Complements to Basel

Goodhart's Law states that any statistical regularity or economic measure that becomes a target for the purpose of policy will lose the information content that qualifies it to play that role.  I've been thinking about that a lot lately in preparation for tomorrow's Complements to Basel conference at the Bank of England, a joint production of the LSE Financial Markets Group and the Centre for Central Banking Studies.  The conference will be chaired by Charles Goodhart himself.

It seems to me that bank capital has become a victim of capital adequacy regulation, in a further proof of Goodhart's Law.

For twenty-five years the Basel Capital Accords have made capital the focus of prudential supervision policy.  Capital during this period has become so distorted and debased by bank managements' determination to game the regulations - and enrich themselves - that it is almost meaningless as a measure of the adequacy of a bank's financial reserves or the competence of bank management.  It is worth noting in this context that profits which are not required as capital reserves go into the bonus pool, giving management a direct pecuniary interest in minimising liquid capital held as reserves.  Most of the banks that have failed in this financial crisis had surplus regulatory capital right up to the day of their collapse - at least according to their internal calculations.

Capital is meant to be held as highly liquid, marketable assets, that can be sold to raise funds in a hurry to support the confidence of depositors and other creditors.  It must be in assets that the financial world would recognise as having established value even under stress conditions if confidence is to be preserved that a bank will withstand the crisis.  Yield hungry managements, determined to hold as little capital as possible, and that in higher yielding, less liquid assets, have made a mockery of the whole concept of capital as a financial reserve.  When it becomes transparently clear that the assets they hold have minimal value and less liquidity, it is governments and central banks that are expected to pick up the slack at taxpayers and savers' expense.

Was RMBS liquid and marketable under stress?  Nope. (50 per cent risk-weight under Basel.)  Was interbank debt liquid and marketable under stress?  Nope.  (20 per cent risk-weight under Basel.)  How about those Greek or Portugese government bonds?  Nope.  (Zero risk-weight under Basel.)  Don't even get me started on credit default swaps, which only have value months later, and then only if an ISDA committee determines a default and the debt auction determining the pay out isn't rigged.


In consequence of banks being undercapitalised and illiquid under stress, governments have had to spend billions in bailouts, eroding their own credit standing and the very bonds their banks hold as capital at the same time, and central banks have "quantitatively eased" their currencies toward debasement.

No one looking at bank capital today recognises a liquid reserve of marketable assets.  Instead we see models which depict a show of compliance with 4,000 pages of standardised complexity.  Where the purpose of capital was once to shore up the confidence of depositors; its purpose now is to minimally satisfy supervisors.

Whatever bank capital once was, and whatever its purpose once was, has been massively eroded by capital becoming the focus of globalised, standardised prudential supervision.

Goodhart's Law confirms the irony that Basel Capital Accords have left banks woefully undercapitalised.  We are all poorer for the lesson.

Extra-Territorial Implications of Dodd-Frank - Part 2

Another excellent podcast on the extra-territoriality of Dodd-Frank as it applies jurisdiction and scope, provided by Julie Schieffer of DerivSource, with Donna Parisi of Shearman & Sterling and David Lucking of Allen & Overy.

The discussion of cross-border perfection of interests in securities has a particular resonance for me.  I was on the International Bar Association Ad Hoc Working Group on Modernising Ownership, Transfer and Pledging Laws which developed the modern legal standards for transfer and perfection of interests in securities.  After almost 20 years, it still isn't clear that US regulators and US judges would recognise international principles.

• Section 772 provides territorial scope of Dodd-Frank jurisdiction for CFTC and SEC, and they are different.  CFTC jurisdiction will not apply unless there is a “direct and significant connection” or attempted evasion of US law.  SEC jurisdiction shall not apply to business outside the USA unless there is evasion.  Both have evasion, but CFTC has “direct and significant connection” test.  Little guidance has been provided from either on how they will interpret these provisions, although CFTC has indicated it will address jurisdiction in Spring 2012.
•  “US Person” definition has not been provided for Title VII of Dodd-Frank.  Scope focuses on types of activities and where they take place and the connection with the US, rather than limiting scope by the nationality of entities entering into transactions.  There is no definition of “US Person” in the Commodities Exchange Act although CFTC rule says a “non-US person” is one organised under the laws of a foreign jurisdiction or that has a principal place of business in a foreign jurisdiction.  For the SEC, Regulation S has a whole body of law as to who is a US person for Regulation S.  Dodd-Frank seems to focus on impact of a transaction on the US for a connection to the US.
• If two persons are clearly outside the US, but the underlying basis of a transaction is in the US, then the status is unclear.
•  There are now final rules on registration provisions and registration can be found on the National Futures Association website.  Market participants are still confused on whether their activities and products bring them within the registration provisions.  Some will have to make a judgement call to start the registration process without being certain which entities or activities may be subject to registration on extra-territorial activity.
•  Likely there will be some structuring and activity which increases the cost of doing business as a consequence of uncertainty as to the application of registration requirements.  This may be particularly a constraint on a large international bank which is uncertain of whether the whole entity must register or just a US branch of the bank.  Requirements for registration include the principles of the organisation and the fingerprints of senior executives.  This will be difficult for some entities where management is likely to resent such intrusive US demands.
•   Both CFTC and SEC have made initial proposals on the definition of a “Swap Execution Facility”.  This is a new concept, though derives from exchanges or contract markets.  The regulators need to explain how SEFs will work.  The SEC and CFTC proposals are very different from each other – so equity derivatives and credit derivatives may be treated differently.  Similar products will have divergent regulation and execution requirements.  This may encourage some geographic migration as platforms are set up near underlying markets.
• Platforms in Europe may be considered to be SEFs by SEC or CFTC, but the authorisation principles and coordination on mutual recognition and supervision are unclear. 
• There was no international consensus that SEFs are “a good idea”.  The G20 did not embrace this idea, although Europe may be moving toward the concept.
• There is broad global consensus that mandatory, central clearing of some derivatives should be required.  The issue for market participants will work in practice.  Section 725(h) provides for exemption of a clearing entity if the CFTC determines it is subject to comparable regulation elsewhere.  The CFTC has not devoted resources to comparability analysis for foreign clearing organisations, so as a practical matter you have different CCPs in different geographies complying with different legal  regimes.
• The US Uniform Commercial Code creates a “security interest” in margin and collateral, but in Europe there are security interests using title transfer.  The two different legal models may create a conflict for anyone taking margin or collateral from a US entity because of the different implications for customer protection in a default.
• Some clearing houses might have gone for mutual recognition – choosing not to register in the US as a Designated Clearing Organisation (DCO).  If this is so, any US customer would have to use a US Futures Commission Merchant.  LCH-Clearnet and ICE, which are already registered as DCOs, have changed their rules to allow FCMs access to clearing members on behalf of their customers to meet US requirements.
• The CFTC has finalised rules on reporting (1) reporting of information to swap data repositiories, (2) public dissemination of information for post-trade price transparency.  Reporting is also a feature under EMIR.  There needs to be further clarity on mutual recognition of reporting or dual reporting requirements.  Confidentiality of information also raises issues in some jurisdictions and with some counterparties, which will have to be reflected in documentation so that reporting can comply with regulatory requirements.  It still isn’t clear that the US will recognise the sufficiency of overseas data repositories, or whether some form of global data repository would be preferable.
• The US political context will be influenced by US political priorities in an election year, including unemployment.  US extra-territoriality may be extended more strictly in order to preserve business in the US, and prevent firms from moving jobs, operations or transactions to overseas markets.  While it would be optimal to address these issues globally through Financial Stability Board or G20, the reality is that this remains impractical given competing domestic priorities.
• Dodd-Frank was enacted in 2010 but implementation is still lagging.  Actual requirements are now rolling out, and 2012 will be a big year to monitor developments and ensure businesses are compliant as rules become effective.  The rules will be evolving over several years as international understandings and clarifications address gaps and inconsistencies, so the compliance challenge will be ongoing.

Extra-Territorial Implications of Dodd-Frank - Part 1

Excellent podcast on the extra-territoriality of Dodd-Frank as it applies to trading, reporting and clearing of OTC derivatives, provided by Julie Schieffer of DerivSource, with Donna Parisi of Shearman & Sterling and John Williams of Allen & Overy.  Below is a summary of the key points, many of which are relevant to choices that clearing houses and CCPs must make in designing their operations, rules and compliance strategies.

Many of the issues for non-US clearing houses and CCPs are similar to those I addressed back in 1996 when I secured for Clearstream, then Cedel, the first exemption from US clearing agency registration which allowed it to clear and settle US Treasuries in Luxembourg.  At a little over two years, it was the fastest SEC determination on a CA-1 Clearing Agency application or exemption application in SEC history. Gaining an exemption from US clearing agency registration is no trivial undertaking, especially when the principles and conditions for such exemptions remain undefined.

• The task of ensuring compliance with US regulations is daunting as many rules remain undefined, and harmonisation of US requirements with those which may apply in Europe and Asia may be problematic for both compliance and commercial reasons.
• The market infrastructure has not yet been built and the interpretation of laws remain uncertain, yet businesses must make decisions on how and where they will contract their derivatives business.
• Title VII of Dodd-Frank defines CFTC and SEC jurisdiction in Section 722, but provides a safe harbour for business without a “direct” US connection or in evasion of US regulation, but there is little guidance on how these provisions would be interpreted in practice.
• Section 725 gives CFTC authority to exempt a clearing house from registration as a Derivatives Clearing Organisation if it can demonstrate that it is subject to an analogous foreign regime, and 752 encourages international harmonisation, but there has been no exemption and the CFTC has not provided guidance on how it might be applied. 
•  Legal extra-territoriality and operational extra-territoriality need to be addressed separately.  Each clearing house operates under a legal regime.  Both ICE Clear and LCH-Clearnet registrations with the CFTC have elected to register as DCOs with the CFTC going forward, so do not provide precedent for the scope or conditions of any exemption.
• Whether brokers need to register as Futures Commission Merchants is also an issue.  CFTC has required DCOs outside the US to change rules to require that clearing members outside the US that handle US clients must register as FCMs with the CFTC.  If a clearing house is not a DCO the CFTC may grant an exemption from clearing member registration as FCMs, but the issue remains unclear.  Exemption authority is not well defined, and may depend on how terms are defined within the regulations.  Needs to be a solution to allow US customers to deal with a foreign clearing member where that clearing member is mandated by foreign law to be domiciled and registered elsewhere.
• Inconsistent and sometimes contrary regulations will require some lead time as well as guidance to resolve.
•  No matter where you are doing business in the world, if you are doing business with a US customer then your business will be subject to Dodd-Frank requirements.  A non-US affiliate of a US person will probably not be subject to the requirements (e.g., a London affiliate of a US bank or corporate).  Branches may raise a more difficult question as branches are typically not treated as separate entities of a bank, so a non-US branch of a US bank may be treated as a US person.  SEC and CFTC interpretations on US persons remain inconsistent.
•  What level of US investor participation in an off-shore fund will trigger treating the off-shore fund as a US person?  Similarly, it may make a difference if there is a US-based investment advisor managing the off-shore fund.
•  The nature of the underlying contract may also have an impact, if the underlying is a US corporate or a US-exchange-traded contract.  The CFTC may be reluctant to carve these out from US jurisdiction.  “contacts and effects” test in 722 of Dodd-Frank may be inconsistent with the US Supreme Court pre-Dodd-Frank decision in the Morrison case which limited extra-territorial scope.
• In addition to CFTC and SEC, Dodd-Frank recognises prudential regulators for the purpose of determining adequate margin and capital.  Institutions subject to Federal Reserve oversight may benefit from a regulator which is more comfortable recognising home country rules on prudential supervision, but this then raises competitive issues for non-banks subject to more restrictive SEC or CFTC regimes.
• It takes quite a long time to sort out the answers to cross-border regulation, and the gaps are often filled by market practice rather than new rules.  Transactional certainty may remain elusive for a long time, which will chill international activity and makes for poor public policy.  Law firms and swap dealers will have to coordinate to fill in the gaps while the agencies deliberate the final rules.
• In the Lehman insolvency, we found great reluctance to cede local interests in times of extreme stress.  There will be various pools of client margin in different pools in different countries leading to lower efficiency and more risk. 
•  Systems and infrastructure should focus in the medium term on cross-margining and netting to reduce margin inefficiencies and provide greater certainty on close-out positions in resolutions.