Economics of Contempt

Speaking of Sheila Bair, she recently floated the idea of forcing the big banks to ringfence their investment banking affiliates. This would primarily affect the universal banks, so as a practical matter we’re really talking about JPMorgan, BofA, and Citi.

Bair only has a couple months left on her term at the FDIC, so it’s understandable that she would want to put this idea out there before she leaves. She wants to ensure that the idea is at least in the mix, even though she knows it’s premature. Hence the very preliminary language she used — saying merely that she’d “like to get some public comment on the idea” of ringfencing.

Her point has been that we may need to make structural changes to the big banks if, after getting all the necessary information through the “resolution plan” process, the FDIC concludes that there’s simply no way to successfully resolve the big universal banks without structural changes. But we haven’t gone through the resolution plan process yet (the rules are still being written), so the FDIC doesn’t have nearly enough information yet to say definitively that structural changes need to be made, let alone what structural changes (e.g., ringfencing) are necessary to make them resolvable.*

Bair is essentially providing cover for her successor, should he/she end up deciding, after going through the resolution plan process, that something like ringfencing is necessary to make the big banks resolvable. By raising the possibility of ringfencing now, she’ll make it easier for her successor (rumored to be longtime Hill aide Martin Gruenberg) to propose ringfencing in the future without it coming as a huge shock and being dismissed out of hand. That’s probably a shrewd move. But I think that’s clearly all that Bair was trying to accomplish.

* I think the resolution plan process will ultimately force the big banks to make changes, but that the changes will be on an institution-by-institution basis. With the possible exception of JPMorgan and Bank of New York, I don’t think any real structural changes will need to be made, since the resolution authority can absolutely work on the dealers.

I know that Yves has a post claiming that the FDIC’s hypothetical Lehman resolution wouldn’t work, but her analysis is quite flawed. Among the myriad mistakes in the post, she and Satyajit Das both invoke scary-sounding cross-jurisdictional problems that simply wouldn’t arise under the resolution authority — since Lehman’s London broker-dealer (LBIE) was funded almost entirely by the holding company (LBHI), selling LBHI to Barclays under the resolution authority would have obviated the need for LBIE to file for bankruptcy in the UK. That’s, umm, kind of the point of the resolution authority.

The WSJ says that it’s “not aware of any governments that have ever asked clearinghouses to manage risks as complicated as those mandated by Dodd-Frank.”

That’s funny, because we still don’t know what financial instruments will be subject to Dodd-Frank’s clearing requirement yet! So how does the WSJ know how complicated the risks that clearinghouses will be asked to manage are? They don’t. The CFTC and the SEC don’t even know yet. The WSJ is just making things up.

This is like the people who make the fairly simple and widely-understood point that clearinghouses don’t work well for illiquid or bespoke instruments, and then claim that because of this, Dodd-Frank’s clearing requirement was a bad idea. They apparently don’t have the patience to wait to see which instruments the CFTC and the SEC decide have to be cleared — they want to demagogue the clearing requirement, and they want to demagogue it now, dammit!

I found this WSJ article on the “new Dodd-Frank lexicon” amusing, since I actually am one of “the small army of lawyers, lobbyists and regulators who speak fluent Dodd-Frank.” That of course means that I have a fancy hard-copy of Dodd-Frank in my office, and an even fancier electronic (PDF) copy. Since I know a lot of lawyers in the financial services area read this blog, as well as non-lawyers who are interested in financial reform, I’ve uploaded my fancy electronic copy of Dodd-Frank here (and embedded below).

By “fancy,” I mean a PDF of Dodd-Frank that has bookmarks to every title, subtitle, and section (and even some subsections) in the law; is fully tagged, so you can copy-and-paste from it without any screwy line breaks; and perhaps most importantly, scales-up the Government Printing Office’s text size (since the tiny text size and unreasonably large page margins make the GPO’s official version practically unreadable). That may all seem trivial, but when you need to be able to quickly locate a specific section in an 848-page bill, having bookmarks to every single section makes a huge difference.

So there, now everyone can benefit from all that expensive software my firm uses for PDFs (which mainly consists of various Evermap products, I believe), as well as the incredible PDF skills of my indispensable assistant.

Dodd-Frank - Full (July 21, 2010)

The White House is evidently having trouble finding a nominee for director of the Consumer Financial Protection Bureau* (CFPB). The list of people who have passed on the job includes former Michigan Gov. Jennifer Granholm, former Sen. Ted Kaufman, Massachusetts AG Martha Coakley, Iowa AG Tom Miller, and Illinois AG Lisa Madigan.

Elizabeth Warren, who is currently setting up the CFPB as a “Special Advisor” to the Treasury Secretary, just can’t get the 60 votes required for Senate confirmation. She couldn’t get 60 votes last year, when there were 59 Dems in the Senate — and she even “made the rounds on the Hill herself to check the math, but she came away with the same conclusion: There was no path to 60.” So her chances of getting 60 votes now that there are only 53 Dems in the Senate are somewhere between exceedingly slim and none. Obama could technically recess appoint Warren, and while the chances of that happening have probably gone up, I’d still be very surprised if he did.

I think Obama should seriously consider Sheila Bair for the CFPB job. As a preliminary matter, she can definitely get 60 votes in the Senate. I know that Chris Dodd approached her last year about the job, and she said she wasn’t interested, but that was then. She still had a year left at the FDIC when Dodd approached her. Now, with only a couple months left at the FDIC, she might be more receptive. Plus, a personal appeal from the president is pretty hard to turn down. (Or so I hear — no president has ever made a personal appeal for my help, because they’re all jerks, and I never wanted to be their friend anyway.)

I haven’t been the biggest Sheila Bair fan in the past, but I’ve more or less made my peace with Bair. I still think she’s a self-promoter, and cares too much about her image in the media. But, to her credit, when it comes down to brass tacks on issues that really matter, she always ends up doing/saying the right thing rather than the popular thing.

Bair is also fiercely territorial, which sometimes bleeds into parochial. During the financial crisis, this was supremely unhelpful. But I think this would be one of her greatest strengths as the CFPB director. Given the CFPB’s bizarre legislative structure, in which the Financial Stability Oversight Council (FSOC) can veto the CFPB’s rulemakings, you want a CFPB director who is territorial, and maybe even a bit parochial. The whole purpose of setting up the CFPB was to establish an agency that has a singular focus: protecting consumers. I think this is necessary as a counterweight to banks and non-bank lenders, who have a massive informational advantage over retail consumers. In order to be that counterweight, the CFPB would really benefit from a director who only cares about her own agency.

* According to the statutory text, it’s technically called the “Bureau of Consumer Financial Protection,” which would make it the BCFP. But that’s stupid, and everyone, including the agency itself, calls it the CFPB. Put this one on the “to do” list for the technical corrections bill.

The 2012 Republican primary is starting to heat up, so I want to get my early 2012 predictions out there. A lot of people don’t like to make concrete predictions this early, for fear of being wrong and then ridiculed in the future. I like to make super-early predictions though. I’ve been wrong about politics before, and I fully recognize that this post may look ridiculous in 18 months. But I do follow this stuff very closely, and I like to think I have a decent political sense. Anyway, on to the predictions.

I think the Republican presidential primary will essentially be a two-man race between Huckabee and Romney. After splitting the early states, I think Huckabee winds up winning the nomination. Huckabee, Romney, and Haley Barbour are the only candidates who can raise real top-tier money. (I’m excluding Sarah Palin because I don’t think she’ll run, but if she does run, then obviously she’ll be able to raise top-tier money too.) Barbour doesn’t have the name recognition or the charm of Huckabee and Romney, and Republican primary voters do tend to nominate candidates who are viewed as having waited their turn. Also, the mainstream media doesn’t respect Barbour; they view him as a crazy, confederate-flag-waving good ol’ boy, and fair or not, that’s how he’ll be portrayed. In addition to Palin, I don’t think Newt Gingrich, Mitch Daniels, or Chris Christie will run. I think Ron Paul will run though. And I think Jon Huntsman will run, but drop out early (he’s setting himself up for 2016, where he could legitimately be dangerous).

Of course, this assumes that Huckabee runs, which he may not. I think he will run, but if he doesn’t, then obviously I think Romney gets the nomination. Either way, the Republican primary is going to be a truly sad spectacle, as the candidates try desperately to out-crazy each other for months on end.

In the general election, I’m actually more scared of Romney than Huckabee. In 2008, I really wanted Romney to get the Republican nomination, because I thought there was just no way that the American voters elect a Mormon president. In 2012, I think the right’s blind anti-Obama rage will cause them to turn out in droves for any Republican nominee — even a Mormon. And Romney’s business background, his experience as a moderate Republican governor of a liberal state, and the fact that he looks extremely presidential (which is sadly an important factor), has the potential to win over Independents. Huckabee, however, will undoubtedly shoot himself in the foot several times in the general election (“discipline” isn’t his forté).

Regardless of who wins the Republican nomination, I think it’s highly likely that Obama will win re-election. Incumbent presidents have a huge advantage with Independents, who already view Obama as a very cerebral person. The circus in the Republican primary will scare most disaffected liberals back into Obama’s corner too. (I do think liberals will revolt against an incumbent Democratic president eventually, but it won’t be Obama.)

Of course, I also hope that this is how the election plays out. As I’ve said before, I’m a Democrat, and an Obama supporter. I voted for him in 2008, gave a not-insubstantial amount of my wife’s money to his campaign and campaign-related groups, and I plan to do the same thing in this election cycle. (I’m something of an easy target for Democratic fundraisers.)

There are certainly things that Obama’s done that I disagree with — first and foremost, the hiring of Rahm as chief of staff. On the other hand, Obama’s administration did address the subject I know by far the most about, and around which I’ve spent almost my entire professional life (financial reform), and I think they handled it very well. No, scratch that, I know they handled it very well.

Moreover, I also recognize that in a lot of decisions, if not most decisions, Obama has significantly more information than we do. That’s just a reality, and one that you can’t ignore. Unfortunately, it’s something I think a lot of Democrats are ignoring, since it’s deeply unsatisfying for people — and especially for people interested in politics — to say, “I don’t know if Obama made the right decision on X, because I don’t have all the information, and he does.” Given that Obama has vastly more information than we do, it’s sometimes (though not all the time) necessarily a matter of whether you trust his judgment. At this point, I still do. That may change in the future, but that’s where I stand right now.

JPMorgan CEO Jamie Dimon’s annual letter to shareholders spends a good deal of time on Dodd-Frank. None of his analysis is particularly insightful — the only thing I learned is that Dimon isn’t a great writer. Nevertheless, Dimon is an influential and ambitious figure, so it’s interesting to see how he presents his thinking on some of these issues. (As should be obvious, I don’t own shares in JPMorgan.)

On the CFPB, Dimon claims that JPMorgan was never really against the creation of a CFPB, just against the creation of a CFPB that might, you know, do stuff that JPMorgan doesn’t like:

We need to create a Consumer Financial Protection Bureau that is effective for both consumers and banks

It has been widely reported that we were against the creation of a Consumer Financial Protection Bureau (CFPB). We were not – we were against the creation of a standalone CFPB, operating separately and apart from whatever regulatory agency already had oversight authority over banks. We thought that a CFPB should have been housed within the banking regulators and with proper authority within that regulator. This would have avoided the overlap, confusion and bureaucracy created by competing agencies.

However, we fully acknowledge that there were many good reasons that led to the creation of the CFPB and believe that if the CFPB does its job well, the agency will benefit American consumers and the system. Strong regulatory standards, adequate review of new products and transparency to consumers all are good things. Indeed, had there been stronger standards in the mortgage markets, one huge cause of the recent crisis might have been avoided. Other countries with stricter limits on mortgages, such as higher loan-to-value ratios, didn’t experience a mortgage crisis comparable with ours. As recently as five years ago, most Americans would have called the U.S. mortgage market one of the best in the world — boy, was that wrong! What happened to our system did not work well for any market participant — lender or borrower — and a careful rewriting of the rules would benefit all.

Dimon is not a fan of Blanche Lincoln’s infamous Section 716 (and in spite of his rhetoric, he’s right about this). Remember when Blanche Lincoln had convinced people that a provision that her Ag Committee staffer threw in at the last second was The Most Important Banking Reform Ever? Anyway, here’s Dimon:

Finally, there is a truly misguided element of Dodd-Frank regarding derivatives. This so-called “spin-out provision” requires firms like ours to move credit, equity and commodity derivatives outside the bank. This requirement necessitates our creating a separately capitalized subsidiary and requiring our clients to establish new legal contracts with this new subsidiary. This is an operational nightmare (which we can handle) but makes it harder to service clients. It runs completely counter to recent efforts by regulators to reduce banks’ exposure to counterparty default. This provision creates a lot of costs and no benefits. We believe that it makes our system riskier — not safer.

On the Volcker Rule, Dimon claims not to care about the prop trading ban, but — surprise, surprise — is ultra-defensive of market-making:

The Volcker Rule needs to leave ample room for market-making — the lifeblood of our capital markets

The Volcker Rule has various components. We have no issue with two of these: the component eliminating pure proprietary trading; and the component limiting banks from investing substantial amounts of their own capital into hedge funds.

Our concern largely is with a third aspect regarding capital and market-making. It’s critical that the rules regarding market-making allow properly priced risk to be taken so we can serve clients and maintain liquidity. The recently proposed higher capital and liquidity standards for market-making operations — the new Basel II and Basel III capital rules — approximately triple the amount of regulatory capital for trading portfolios inclusive of market-making and hedging activities. For the most part, these capital rules protect against excessive risk taking. We don’t believe any additional rules are needed, under the Volcker Rule or otherwise. However, if there must be more rules, these rules need to be carefully constructed (e.g., they should distinguish between liquid and illiquid securities, allow for hedging either on a specific-name or portfolio basis, etc.). When market-makers are able to aggressively buy and sell securities in size, investors are able to get the best possible prices for their securities.

On the resolution authority, Dimon thinks preferreds and unsecured debt should be automatically converted to equity:

Resolution Authority needs to be properly designed

Simply put, Resolution Authority essentially provides a bankruptcy process for big banks that is controlled and minimizes damage to the economy. We made a mistake when we called this aspect of financial reform “Resolution Authority,” which sounds to the general public very much like a bailout. Perhaps a better name for it would have been “Minimally Damaging Bankruptcy For Big Dumb Banks” (MDBFBDB). Banks entering this process should do so with the understanding and certainty that the equity will be wiped out, the clawbacks on compensation will be fully invoked, and the company will be dismembered and eventually sold or liquidated.

When the FDIC takes over a bank, it has full authority to fire the management and Board of Directors and wipe out equity and unsecured debt — in a way that does not damage the economy. Controlled failure of large financial institutions should work the same way. It is complex because these companies are big and global and require international coordination. However, if the process is carefully constructed (and completely apolitical), controlled failure can be achieved.

In the process, the role of preferred equity and unsecured debt needs to be clarified. This may require corresponding accounting changes. My preference would be, at the point of failure, to convert preferred equity and unsecured debt to pure, new common equity. For example: When Lehman went bankrupt, it had $26 billion of equity and $128 billion of unsecured debt. If, on the day of bankruptcy, the regulators had converted that unsecured debt to equity, Lehman would have been massively overcapitalized and possibly able to secure funding to continue its operations and meet its obligations. The process to sell or liquidate the company would have been far more orderly. And the effect on the global economy would have been less damaging.

I think Deutsche Bank's latest reorganization may be too clever by half. Deutsche Bank currently has a US bank holding company (BHC) called Taunus, which houses its US banking unit (Deutsche Bank Trust Corp.), its US broker-dealer (Deutsche Bank Securities, Inc.), and various other US nonbank financial firms. Taunus has a combined $373bn in assets, of which only about $18bn come from its US banking unit. In order to avoid being subject to the Collins Amendment, which requires all US bank holding companies to maintain the same capital ratios as US depository institutions (the horror!), Deutsche Bank is planning to move its US banking unit out of Taunus, and then to deregister Taunus as a BHC.

This, Deutsche Bank apparently reasons, will allow Taunus to escape the Collins Amendment (§ 171 of Dodd-Frank). Is Deutsche Bank right? Probably not. The Collins amendment doesn't just apply to US bank holding companies. Read the statute. Section 171(b)(2) provides: (empashsis mine)

(2) MINIMUM RISK-BASED CAPITAL REQUIREMENTS.—The appropriate Federal banking agencies shall establish minimum risk-based capital requirements on a consolidated basis for insured depository institutions, depository institution holding companies, and nonbank financial companies supervised by the Board of Governors. The minimum risk-based capital requirements established under this paragraph shall not be less than the generally applicable risk-based capital requirements, which shall serve as a floor for any capital requirements that the agency may require, nor quantitatively lower than the generally applicable risk-based capital requirements that were in effect for insured depository institutions as of the date of enactment of this Act.

"Nonbank financial companies supervised by the Board of Governors" are nonbank financial companies that the Financial Stability Oversight Council (FSOC) has deemed "systemically important" under § 113 of Dodd-Frank. So Taunus can only escape the Collins Amendment if it's not a BHC or a "systemically important" nonbank financial company.

The problem is that after deregistering as a BHC, Taunus will almost certainly be deemed "systemically important" by the FSOC. To argue that Deutsche Bank's US broker-dealer — one of the biggest, baddest dealers on the Street, and a major player in the derivatives markets — isn't systemically important would be beyond ridiculous. I simply cannot conceive of a scenario in which the FSOC doesn't designate Taunus systemically important. Thus, deregistering Taunus as a BHC will not allow Taunus to avoid the Collins Amendment.

Now, it's true that § 165 allows the Fed to tailor the capital requirements of systemically important nonbanks (bank-like capital requirements might not be appropriate for certain types of nonbank financial companies). The interaction between § 171 and § 165 is unclear, and is subject to some dispute. However, the most natural reading is that § 171 establishes a floor on the capital requirements for systemically important nonbanks — they have to at least be equal to the capital requirements for US depository institutions — and that § 165 allows the Fed to tailor the capital requirements for nonbank financial companies above that floor.

Deutsche Bank seems to be betting that: (a) § 165 trumps § 171 outright; and (b) the Fed will use its discretion in tailoring the enhanced capital requirements under § 165 to permit Taunus to hold significantly less capital. I think that's a bet they're likely to lose. The view that § 165 trumps § 171 outright rests on a very strained interpretation of the law — the language of § 171 is very explicit. If that is indeed what Deutsche Bank is banking on, then I think they're getting very bad advice.

As I’ve said before, I’ve become a big fan of the “resolution plans” (a.k.a., “living wills”) that Dodd-Frank requires. They’ll be enormously useful in resolving large financial institutions under the new resolution authority, primarily because they’ll ensure that regulators have all the information they need to actually execute a smooth resolution of a major bank (e.g., organizational structure, funding practices, trading systems, major counterparties).

Resolution plans are one of those things that have the potential to be incredibly important, but that you could also see regulators basically ignoring — that is, requiring the minimum amount of information, or allowing banks to include only publicly available information, or something like that. For resolution plans to be as important as I think they can be, the regulators absolutely have to take them seriously.

The Fed and FDIC approved a joint proposed rule on resolution plans earlier this week, and I’m pleased to report that they’re clearly taking resolution plans very seriously — and then some. These are going to be substantial documents. It’s going to require a lot of work for banks to put these resolution plans together. The proposed rule requires a ton of information, covering all major aspects of the whole financial institution, and I haven’t thought of any area that they’ve missed.

This is just one paragraph from the overview of the informational content of the resolution plans:

The information regarding the Covered Company’s overall organization structure and related information should include a hierarchical list of all material entities, jurisdictional and ownership information. This information should be mapped to core business lines and critical operations. An unconsolidated balance sheet for the Covered Company and a consolidating schedule for all entities that are subject to consolidation should be provided. The Resolution Plan should include information regarding material assets, liabilities, derivatives, hedges, capital and funding sources and major counterparties. Material assets and liabilities should be mapped to material entities along with location information. An analysis of whether the bankruptcy of a major counterparty would likely have an adverse effect on and result in the material financial distress or failure of the Covered Company should also be included. Trading, payment, clearing and settlement systems utilized by the Covered Company should be identified.

Seriously, good luck with that, guys. (I’m glad I’m not in-house anymore, because with my luck, I just know I would’ve been asked to do this. Although my old bank was actually quite good at maintaining this kind of firm-wide information, so it might not have been that bad. Plus, I would’ve delegated the crap out of it.)

I do have two complaints though. Both relate to the other major aspect of the resolution plan — the part where the financial institution describes how it can be resolved in an orderly manner. Now, I already think that this aspect of the resolution plan will be less useful, simply because the structure of every resolution/bankruptcy/restructuring depends critically on the specific circumstances the institution faces at the time. It’s impossible to know who the potential buyers will be, because whether another institution is interested in the acquisition depends on its own health, including how well it could manage the fallout from a major bank being resolved under the resolution authority. And the identity of the acquirer absolutely drives the structure of any deal.

That said, I don’t think this aspect of the resolution plan will be completely useless. Regulators could glean some legitimate insights from the financial institution’s hypothetical plan.

So my first complaint is that the proposed rule requires the financial institutions to describe how they would resolve themselves only under the Bankruptcy Code, and not under the new resolution authority. I understand that the statute requires the regulators to evaluate the resolution plans on whether they would facilitate an orderly resolution under the Bankruptcy Code. But the text of the statute, while confusing, does not require that the financial institutions only describe resolutions under the Bankruptcy Code — or even that they address the Bankruptcy Code at all.

The key provision in Dodd-Frank, § 165(d)(1), simply requires that a financial institution periodically submit “the plan of such company for rapid and orderly resolution in the event of material financial distress or failure.” Notice that it doesn’t say that the “rapid and orderly resolution” has to be under the Bankruptcy Code. This leaves the door open for the regulators to require the financial institutions to describe how they could be smoothly resolved under the new resolution authority as well. Regulators couldn’t deem a bank’s plan “deficient” because of its description of a resolution under the new resolution authority, but who cares? At least the regulators would have the description.

My point is: why not require the financial institutions to describe a resolution under both the Bankruptcy Code and the resolution authority? There are key differences between the two insolvency regimes, so having two separate descriptions would be useful.

My second complaint is that the proposed rule requires the financial institutions to describe a resolution under the Bankruptcy Code that can be accomplished “within a reasonable period of time.” I strongly suggest that this language be changed to something like, “on an expedited basis.” The problem is that a “reasonable period of time” for a resolution under the Bankruptcy Code is much longer than we can afford the resolution of a major financial institution to take. To successfully resolve a major financial institution, the resolution has to be effectively over-and-done-with in a few days — a week, tops. The uncertainty in the Lehman resolution was crippling — it was pure Knightian uncertainty in action, as everyone in the market (and especially Lehman creditors) assumed the worst and panicked.

Resolutions under the Bankruptcy Code often take years. Even “pre-packaged” bankruptcies can take a month. If the next resolution of a major financial institution takes a month, I absolutely guarantee that there won’t be anything “orderly” about it. So please, if you’re going to have the financial institutions describe how they would resolve themselves under the Bankruptcy Code, at least make sure they describe a resolution that would, you know, actually work.

My previous post looked at one of the two major issues in Basel III’s all-important liquidity requirements that still have to be determined by national regulators. This post will look at the other major issue that was left to national regulators, which I’m trying to get people to call “the Citigroup rule.” (Do it, it’s cool.)

To recap, the main component of Basel III’s liquidity requirements, the Liquidity Coverage Ratio (LCR), requires internationally active banks to maintain a stock of “high-quality liquid assets” that’s sufficient to cover cash outflows in a 30-day stress scenario. The cash outflows in the stress scenario are calculated by applying “run-off rates” to each source of funding (e.g., unsecured wholesale funding, repos, etc.). Most of the action/controversy here is in the different run-off rates used.

Under the heading, “Other contingent funding obligations,” the final Basel III document says: (emphasis mine)

101. These contingent funding obligations may be either contractual or non-contractual and are not lending commitments. Non-contractual contingent funding obligations include associations with, or sponsorship of, products sold or services provided that may require the support or extension of funds in the future under stressed conditions. Non-contractual obligations may be embedded in financial products and instruments sold, sponsored, or originated by the institution that can give rise to unplanned balance sheet growth arising from support given for reputational risk considerations. These include products and instruments for which the customer or holder has specific expectations regarding the liquidity and marketability of the product or instrument and for which failure to satisfy customer expectations in a commercially reasonable manner would likely cause material reputational damage to the institution or otherwise impair ongoing viability.

Did you catch that? Banks have to set aside high-quality liquid assets to cover liquidity support for clients that they’re not technically required to provide, but likely would anyway. Some people might look at that and immediately say it’s ridiculous, because how can a regulator predict what a bank will do to protect its reputation in a crisis? Or what a bank considers “material reputational damage”? But it’s not actually ridiculous. Moreover, to be truly effective, this is something the LCR absolutely has to grapple with.

The reason I call this “the Citigroup rule” is that this is exactly what happened to Citi when it bailed out its SIVs in 2007-2008. (Yes, other banks like HSBC and BofA rescued their SIVs too, but none on nearly the same scale — Citi’s decision to rescue its SIVs resulted in nearly $100bn of the most toxic assets being brought back onto Citi’s balance sheet, and was arguably the bank’s fatal mistake.)

Citi had been the largest sponsor of structured investment vehicles (SIVs), which invested in long-term assets, including MBS and CDOs, and funded themselves by selling short-dated asset-backed commercial paper (ABCP) and medium-term notes. Citi structured, underwrote, and then “advised” its SIVs. The SIVs’ senior debt was primarily sold to Citi’s institutional clients, while money-market mutual funds were the main buyers of the short-term ABCP. When the ABCP market imploded in the Fall of 2007 due to subprime concerns, the SIVs were forced to sell assets into an illiquid market in order to fund themselves, leading to large losses on their MBS holdings.

Citi’s institutional clients (i.e., the senior debt holders) were, shall we say, “not pleased.” Citi had structured, underwritten, and were now managing these SIVs, which had been pitched as ultra-safe investments, and the institutional clients damn-well expected Citi to help the SIVs out. But according to its 2007 10-K, Citi “was not contractually obligated to provide liquidity facilities or guarantees to the SIVs.”

However, had Citi simply hung the senior debt holders out to dry and refused to provide any support to the SIVs, they almost certainly would’ve lost a good deal of business from those institutional clients, and suffered a big reputational hit.

So what did Citi do? Naturally, it chose to rescue its SIVs — providing liquidity facilities for five of its seven SIVs, which had $58bn in total assets — rather than take a big reputational hit. Per a December 13, 2007 press release: (emphasis mine)

Citi announced today that it has committed to provide a support facility that will resolve uncertainties regarding senior debt repayment currently facing the Citi-advised Structured Investment Vehicles (“SIVs”).

This action is a response to the recently announced ratings review for possible downgrade by Moody’s and S&P of the outstanding senior debt of the SIVs, and the continued reduction of liquidity in the SIV related asset-backed commercial paper and medium-term note markets. These markets are the traditional funding sources for the SIVs. Citi’s actions today are designed to support the current ratings of the SIVs’ senior debt and to allow the SIVs to continue to pursue their current orderly asset reduction plan. As a result of this commitment, Citi will consolidate the SIVs’ assets and liabilities onto its balance sheet under applicable accounting rules.

And this wasn’t limited to SIVs: Citi later rescued four of its hedge funds (including the Vikram Pandit-run Old Lane Partners), none of which Citi had been under any explicit contractual obligation to support. The hedge funds had a combined $15bn in assets, which Citi had to eventually bring back on its balance sheet.

There’s no doubt that this was a big, sudden drain on Citi’s liquidity. The SIVs alone probably issued between $10–$15 billion of commercial paper per month, which Citi had suddenly committed itself to buying on an ongoing basis. And then there were the SIVs’ medium-term notes, which Citi also had to roll over.

This is the kind of situation that “the Citigroup rule” is designed to protect against. The cash outflows are reasonably foreseeable — everyone knew that Citi was eventually going to rescue its SIVs — but not contractually obligated. Forcing banks to account for these cash outflows its their liquidity pools is critical because in a real crisis, banks really will end up providing this kind of liquidity support (no matter how vehemently they insist otherwise). Another benefit is that the rule will help prevent the abuse of off-balance-sheet accounting, where banks move assets into facilities that are technically off-balance-sheet, but that everyone knows will come back on the banks’ balance sheets if things go sour.

Obviously, what qualifies as a “non-contractual funding obligation” will have to be determined on a case-by-case basis, and will necessarily be at a regulator’s discretion. But determining when a bank is likely to choose to provide liquidity support shouldn’t be as tricky as it sounds. Think about it: for the bank’s failure to provide liquidity support to cause “material reputational damage,” it would have to be obvious to pretty much everyone that the bank should have provided liquidity support — because if it’s not obvious to pretty much everyone, then would it really cause material reputational damage?

As to the run-off rate for these “non-contractual funding obligations,” I’d advocate a very high run-off rate. This kind of non-contractual liquidity support is, almost by definition, required precisely when the market is least liquid (and thus liquidity is the most expensive for the bank). After all, if the market was still liquid, then there would be no need for the bank to provide the liquidity support in the first place. Also, if the regulator determines that the bank would step in and buy an entity’s commercial paper, or would buy back a bond that it just underwrote, then there’s no reason to think that the bank would only buy some of the commercial paper, or repurchase some of the bond issue. If the bank is providing liquidity support specifically to maintain its reputation, then it’s only natural to assume that the bank will go the whole 9 yards.

As I said in my previous post, the new Basel III liquidity requirements are a massive deal, and one of the most important aspects of financial reform, but have been almost completely ignored by commentators as well as the press. As a result, I think it would be useful for me to highlight the most important aspects of the new liquidity requirements that were left to national regulators — and that therefore are still up in the air. I’m only going to address the Liquidity Coverage Ratio (LCR) here, since the other component of the liquidity requirements, the Net Stable Funding Ratio, isn’t scheduled to be implemented until 2018, if it’s ever implemented at all (and I have serious doubts about whether it’ll ever be implemented in anything like its current form, which is barely even coherent).

Broadly, the Liquidity Coverage Ratio requires internationally active banks to maintain a stock of “high-quality liquid assets” that’s sufficient to cover cash outflows in a 30-day stress scenario. In other words, banks are required to have enough cash or cash-like instruments on hand to survive a really horrible, financial-crisis-level 30 days, in which the funding markets all but shut down. The cash outflows in the stress scenario are calculated by applying “run-off rates” to each source of funding (e.g., unsecured wholesale funding, repos, etc.). Most of the action/controversy here is in the different run-off rates used. (I gave a more detailed explanation of the LCR here and here.)

There are, in my opinion, two major issues that still have to be determined by national regulators: (1) the run-off rate for market valuation changes on derivatives transactions; and (2) the definition of, and run-off rate for, so-called “non-contractual contingent funding obligations.” This post will address the first issue. My next post will deal with the second issue (which I’ve come to the conclusion should absolutely be called “the Citigroup rule”).

Market valuation changes on derivatives transactions

The final Basel III document amazingly contains only three sentences on this issue:

Increased liquidity needs related to market valuation changes on derivative or other transactions: (non-0% requirement to be determined at national supervisory discretion). As market practice requires full collateralisation of mark-to-market exposures on derivative and other transactions, banks face potentially substantial liquidity risk exposures to these valuation changes. Inflows and outflows of transactions executed under the same master netting agreement can be treated on a net basis.

To use a familiar example that most people understand, this is the liquidity risk that brought down AIG’s CDS book. AIG entered into CDS contracts which required it to post collateral when the market value of the underlying CDOs fell. By entering into these CDS contracts, AIG took on massive liquidity risk — that is, AIG was exposed to the risk that the market valuation of the underlying CDOs would fall, requiring it to come up with cash to post as collateral. If AIG had been subject to Basel III’s new liquidity rules, it would’ve been required to hold additional “high-quality liquid assets” in its liquidity pool to cover the potential collateral calls.

So what regulators have to determine here is basically how far market valuations on derivatives can fall during a 30-day financial crisis. If the regulators say that market values on, say, the CDX IG contract (a popular index CDS tracking investment-grade corporate bonds) would fall 20% in the 30-day stress scenario, then that’s a 20% run-off rate for CDX IG protection sellers. Obviously, there will have to be different assumptions on market value changes for different products — e.g., the price of high-yield debt would almost certainly fall much further than the price of investment-grade debt in a crisis, so banks that sold protection on the CDX HY contract would experience much greater cash outflows than banks that sold protection on the CDX IG contract. Interest-rate swaps will presumably need different assumptions too — Libor’s volatility, for instance, played havoc with rate swap valuations after Lehman failed.

(Oddly though, the language of the Basel III document suggests that banks that would benefit from market valuation changes on derivatives wouldn’t get to count those cash inflows unless those derivatives were executed under a master agreement with other derivatives that would suffer from the market valuation changes. They couldn’t be counted under any of the separately-defined “Cash Inflows” categories, so the only way those inflows could be counted is if they’re netting off outflows under a master agreement. Personally, I doubt this is what the Basel Committee intended, so I’m expecting this to change when the regulators get into the rulemaking process.)

The reason this is so important is that when you get to the dealer bank level, large market value changes can cause a lot of money to change hands, and if a dealer isn’t running a very flat (i.e., market-neutral) book, it can suffer significant cash outflows. Just ask Morgan Stanley.

Not only are the levels that regulators set here extremely important to the robustness of the liquidity requirements, but they’ll also provide a unique insight into the kind of crisis that regulators think banks should be able to withstand — and, also, into how seriously the regulators are taking the job of writing regulations to prevent another financial crisis.

In a surprise move, the Basel Committee indicated this week that they're still open to tweaking ($) the new liquidity requirements.

The liquidity requirements are a massive deal for banks, although you wouldn't know that from reading the financial press, which hardly ever mentions them. The Basel Committee's "quantitative impact study" showed that banks face a shortfall of liquid assets of $2.48 trillion for just one component of the liquidity requirements, which is over three times the size of the banks' capital shortfall under Basel III.

The liquidity requirements are by far the most important outstanding aspect of financial reform, so the fact that the Basel Committee is open to tweaking them even a little is a big deal. However, the secretary-general of the Basel Committee, Stefan Walter, did make clear that they were not open to one particular argument from the banks:

A key element of the rules are its assumptions about the rate at which different bank funding sources run off in a liquidity crisis, but Walter warned that the Basel Committee will not be swayed by observed run-off rates from the stressed conditions of the last few years. "If an institution comes to us and says ‘Here's our experience in terms of outflows during the crisis,' we would point out that those were recorded in the context of massive public support," he said.

Gee, that rebuttal sounds familiar. Oh yeah, here's what I wrote about the liquidity requirements way back in August:

[The banks'] main argument involved claiming that the run-off rates they experienced during the financial crisis were materially lower than the Committee's proposed run-off rates. This, they argued, demonstrated that the Committee was being excessively conservative. (See e.g., JPMorgan, passim)

The problem with this is that it's a really, umm, stupid argument. Yes, the run-off rates were probably lower during the financial crisis, but there were also massive government bailouts during the financial crisis. After Lehman failed, the market only made it 2 days without a government bailout — the Fed rescued AIG on Tuesday night, and Schumer leaked that the government was planning a system-wide bailout on Thursday. Regulators were kinda-sorta hoping that we could do the next financial crisis without massive government bailouts.

Good to see the Basel Committee giving the banks' argument the treatment it deserves!

I read an excellent book recently, which has taken on an almost eerie relevance right now: Zero-Sum Game: The Rise of the World's Largest Derivatives Exchange, by Erika S. Olson. It's a blow-by-blow account of the (really very dramatic) 2007 merger between the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). Olson was in the perfect position to write the book — she was a Managing Director at CBOT at the time, so was sufficiently senior that she was very close to, if not directly involved in, the behind-the-scenes action; but she had also just taken the job, so she wasn't too emotionally attached to the CBOT to give an accurate account.

Olson is clearly a very talented writer too: the book was a terrifically enjoyable read, which was something of a surprise. I easily read the entire book on a round-trip domestic flight, and I'm not an abnormally fast reader (one of the drawbacks of compulsively reading every single footnote/endnote in every book I read).

Of course, the story is dramatic in itself — CME and CBOT were longtime and extremely bitter rivals to begin with, and then IntercontinentalExchange (ICE) came in with a surprise hostile bid for CBOT, a bidding war ensued, etc., etc.

The story is eerily similar to the bidding war that's going on right now for NYSE Euronext. First, Deutsche Börse and NYSE announced that they had agreed to a $10.2bn merger, and then last week Nasdaq and ICE (again!) came in with a hostile competing bid for NYSE that totaled $11.3bn. And that's where we stand right now: with all eyes on NYSE's board of directors, as it weighs the competing bids. Both bids would raise significant antitrust issues — which CME and CBOT went through in 2007 as well — so the Department of Justice is waiting in the wings. Really, it's almost hard to describe how much the current NYSE bidding war is a replay of the CME/CBOT merger.

The entire exchange world is going through a serious round of Merger Mania right now, so Zero-Sum Game almost couldn't be more relevant.