Tag Archives: Financial regulation

(Revised) A Constantly Changing Landscape

The landscape in which financial institutions operate is very different now than it was before the financial crisis of 2008. Mergers and acquisitions between healthy firms and failing firms allowed the strong to get stronger and subsequently gain market share. As the market has grown more concentrated, it has also grown less competitive. Although competition is a corner stone of capitalism, maybe large banks help promote financial stability. Whether or not this is true, new government regulations have been enacted with the sole purpose of reducing risk taking by financial institutions.

Unable to put as much capital at risk as before, banks are shedding operations that were once major profit centers. For example, the Volker Rule bans propriety trading and limits commercial banks to hedging and market making. Return on equity (ROE), a closely watched measure of profitability, has dropped from double digits to single digits for most banks and I believe this is representative of increased regulation. Higher capital requirements mandates that a significant portion of cash is set aside. Essentially, cash must be tied up as an unproductive asset (rather than being put at risk in order to earn a return).

While some aspects of bank operations have been forced to shrink (or be eliminated), an area of growth for banks has been in commercial lending (i.e. lending to businesses). According to the Wall Street Journal, “Lenders, too, are making bigger bets on an economic expansion at a time when tighter restrictions on many banking functions have placed more importance on core lending activities to boost earnings”. Although banks might have preferred riskier operations in order to earn a higher return, more lending to businesses is certainly better for economic growth. In addition to being less risky than certain activities such as proprietary trading, lending is a vital source of credit that promotes booming business cycles.

The increase in lending to business has been a two way street. According to the Wall Street Journal, “The rise is being driven both by banks, which are loosening their lending standards, and companies, which are seeking more money, bank executives said”. On the one hand, companies are seeking cash. If businesses use this cash to cover day-to-day expenses (i.e. meeting current obligations), then this might not mean so much for economic growth. If businesses use this cash for capital expenditures (i.e. long-term investments in equipment), then this businesses might be indicating a positive outlook for economic growth. On the other hand, banks very much want to lend the cash as evidenced by lower lending standards. Although increased availability of credit is important for economic growth, an over-leveraged can easily fall into a financial crisis. According to the Wall Street Journal, “And while relaxed standards aren’t likely to cause banks much trouble in the near future, it was reckless lending that helped fuel the financial crisis”. As long as commercial lending is monitored correctly, then the risk should be manageable.

Although banks have increased lending to businesses, the same cannot be said for lending to consumers. In order to reverse this trend, banks have loosened standards for homebuyers. According to the Wall Street Journal, “Mortgage lenders are beginning to ease the restrictive lending standards enacted after the housing boom turned to bust, a sign of their rising confidence in the housing market”. A meaningful re-acceleration of the housing market is crucial for justifying expectations for economic growth. Although the housing market seemed to heat up last year, it slowed down in the fourth quarter and the first quarter of this year. Although one factor contributing to the slowdown might have been the winter weather, rising interest rates also certainly played a role. Higher interest rates decrease affordability for homebuyers.

Changes in interest rates have significant implications for both borrowers and lenders. According to the Wall Street Journal, “Some banks said the prospect of rising interest rates in the next few years could spur additional growth in commercial lending”.  Rising interest rates make lending more appealing for a few reasons. First, creditors get to collect higher interest payments. At the expense of debtors, banks earn increased revenue from lending activities. Second, many financial institutions have a mismatch between asset and liability maturity structures. Banks’ assets are mainly long-term loans and their liabilities are mainly short-term deposits. When interest rates rise, the value of the assets decrease more than the value of the liabilities. Banks can hedge interest rate risk and realign asset and liability maturity structures through commercial lending.

I cannot help but be concerned when I hear banks are lowering their lending standards because I am reminded of bank conduct during the housing bubble. I can only hope that regulators are watching more closely this time.

Commercial Lending on the Rise

Since the financial crisis, the climate has been constantly changing for financial institutions. Bankruptcies allowed banks to grow in size as healthy banks absorbed failing banks. Since then new regulations have been imposed on the largest financial institutions changing (and in some cases eliminating) many of their most profitable operations. For example, the Volker Rule bans   propriety trading by commercial banks. Return on equity (ROE), a closely watched measure of profitability, has dropped from double digits to single digits for most banks and this is representative of increased regulation. For example, higher capital requirements mandates that a significant portion of a bank’s capital is tied up being unproductive rather than being put to use (i.e. put at risk in order to earn a return).

While some aspects of bank operations have been forced to shrink (or be eliminated), an area of growth for banks has been in their lending to businesses. According to the Wall Street Journal, “Lenders, too, are making bigger bets on an economic expansion at a time when tighter restrictions on many banking functions have placed more importance on core lending activities to boost earnings”. Although banks might have preferred to continue running certain risky operations such as proprietary trading, I think the increase in lending is is more beneficial for economic growth. In addition to being less risky than certain activities such as proprietary trading, lending is an vital source of credit that can promote booms in business cycles.

The increase in lending to business has been a two way street. According to the Wall Street Journal, “The rise is being driven both by banks, which are loosening their lending standards, and companies, which are seeking more money, bank executives said”. On the one hand, companies are seeking cash. If businesses use this cash to cover day-to-day expenses (i.e. meeting current obligations), then this might not mean so much for economic growth. If businesses use this cash for capital expenditures (i.e. long-term investments in equipment), then this might indicate a positive outlook for economic growth. On the other hand, part of the jump in lending is due to banks lowering their standards. Although increased availability of credit is important for economic growth, an over-leveraged can easily fall into a financial crisis. According to the Wall Street Journal, “And while relaxed standards aren’t likely to cause banks much trouble in the near future, it was reckless lending that helped fuel the financial crisis”. I agree that we are far from the dangerous lending that occurred prior to the financial crisis, however, I hope a minimum level of lending standards can be maintained so that we avoid another financial disaster.

Although banks have increased lending to businesses, the same cannot be said for lending to consumers. In order to reverse this trend, banks have loosened standards for home buyers. According to the Wall Street Journal, “Mortgage lenders are beginning to ease the restrictive lending standards enacted after the housing boom turned to bust, a sign of their rising confidence in the housing market”. A meaningful re-acceleration of the housing market is crucial for justifying expectations for economic growth. Although we had a nice pop last year, the housing market slowed down in the fourth quarter and the first quarter of this year. Part of the slowdown might have been due to weather as well as the rising interest rates.

Rising interest rates making lending more appealing for a few reasons. According to the Wall Street Journal, “Some banks said the prospect of rising interest rates in the next few years could spur additional growth in commercial lending”. First, higher interest rates help creditors and hurt debtors. Although debtors must make higher interest payments, creditors get to collect higher interest payments. Second, many financial institutions have a mismatch between asset and liability maturity structures. Banks’ assets are mainly long-term loans and their liabilities are mainly short-term deposits. When interest rates rise, the value of the assets decrease more than the value of the liabilities because longer duration securities are more sensitive to changes in interest rates. Making more commercial loans enables banks to realign asset and liability maturity structures.

New Financial Regulation’s Future

Under this unusually cold weather, banks are experiencing much colder season due to the decrease of trading in mortgage backed securities. The Wall Street Journal reported that, in this January and February, average daily volume of trading in mortgage backed securities has dropped 32% and 41% respectively year on year basis. Considering typical increase of bonds trading in the first quarter of year when financial companies build their portfolio for new year, this sharp decrease of bond trading is very likely to result in decrease of banks’ profits this year. Banks have enjoyed big revenue from trading of bond, currencies and other financial markets products, and those revenues make up quite substantial proportion of bank profits.

The decrease of trading volume in mortgage backed securities resulted from decrease of new issuance of Fannie- and Freddie-backed securities, which are major issuers of mortgage backed securities. Their issuances of this year have dropped 57% from a year ago. Once Volcker rule, which is scheduled to be effective in July 2015, is implemented, banks are more likely to experience loss of trading profits from bonds, currencies and other commodities because Volcker rule strictly regulates banks’ proprietary trading. Banks will become more dependent on customer order flows rather than their own proprietary trading.

I think that this decrease of trading volume is surely bad not only for the banks’ profit, but also for market efficiency. As trading volume decreases, investors are likely to bear more time and cost for trading mortgage backed securities and other financial products. However, from the perspective of financial regulation, this decrease of trading volumes may signal decrease of excessive trading activities of banks, which contributed to outbreak of the Great Recession, and represent more sound investment behaviors of banks. In that regard, decrease of trading volume is not always a bad thing.

But, as banks are experiencing loss of profits, I worry that there is increasing pressure of loosening new financial regulations such as the Volcker Rule. In January, right after the Volcker Rule is approved by the congress, financial regulators succumbed to banks’ pressure to permit banks to keep holding some CDO(collateral debt obligation), which are backed by banks’ debt. The American Bankers Associations sued financial regulators for forcing more than 275 banks to sell their CDO and to induce significant loss, and they dropped the law suit later. Another attempt to loosen financial regulations focuses on investment of CLO(collateralized loan obligation), which are bundles of securities including loans. Congress are now asking financial regulators to exempt those CLO investment from the Volcker Rule regulation.

As I watch current developments of new financial regulations, there may be more changes to allow banks to behave in more like pre-crisis way in the future. As economic situations are getting better, people are very likely to forget the past pains and to become more confident. At that time, proponents of free markets will be more vocal arguing for all virtues of liberalizations of financial markets, and financial regulations lose more and more grounds and eventually become useless. I believe that financial regulators should be ready to fight against banks to prevent these potential movements of markets.

Difficulties of financial regulation

I agree with the opinion that the main difficulties of financial regulations to deal with ever-developing financial innovation come from the fact that we cannot know what new financial products bring about in the future. Financial regulators cannot do any experiment for new financial products before they allow those new financial products into the markets and see what is really happening.

The Economist introduced two main approaches that current financial regulators are taking after the Great Recession. One is to curb excessive credit creation in order to prevent asset bubbles, and the other is to strengthen safety net in order to minimize negative effects of financial crisis. While Adair Turner, a former head of Britain’s Financial Services Authority, supports for the former financial regulation approach, Marcelo Prates from the central bank of Brazil supports for the latter approach

I think the current discussion on financial regulation can be divided into two groups. As Lord Turner focuses on “the wrong sort of capital flow” and excessive credit creation, one group emphasizes the preemptive measure to minimize possibility of financial crisis. On the other hand, as Mr. Prates argues for strengthening safety net including personal responsibilities of bank executives, deposit insurance and resolution process for failed institutions, the other group emphasizes streamlining resolution process of financial crisis. Theses include minimization of damage resulted from financial crisis and regaining financial markets integrity at the earliest possible time.

I think that both the preemptive measure to prevent financial crisis and streamlining process of financial crisis resolution are important in dealing with financial crisis. In my opinion, however, financial regulators should pour more endeavors to prevent the recurrence of the financial crisis. Once financial crisis occurs, its costs are enormous in terms of lost economic activities and inefficiencies. So, to prevent the very possibility of financial crisis is the way to minimize the total costs of financial instability. In that sense, financial regulators should focus more on strengthening capital requirements and controlling leverage, whicah are mainly used to curb excessive accumulation of credits.

The Economist also introduced the problems of complication of regulation. For example, the U.S. introduced extremely complicated regulation rules, Dodd Frank act, after the Great Recession. This complicated financial regulation increase the burden of the financial regulators too as well as financial companies. If regulations become too complicated, financial regulators also spend lots of energy to understand financial regulations and examine violations, and it would be very difficult for financial regulators accurately to examine whether financial companies violated any regulation. It is very possible that both the financial regulators and financial companies do not understand clearly contents of regulations. This difficulty of compliance of financial regulations may induce more violation of regulations and disputes between financial regulators and companies. These all hurts credibility of financial authority. Therefore, I think that new financial regulations should more focus on the prevention of financial crisis, and be simple and clear to minimize costs of compliance and examination of those financial regulations.

Yellen Breaks the Ice

In her inaugural public appearance since becoming the central bank’s first chairwoman, Janet Yellen confirmed that her intention is to continue the policies of her predecessor (Ben Bernanke). According to the Wall Street Journal, “Her comments left little doubt that her plan – as was Mr. Bernanke’s – is to tiptoe away from those policies only gradually as the economy improves”. I agree that it is time to wind down the Fed’s unconventional monetary policy in which it conducts large-scale asset purchases. First, quantitative easing seems to have served its purpose of lowering long-term interest rates. Second, I still worry that we might face some undesirable consequences from quantitative easing down the road. Now that quantitative easing has fulfilled the intentions of its creators, it should be phased out sooner rather than later in order to reduce whatever unintentional effects might be looming in the future.

Although the continuation of the taper means a reduction in stimulus, financial markets responded well to the plan that Yellen outlined. Furthermore, I think financial markets were extremely pleased that Yellen appeared completely as advertised (meaning she performed as expected and without any surprises). According to the Wall Street Journal, “In two instances, she thanked lawmakers for calling her unexciting”. Yellen’s primary theme during her public appearance was predictability. Every detail of the presentation seemed to be planned perfectly. The financial markets are notably sensitive to everything, which includes what Yellen says and how she says it.

Yellen’s calm demeanor and clear rhetoric is exactly what everyone was hoping for and I think the financial markets were extremely pleased with the lack of surprises. According to the Wall Street Journal, “The markets, having anticipated a steady stance, greeted Ms. Yellen’s comments with approval”. As expected, Yellen will continue with the taper and not change the course of the Fed. Despite the two months of disappointing employment reports, the Fed will taper at the same pace ($10 billion reduction per month). Although financial markets rallied when the Fed surprisingly delayed the beginning of the taper last year, I do not believe the financial markets would handle such a surprise the same way today because tapering has already begun. Unless a significant problem develops in the economy, such a deviation from the plan set out only a month ago would signal a lack of confidence in the recovery. If the Fed was confident enough to announce the taper in December, then a departure from the taper only a month later would likely spook investors. Obviously, a major change for the worse would lead the Fed to dramatically change course. However, that event has not occurred yet and I hope it will never.

Yellen was so eloquent that she even managed to dodge the numerous questions she received regarding financial regulation. Although she did not provide any significant details, she seemed to defend and support the Dodd-Frank legislation. According to the Wall Street Journal, “[Yellen’s] comments suggest she’s likely to continue the Fed’s efforts to implement the 2010 Dodd-Frank financial overhaul in a way that places higher burdens on companies viewed as posing risks to the broader financial system. That could mean more capital and liquidity rules requiring the biggest banks to meet higher standards than smaller firms”. The implementation of Dodd-Frank has been a lengthy process with much scrutiny. On the one hand, some critics claim it is too tough and requires banks to hold too much capital. On the other hand, some critics claim it is too lenient and does not require banks to hold enough capital. In this situation, I am torn because I do not know the right amount of capital for banks to hold.

Currently, the additional amount of capital that banks are required to hold is already noticeable. For example, the return on equity for the largest financial institutions is down considerably. Although I understand that the intentions of Dodd-Frank is to avoid the next financial crisis, forcing banks to hold excess capital likely also restricts them from making loans and engaging in other activities that spur economic growth. I would imagine that Dodd-Frank will be shaped to keep American banks on the same page as European banks, which are subject to Basel III capital requirements. I think that it is in the best interest of the global economy to have similar global financial regulations. Otherwise the financial institutions of some countries will have a competitive advantage, but also be much riskier and be a potential danger to the global financial system. I look forward to how Dodd-Frank and other financial regulations are executed.

Earnings in the Financial Sector

Although the U.S. economic recovery is still trying to gain momentum, some of the U.S. banks are bigger and earning near their record levels. J.P. Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley earned $76 billion in 2013. According to the Wall Street Journal, “That is $6 billion shy of the collective all time high achieved in 2006, a year U.S. housing prices peaked amid a torrid economic expansion”.

The strength in the financial sector is reflected in their stock prices. The Financial Select Sector SPDR, which is an exchange-traded-fund that tracks the financial sector, is at its highest level since before the financial crisis in 2008-2009.

Ticker: XLF

Ticker: XLF

Banks must continue their strong performance in order sustain their increase in share price. According to the Wall Street Journal, “Now that their stocks have run up so sharply, banks will have to perform well to keep share prices buoyant”. If they fail to meet expectations, they will likely watch their stock prices spiral downward. Thus, banks might undertake risky-decision making or other methods to juice earnings.

During the financial crisis, there were some high profile acquisitions by large U.S. banks that significantly increased market concentration. The consolidation involved stronger banks acquiring weak or failing financial institutions. According to the Wall Street Journal, “Wells Fargo, a West Coast institution that became a national presence after its 2008 purchase of Wachovia Corp., posted the highest annual net income in its 161-year history last year. Bank of America, which gained heft on Wall Street when it bought securities firm Merrill Lynch & Co. in 2009, had its best year since 2007, as revenue increased in all five of its major business units”. In the short run, acquiring failing institutions such as Merrill Lynch and Wachovia (that had massive amounts of subprime, toxic debt soon to default) depressed earnings. However, these acquisitions are clearly proving beneficial in the long run. With the losses already being absorbed, the banks can now enjoy the benefits of economies of scale and increased market share. The banking industry is more concentrated than before the financial crisis. High market concentration and massive barriers to entry in the banking industry creates questionable conduct in which banks are enjoying substantial earnings.

Another reason for near-record earnings is that the healthier U.S. economy is encouraging banks to hold fewer reserves to protect themselves against the possibility of borrowers defaulting. According to the Wall Street Journal, “J.P. Morgan, Bank of America, Citigroup and Wells Fargo freed up $15 billion in loan-loss reserves during 2013, including $3.7 billion in the fourth quarter. That money goes directly to the bottom line, boosting profits. The releases made up 16% of these banks’ pretax income for that final quarter”. The problem with this is that it means earnings are artificially inflated. In other words, this gain is unsustainable and does not reflect earnings from selling a good or service that is a part of ongoing business. When this unsustainable source of earnings disappears, banks will feel an incredible amount of pressure to find another way to juice earnings (or stock prices will likely fall).

The decision of these large U.S. banks to hold less loan-loss reserves is extremely controversial. According to the Wall Street Journal, “Some investors aren’t pleased that big banks continue to rely so heavily on improving credit conditions to pump profits. Regulators have warned the moves may be too aggressive, and that they are unsustainable. The reserves have added to aggregate earnings in every quarter for nearly four years”. Not only is the reduction in loan-loss reserves artificially inflating profits and creating increased expectations for future earnings, it makes me question quality in bank earnings.

The weakness in bank earnings is reflected in their return on equity (ROE), which relates the earnings of the firm to Owners’ Equity. An underlying assumption is that the earnings of the firm belong to the firm’s owners, which makes ROE a closely watched investment-performance ratio for stockholders. According to the Wall Street Journal, “Return on equity has been a problem for banks since the crisis, as regulators cracked down on risky, but potentially profitable, businesses and required financial firms to raise equity to make their capital structures safer”. Regulation is requiring that banks hold more capital rather than put that capital to work. In order to improve ROE, you cannot just increase sales. Rather you must increase the efficiency by which sales are generated. As the economy improves, investors are going to want ROE to improve and this is being made hard by strict financial regulation. This has promoted banks to reduce compensation, cut their workforce, and shed certain lines of business. Although financial regulation is designed to create financial stability, it is creating huge challenges for banks (reflected by a low ROE).

Ban on Proprietary Trading for Banks too big to fail in EU?

European Union policy makers, lead by EU financial services chief Michel Barnier, are considering drafting legislation that curbs the European Union’s biggest banks from trading with their own money.  Barnier’s proposed legislation would strengthen bank-structure rules and give power to supervisory institutions like the European Central Bank.  Barnier’s goal is to create more legislation to prevent European Banks that are too big to fail from making risky bets that could potentially put customer’s deposits in harms way.  “Barnier’s proposals, which also include tougher transparency rules for trading in repurchase agreements, or repos, and other securities financing transactions, would apply to banks whose activities exceed certain financial thresholds.” (http://www.businessweek.com/news/2014-01-06/eu-s-barnier-weighs-proprietary-trading-ban-for-large-banks)

The EU’s ban on proprietary trading is viewed very similar to the US’s bill that passed last year known as the Volcker Rule which banned commercial banks from participating in proprietary trading.  It restricts banks from making speculative investments that do not benefit their customers.  The European Union and the United States created this legislation to prevent a repeat of the 2007-2009 financial crisis.  They want to keep tax payers away from having to bail large financial institutions out when they make risky, speculative investments that put customer’s deposits in harms way.

“Policymakers want to rein in excessive trading risks in the EU banking sector, whose assets total some 43 trillion euros ($59 trillion), that could threaten depositors if trades go wrong and potentially put taxpayers on the hook in a rescue.” (http://www.reuters.com/article/2014/01/06/eu-banks-idUSL6N0KG1QZ20140106)

The issue with the European Union’s proposed ban on proprietary trading is that it is no where near as strong as the US Volcker rule and is viewed by many to be “too watered down” (Reuters).  The proposed legislation allows French and German large universal banks to keep from splitting up into deposit only and investment only banks.  Instead of creating legislation that restricts banks that are considered too big to fail, the legislation protects and allows these banks to continue to be too big to fail.  The main reason that the EU wants to stop short of the Volcker rule is to protect and keep European banks competitive.  Barnier’s proposal is heavily influenced by Finish central bank minister Erkki Liikanen who believes that there should be a mandatory separation between deposit taking services and proprietary trading services.  Britain, Germany and France, countries with the largest financial sectors in the EU, have unilaterally opposed this idea.  This brings again brings into question the sustainability of the European Union.  Many view the legislation as a compromise between Liikanen’s proposal and Germany, Britain and France’s opposition but Alexander Carr, a regulatory lawyer from london, believes that by seeking to please everyone, Barnier has made it near impossible for the legislation to pass through the EU commission.  In the end, this questions whether the EU has the ability to sustain itself through another economic crisis with only Monetary policy unity.  If the EU had control of fiscal policy, maybe we would be seeing another Volcker rule pass in the EU, instead of a compromise between everyone that produces a “cop-out compromise” (Reuters).