocating passage of the Commodity Futures Modernization Act of 2000. He stated that OTC derivatives dealers should be regulated but was careful not to specify under what statutory framework nor by which agency. Given that the Obama Administration will be making proposals concerning financial regulation, that was prudent on Gensler’s part.
He also spoke favorably concerning establishing clearinghouses for standardized products. That has become conventional Washington wisdom, though there may be some push back on mandating central counterparties by industry participants. Arguments against this include that the concentration of risk in a single entity is itself a source of systemic risk and that netting efficiencies may not be realized. (On the latter point, see this draft paper by Darrell Duffie and Haoxiang Zhu of Stanford University, “Does a Central Clearing Counterparty Reduce Counterparty Risk?") Arguments for a central counterparty include greater transparency, increased discipline (including consistent rules about the posting of collateral), operational efficiencies, and easier access by government regulators to information. In addition, regulators could exert more control over the market by regulating a clearinghouse and central counterparty, which, depending on who you are, is either a pro or a con.
Gensler went to great lengths to reassure the Senators that he would be a tough regulator. I see no reason not to believe him. The OTC derivatives industry will also likely not be entirely comfortable with him at the CFTC, though it is not clear at this point what the extent of his authority and influence on OTC derivatives policy issues will be.
What was somewhat surprising in the question and answer portion of the hearing was Gensler’s remarks about the price runup in tangible commodities prices, especially oil last summer. He stated that tangible commodities had come to be viewed as a separate asset class for those seeking diversification, and he said this was a major cause of the increase in prices. He also said that those who invested in commodities such as oil expected prices to increase, but like those investing in real estate, they proved to be “terribly wrong,” with adverse consequences for the American people.
The price of oil is notoriously volatile, and this has been true for a long time. It seems hard, though, to give credence to the argument that the futures markets were the cause of the increase in prices, if that is what Gensler meant. Something has to happen in the cash market for this to happen. The potential for or threat of delivery on the futures market is what causes the price of futures and the underlying cash commodity to be linked and to converge at maturity.
In this connection, Gensler talked about the Hunt Brothers and silver. It is true that the Hunt Brothers took large position in silver futures which eventually resulted in financial disaster for them when silver prices came crashing down from a high of about $50 an ounce in early 1980. But an important point to remember about that episode is that the Hunt Brothers were active in the cash market by buying physical silver and were taking delivery of silver on the futures market.
With respect to oil, it is a voluminous commodity for which there is limited storage capacity. As a CFTC economist once characterized it to me a long time ago, it is a “flow through” market. Once the oil is out of the ground and in the system of tankers, refineries, and delivery of refined products to users, it has to be kept moving and therefore sold at the market clearing price. Room has to be made for the oil that keeps coming. Very few market participants have the capacity to store a significant amount of oil somewhere and therefore drive up the price. If the futures market gets out of line with underlying cash market fundamentals, the likely result is that knowledgeable traders will take the opposite side of the trade, since they know the futures price has to converge with the cash market price. In other words, the explanation of the runup in oil price last summer has to be sought elsewhere than in the futures market.
Gensler went further in this discussion of tangible commodity prices and advocated position limits, thus implying that those in place are not tough enough. One hopes that this does not mean that the CFTC or the exchanges should use tools such as imposing stricter position limits in order to affect market prices. The CFTC prides itself on being a market neutral regulator. The futures markets, ignoring transaction costs, are a zero-sum game – the gains and losses exactly offset each other. The regulator should not be taking sides.
In any case, the imposition of stricter position limits on oil futures would be unlikely to affect the market price in any significant way. Also, the price of oil has come down – where is the chorus of complaints about the short sellers? – and OTC derivatives issues are more likely to be an immediate issue for Gensler, as well as the managing of the CFTC’s relationships with the SEC and the bank regulators.
Friday, February 27, 2009
Wednesday, February 18, 2009
Further Thougts on Financial Regulation
The ability of the federal and state governments to navigate the current economic and financial troubles is in some doubt. The U.S. Congress divided on partisan lines on the stimulus bill, and the political mess in Sacramento, which one can only hope does not lead to an avoidable economic disaster, does not make one sanguine about what may come next.
With emotions heightened by economic fears and distress, the issue of restructuring the financial regulatory system in the U.S. will be taken up, probably sometime this year. There will be demands to do something, but it will be difficult to agree on what that should be. The hope is that the necessity to compromise on legislation and incorporate ideas from people with different philosophies results in laws that are both widely accepted and effective. Sometimes, though, this results in poorly drafted and self-contradictory legislation, and the courts are left to sort out the resulting mess.
For example, the Commodity Exchange Act is a badly drafted statute, and has generated much litigation over its meaning, with the SEC and the CFTC often offering courts opposing briefs. The litigation reached the point of near absurdity, at least from this non-lawyer’s point of view, when a Supreme Court case hinged on the definition of the word “in.” The 1997 case, Dunn v. CFTC, concerned what would seem like a simple question – whether or not the CFTC had jurisdiction over OTC foreign currency options. But this question, and others revolving around the limits of CFTC jurisdiction over derivatives, consumed an inordinate amount of time and energy in disputes among government agencies and different industry groups for approximately 25 years. This is something to be avoided.
But will it be? The concern rises from both the charged political atmosphere and the Paulson Blueprint, which many think, or are hoping, will provide the framework for considering regulatory restructuring issues.
The difficulty of dealing with these issues in an atmosphere of economic fear and political calculations needs no explanation. It should be noted, though, that financial regulatory issues are often difficult to deal with, even in somewhat calmer times. The Gramm-Leach-Bliley Act, enacted in November 1999, for example, led to a long, bitter fight between the SEC and the bank regulators over what securities activities bank trust departments could engage in without triggering SEC broker-dealer registration and other requirements.
The Paulson Blueprint posits as the “long-term optimal regulatory structure” a regime governed by three “distinct” regulators. Each of these regulators would be focused on one of “three key” areas – market stability, prudential financial regulation for entities benefitting from government guarantees, and business conduct regulation. The market stability regulator would be the Federal Reserve; the two others would be newly created agencies. In addition, two other government agencies would be created – the “Federal Insurance Guarantee Corporation,” with very limited regulatory authority, and a “Corporate Finance Regulator.”
Part of the problem with this structure is the potential overlap in the three areas. For example, the catalyst for the current financial crisis was the problems with subprime mortgages. Extending mortgages to individuals for more than they could afford on the belief that a rising housing market would make everything all right, and in any case the mortgages would end up in someone else’s portfolio, would seem to be a business conduct issue. But it turned out to be also something that would involve prudential financial regulation and market stability. Who would be responsible for something like this under the new structure. What if the three regulators disagreed?
Another issue that raises some concern is the role of the Federal Reserve in this structure. It is clear why the Paulson Blueprint assigned the Fed this authority, since there is no clear alternative. The Treasury Department is not set up to do this, and it does not have the continuity in the most senior positions to perform this function with any degree of consistency over time.
The Fed, though, would be losing its current authority over Fed member state-chartered banks. It would be monitoring and gathering information on potential risks to the system, without being involved in the normal examination process. One could well imagine that the Fed would be looking for things to do, and that this would bring it in conflict with the other two regulators.
Moreover, many observers think the Federal Reserve has made some mistakes in recent years that have contributed to the current crisis. Arguably, interest rates were kept too low for too long, especially in the face of a housing bubble that the Fed was late to recognize, and it did not use its authority to curb abuses in subprime mortgage lending practices. While this will be debated, if the Fed’s monetary policy is mistaken at some future point and is leading to market instability, how can it adequately perform the role of market stability regulator? There is no good answer to this question, and, if one thinks that there should be a dedicated market stability regulator, the Fed is the logical choice, but there may need to be a change in the Fed’s structure to do this well. Or, one may want to rethink this issue.
The Paulson Blueprint appears to take a middle position between the very fractionated regulatory system in the U.S. and the single financial regulator in the U.K. Otherwise, the Blueprint likes the idea of “principles,” rather than rules-based regulation, said to be operative in the U.K. It is not totally clear what this distinction means, since the U.K.’s Financial Services Authority has issued plenty of rules, and, one hopes, financial rules are based on principles. At the time, “principles-based” regulation seemed to be easily deciphered code for lighter regulation, but that is clearly not going to happen any time soon.
In any case, both the U.S. and the U.K. regulatory structures did not perform well as the seeds of the current crisis were germinating. The current buzz phrase is “smart regulation,” as contrasted with tougher or weaker regulation. This sounds good, but what does it mean? No one is for stupid regulation.
The Administration and Congress should proceed carefully and thoughtfully as it considers regulatory structure and not pass something just so that they can say they did something. The U.S. regulatory structure was not planned and is the result of particular historical circumstances. It can be improved. But there are limits on what can be accomplished now to deal with future problems. We do not know what those will be, and ultimately we will depend on the people in power at the time to develop appropriate policy.
With emotions heightened by economic fears and distress, the issue of restructuring the financial regulatory system in the U.S. will be taken up, probably sometime this year. There will be demands to do something, but it will be difficult to agree on what that should be. The hope is that the necessity to compromise on legislation and incorporate ideas from people with different philosophies results in laws that are both widely accepted and effective. Sometimes, though, this results in poorly drafted and self-contradictory legislation, and the courts are left to sort out the resulting mess.
For example, the Commodity Exchange Act is a badly drafted statute, and has generated much litigation over its meaning, with the SEC and the CFTC often offering courts opposing briefs. The litigation reached the point of near absurdity, at least from this non-lawyer’s point of view, when a Supreme Court case hinged on the definition of the word “in.” The 1997 case, Dunn v. CFTC, concerned what would seem like a simple question – whether or not the CFTC had jurisdiction over OTC foreign currency options. But this question, and others revolving around the limits of CFTC jurisdiction over derivatives, consumed an inordinate amount of time and energy in disputes among government agencies and different industry groups for approximately 25 years. This is something to be avoided.
But will it be? The concern rises from both the charged political atmosphere and the Paulson Blueprint, which many think, or are hoping, will provide the framework for considering regulatory restructuring issues.
The difficulty of dealing with these issues in an atmosphere of economic fear and political calculations needs no explanation. It should be noted, though, that financial regulatory issues are often difficult to deal with, even in somewhat calmer times. The Gramm-Leach-Bliley Act, enacted in November 1999, for example, led to a long, bitter fight between the SEC and the bank regulators over what securities activities bank trust departments could engage in without triggering SEC broker-dealer registration and other requirements.
The Paulson Blueprint posits as the “long-term optimal regulatory structure” a regime governed by three “distinct” regulators. Each of these regulators would be focused on one of “three key” areas – market stability, prudential financial regulation for entities benefitting from government guarantees, and business conduct regulation. The market stability regulator would be the Federal Reserve; the two others would be newly created agencies. In addition, two other government agencies would be created – the “Federal Insurance Guarantee Corporation,” with very limited regulatory authority, and a “Corporate Finance Regulator.”
Part of the problem with this structure is the potential overlap in the three areas. For example, the catalyst for the current financial crisis was the problems with subprime mortgages. Extending mortgages to individuals for more than they could afford on the belief that a rising housing market would make everything all right, and in any case the mortgages would end up in someone else’s portfolio, would seem to be a business conduct issue. But it turned out to be also something that would involve prudential financial regulation and market stability. Who would be responsible for something like this under the new structure. What if the three regulators disagreed?
Another issue that raises some concern is the role of the Federal Reserve in this structure. It is clear why the Paulson Blueprint assigned the Fed this authority, since there is no clear alternative. The Treasury Department is not set up to do this, and it does not have the continuity in the most senior positions to perform this function with any degree of consistency over time.
The Fed, though, would be losing its current authority over Fed member state-chartered banks. It would be monitoring and gathering information on potential risks to the system, without being involved in the normal examination process. One could well imagine that the Fed would be looking for things to do, and that this would bring it in conflict with the other two regulators.
Moreover, many observers think the Federal Reserve has made some mistakes in recent years that have contributed to the current crisis. Arguably, interest rates were kept too low for too long, especially in the face of a housing bubble that the Fed was late to recognize, and it did not use its authority to curb abuses in subprime mortgage lending practices. While this will be debated, if the Fed’s monetary policy is mistaken at some future point and is leading to market instability, how can it adequately perform the role of market stability regulator? There is no good answer to this question, and, if one thinks that there should be a dedicated market stability regulator, the Fed is the logical choice, but there may need to be a change in the Fed’s structure to do this well. Or, one may want to rethink this issue.
The Paulson Blueprint appears to take a middle position between the very fractionated regulatory system in the U.S. and the single financial regulator in the U.K. Otherwise, the Blueprint likes the idea of “principles,” rather than rules-based regulation, said to be operative in the U.K. It is not totally clear what this distinction means, since the U.K.’s Financial Services Authority has issued plenty of rules, and, one hopes, financial rules are based on principles. At the time, “principles-based” regulation seemed to be easily deciphered code for lighter regulation, but that is clearly not going to happen any time soon.
In any case, both the U.S. and the U.K. regulatory structures did not perform well as the seeds of the current crisis were germinating. The current buzz phrase is “smart regulation,” as contrasted with tougher or weaker regulation. This sounds good, but what does it mean? No one is for stupid regulation.
The Administration and Congress should proceed carefully and thoughtfully as it considers regulatory structure and not pass something just so that they can say they did something. The U.S. regulatory structure was not planned and is the result of particular historical circumstances. It can be improved. But there are limits on what can be accomplished now to deal with future problems. We do not know what those will be, and ultimately we will depend on the people in power at the time to develop appropriate policy.
Wednesday, February 11, 2009
The Regulators’ Dilemma
Listening to the chatter about the economy, one could be excused from concluding that the problem is that Americans both do not save enough and do not consume enough. While we are taken to task for our low savings rate, arguments rage about how much of a tax rebate will be spent and, therefore, “stimulate” the economy. The politicians hope rebates will be spent, and the personal finance columnists urge that individuals use them to increase savings or pay down debt.
Remember the discussion of the “paradox of thrift” and the “fallacy of composition” in the Samuelson economics textbook that used to have a near monopoly for introductory economics courses. If each person acts in his best interest, this may not always serve the common good, it was argued. An example is everyone standing up to watch a critical play at a sporting event.
These concepts can be imported to the current banking situation. While part of the blame for the current financial crisis is ascribed to banks for lowering their credit standards and making risky loans, the banks are now being urged to make more loans. From the point of view of any particular bank, however, lending has gotten riskier given the state of the economy. Hence, having been burned on some of the loans and investments they made when times were good, they are understandably cautious in their lending activities now. The economy, though, could benefit from increased lending, thus serving to lower the overall default rate.
Given this, what is the federal government and the numerous regulators of banks supposed to do? Should they crack down on lending practices to make sure their charges do not get into further trouble, or should they somehow encourage increased lending? This dilemma may have been avoided if the regulators had been tougher when times were good, but then most people thought things would never get this bad.
Remember the discussion of the “paradox of thrift” and the “fallacy of composition” in the Samuelson economics textbook that used to have a near monopoly for introductory economics courses. If each person acts in his best interest, this may not always serve the common good, it was argued. An example is everyone standing up to watch a critical play at a sporting event.
These concepts can be imported to the current banking situation. While part of the blame for the current financial crisis is ascribed to banks for lowering their credit standards and making risky loans, the banks are now being urged to make more loans. From the point of view of any particular bank, however, lending has gotten riskier given the state of the economy. Hence, having been burned on some of the loans and investments they made when times were good, they are understandably cautious in their lending activities now. The economy, though, could benefit from increased lending, thus serving to lower the overall default rate.
Given this, what is the federal government and the numerous regulators of banks supposed to do? Should they crack down on lending practices to make sure their charges do not get into further trouble, or should they somehow encourage increased lending? This dilemma may have been avoided if the regulators had been tougher when times were good, but then most people thought things would never get this bad.
Wednesday, February 4, 2009
Organizational Boxes and the Limits of Financial Regulation
Now that it has happened, the current financial and economic crisis can be said to be overdetermined. Choose whom or what you want to blame – the Fed for keeping interest rates too low for too long and not using its existing authority to limit subprime mortgage abuses, financial market participants for employing excessive leverage and/or lax credit standards, Fannie Mae and Freddie Mac for undertaking too much risk with too little capital and contributing to the weakening of mortgage underwriting standards, novel financial products such as certain OTC derivatives and CDOs for creating hard to understand linkages among market participants and contributing to excessive risk-taking, regulators for failing to do their jobs, etc. It now all seems so clear that this was inevitable, but, before it happened, the consensus not so long ago was that the worst that could happen was perhaps a leveling off of housing prices and some containable problems with subprime mortgage defaults and foreclosures. Those predicting disaster were dismissed, at best, as having an interesting point of view.
In reaction to the current economic travails, there are calls for restructuring our financial regulatory system to make sure this does not happen again. Our financial regulatory system has some obvious flaws, and the performance of regulators has been less than optimum. The system could benefit from change. But we should not delude ourselves that there is some ideal regulatory structure that will prevent all further crises. After all, most people, in and out of government, missed that the financial system was waiting for a match, which turned out to be the problems in subprime mortgages, to start the forest fire with which we now have to contend. Moreover, neither the single regulator model in the U.K. nor the fragmented regulatory structure in the U.S. performed admirably as this crisis was developing.
In any case, regulatory restructuring will be difficult to accomplish. For evidence, just look at the Special Report on Regulatory Reform by the Congressional Oversight Panel (created by the TARP legislation). The three members of that panel appointed by Democrats approved the report, and the two members appointed by Republicans essentially produced another report. To compound ideological differences, there will also be turf considerations among Congressional committees and government agencies and the business interests of those subject to regulation as legislative proposals are considered.
An obvious problem that should be corrected at some point is the fragmented nature of bank regulation and the budgetary incentives for the Office of the Comptroller of the Currency and the Office of Thrift Supervision to retain the institutions they charter. But making wholesale regulatory reform as was done in the 30s should not be done in haste. Some consensus needs to be formed about what it is we expect from financial regulators.
An example of regulation that was done badly was the creation of the Office of Federal Housing Enterprise Oversight (“OFHEO”) in the early 1990s as the financial safety and soundness regulator of Fannie Mae and Freddie Mac. There was justifiable concern in the George H.W. Bush Administration about the risks these institutions posed to the financial system and to the federal government, which everyone knew would be called upon to help out if the firms got into financial trouble. But OFHEO failed. Fannie Mae and Freddie Mac became riskier, not safer, during the period they were regulated by OFHEO. The mistake of establishing a small regulator charged with overseeing two enormous and politically powerful entities is not likely to be repeated. But that does not mean other mistakes will not be.
Among other issues, careful thought is needed concerning how much power should be concentrated in one or several agencies, how to resolve issues of regulatory overlap if there is more than one agency, and the proper regulatory role of the central bank. Also the management of potential conflicts among agencies need to be considered, such as one agency charged with encouraging prudential lending practices and another agency concerned that a credit crunch is stifling economic growth.
In reaction to the current economic travails, there are calls for restructuring our financial regulatory system to make sure this does not happen again. Our financial regulatory system has some obvious flaws, and the performance of regulators has been less than optimum. The system could benefit from change. But we should not delude ourselves that there is some ideal regulatory structure that will prevent all further crises. After all, most people, in and out of government, missed that the financial system was waiting for a match, which turned out to be the problems in subprime mortgages, to start the forest fire with which we now have to contend. Moreover, neither the single regulator model in the U.K. nor the fragmented regulatory structure in the U.S. performed admirably as this crisis was developing.
In any case, regulatory restructuring will be difficult to accomplish. For evidence, just look at the Special Report on Regulatory Reform by the Congressional Oversight Panel (created by the TARP legislation). The three members of that panel appointed by Democrats approved the report, and the two members appointed by Republicans essentially produced another report. To compound ideological differences, there will also be turf considerations among Congressional committees and government agencies and the business interests of those subject to regulation as legislative proposals are considered.
An obvious problem that should be corrected at some point is the fragmented nature of bank regulation and the budgetary incentives for the Office of the Comptroller of the Currency and the Office of Thrift Supervision to retain the institutions they charter. But making wholesale regulatory reform as was done in the 30s should not be done in haste. Some consensus needs to be formed about what it is we expect from financial regulators.
An example of regulation that was done badly was the creation of the Office of Federal Housing Enterprise Oversight (“OFHEO”) in the early 1990s as the financial safety and soundness regulator of Fannie Mae and Freddie Mac. There was justifiable concern in the George H.W. Bush Administration about the risks these institutions posed to the financial system and to the federal government, which everyone knew would be called upon to help out if the firms got into financial trouble. But OFHEO failed. Fannie Mae and Freddie Mac became riskier, not safer, during the period they were regulated by OFHEO. The mistake of establishing a small regulator charged with overseeing two enormous and politically powerful entities is not likely to be repeated. But that does not mean other mistakes will not be.
Among other issues, careful thought is needed concerning how much power should be concentrated in one or several agencies, how to resolve issues of regulatory overlap if there is more than one agency, and the proper regulatory role of the central bank. Also the management of potential conflicts among agencies need to be considered, such as one agency charged with encouraging prudential lending practices and another agency concerned that a credit crunch is stifling economic growth.
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