What We’re Reading in Financial Regulatory Reform, September 25

As Washington winds down from a spiritual week, we hope these readings from the financial regulatory world inspire you. As always, the views expressed in these articles do not necessarily represent the views of the initiative, its co-chairs, task force members or the Bipartisan Policy Center.

Compiled by Aaron Klein, Justin Schardin, Kristofer Readling and Olivia Weiss.

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What we’re reading on cyber security and anti-money laundering

“Acceleration in Suspicious Activity Reporting Warrants Another Look”
By Aaron Klein, Director and Kristofer Readling, Policy Analyst, Financial Regulatory Reform Initiative, Bipartisan Policy Center

“BPC’s Financial Regulatory Reform Initiative set out to find empirical evidence of anti-money laundering (AML) expansion. The data shows a 55 percent increase in the number of Suspicious Activity Reports (SAR) filings after the USA PATRIOT Act (Patriot Act) was passed from the pre-2001 trend. This suggests that something has indeed changed the reporting mindset of institutions subject to the BSA. It also raises some questions: what are these additional reports being used for? Do regulators have the resources necessary to handle the increased flow of information? Are resources being used as efficiently as possible to catch the most important targets of illegal activity?” Read the post.

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“Remarks at The Center For Strategic And International Studies Strategic Technologies Program”
By Sarah Bloom Raskin, Deputy Secretary, U.S. Department of the Treasury

“Cyber insurance provides an important risk mitigation tool by allowing policyholders to transfer some financial exposure associated with cyber events. Cyber insurance can play another role as well. The underwriting process itself can bolster cybersecurity. To qualify for cyber insurance, a business typically fills out an application seeking details on its risk level and controls that mitigate the risk. The act of engaging in this process helps businesses identify tools and best practices that they may be lacking. Some insurers go a step further by asking questions during the underwriting process to better gauge how embedded cybersecurity is in a company’s governance, control, and enterprise risk management infrastructures.” Read the speech.

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“Casting a Wide Net: The Expanding Reach of Anti-Money Laundering Laws”
By Kristofer Readling, Policy Analyst, Financial Regulatory Reform Initiative, Bipartisan Policy Center

“The range of activities leading to BSA prosecutions raises questions about the purpose of the BSA, its expansion and the proper scope of its use, because the core conduct at issue is often unrelated to money laundering. The BSA’s history shows a narrative of Congress expanding the BSA’s application to an ever wider range of activities. This expansion is set to continue as the U.S. Treasury Department now intends to bring managed funds under the jurisdiction of the BSA.” Read the post.

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What we’re reading from key policymakers

“Letter to Government Accountability Office regarding the Federal Reserve dividend rate”
By Jeb Hensarling, Chairman, Committee on Financial Services, U.S. House of Representatives

“I write to request that the Government Accountability Office (GAO) study and report on the policy implications, including the effect on the federal banking regulators, the Federal Reserve Banks, and the national and state bank members of the Federal Reserve system, of modifying or eliminating the existing requirement that all Fed member banks purchase stock issued by their respective Federal Reserve Bank.” Read the letter.

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“Remarks by FDIC Chairman Martin J. Gruenberg To the FDIC Banking Research Conference; Arlington, VA”
By Martin J. Gruenberg, Chairman, Federal Deposit Insurance Corporation

“In the United States, the statutory mandate for the FDIC is clear: Use the living will process to bring about real-time changes in the structure and operations of firms to facilitate orderly resolution under bankruptcy. And, if necessary, be prepared to use the powers available under the Orderly Liquidation Authority to manage the orderly failure of a firm. And to be clear, if the FDIC had to use the Orderly Liquidation Authority, it would result in the following consequences for the firm: shareholders would lose their investments, unsecured creditors would suffer losses in accordance with the losses of the firm, culpable management would be replaced, and the firm would be wound down and liquidated in an orderly manner at no cost to taxpayers.” Read the speech.

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“The Leverage Ratio and Derivatives: Presented to the Exchequer Club of Washington, D.C.”
By Thomas M. Hoenig, Vice Chairman, Federal Deposit Insurance Corporation

“I see no credible case that strong capital requirements undermine the U.S. financial system or economy, as some contend, or that the system has suffered from insufficient bank derivatives activity. Weakening derivatives capital requirements would encourage even larger volumes of interlinked and opaque derivatives activity. Such an outcome strikes me as a counterintuitive and jarring abandonment of post-crisis regulatory initiatives. For myself, as a U.S. regulator, I would be hard pressed to support proposals that weaken the leverage treatment of derivatives for U.S. banking organizations.” Read the speech.

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What we’re reading on market liquidity

“Gradualism in Monetary Policy: A Time-Consistency Problem?”
By Jeremy C. Stein, Visiting Professor of Business Administration and Adi Sunderam, Assistant Professor of Business Administration, Harvard University and NBER

“We have argued that in our setting, it can be valuable for a central bank to develop an institutional culture and set of norms such that a concern with bond-market volatility does not play an outsized role in policy deliberations. In other words, it can be useful for monetary policymakers to build a reputation for not caring too much about the bond market.” Read the paper.

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“An Agent-based Model for Crisis Liquidity Dynamics, Working Paper,” Office of Financial Research
By Richard Bookstaber, Head of Risk Management and Managing Director, Office of the Chief Investment Officer, Regents of the University of California and Mark Paddrik, Researcher, Office of Financial Research

“We develop an agent-based model with the objective of evaluating the market dynamics that lead the market supply of liquidity to recede during periods of crisis. The model uses a limit-order-book framework to examine the interaction of three types of traditional market agents: liquidity demanders, liquidity suppliers, and market makers. The paper highlights the implications of changes in market makers’ ability to provide intermediation services and the heterogeneous decision cycles of liquidity demanders versus liquidity suppliers for crisis-induced illiquidity.” Read the paper.

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“85th Annual Report”
By the Bank for International Settlements

“The fragility of otherwise buoyant markets was underscored by increasingly frequent bouts of volatility and signs of reduced market liquidity. Such signs were perhaps clearest in fixed income markets, where market-makers have scaled back their activities and market-making has increasingly concentrated in the most liquid bonds. As other types of players, such as asset managers, have taken their place, the risk of “liquidity illusion” has increased: market liquidity appears ample in normal times, but vanishes quickly during market stress.” Read the report.

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The Dark Side of Pools: What Investors Should Learn From Regulators’ Actions
By The Healthy Markets Association

“In each of these endeavors, investors should promote rigorous best practices by their brokers, by the dark pools to which they route orders, and within their own trading strategies. Investors can and should demand regulatory requirements that far exceed those in place today. Dark pools perform a critical function for investors and are not going away. Unfortunately, holes in the regulation and oversight of dark pool shave created a trading environment in which investors must blindly trust dark pool operators. The breadth, depth, and severity of recent regulatory actions plainly demonstrates that investors cannot blindly trust any dark pool. Investors are now warned.” Read the report.

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“Liquidity”
By Howard Marks, Co-Chairman, Oaktree Capital Management L.P.

“Often during crises, investors take to the sidelines, such that there are no buyers for the assets the come up for sale. Liquidity dries up, and prices plummet. In the past, banks have stepped forward, risking their proprietary capital in pursuit of profit. Many times, in our experience, banks have competed strongly against us to buy distressed debt, thereby supplying liquidity to the market. Although the eventual impact of the Volcker Rule is unknown, any diminution of the banks’ likelihood of engaging in proprietary buying during crises suggests a significant reduction in liquidity just when it may be needed the most.” Read the memo.

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What we’re reading on consumer protection

“Forward Through Ferguson: A Path Toward Racial Equity”
By The Ferguson Commission

“In many areas, the number of alternative financial service providers (check cashers, title lenders and payday lenders) far exceeds the number of bank and credit union branches. Alternative financial service providers can be Consumer Protection attractive because of proximity, and convenience—many offer a range of payment services, such as cashing pay checks, selling money orders with stamped envelopes, serving as agents for utility bill payments, and transmitting funds electronically for money transfers, all in one location. Financial empowerment centers, in contrast, seek to provide a one-stop-shop for the un- or under-banked that provides community development banking, multigenerational financial education, and convenient financial services with reasonable interest rates. The Commission recommends the development and support of these centers. It has been shown that very poor families can save and accumulate assets when well-structured products, programs, and policies are accessible.” Read the report.

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“Opportunities Exist to Enhance Management Controls Over the CFPB’s Consumer Complaint Database”
By the Office of the Inspector General, Board of Governors of the Federal Reserve System and the Consumer Financial Protection Bureau

“Overall, we found that the CFPB has taken steps to secure the DT Complaint Database in accordance with FISMA and the agency’s information security policies and procedures. For example, the CFPB has deployed network-level firewalls and intrusion detection systems for the DT Complaint Database. … Specifically, we identified improvements that are needed in the timely installation of database level patches, the enforcement of password expiration and user access requirements, and the logging and review of security events. Our report includes seven recommendations to strengthen controls for the DT Complaint Database in these areas.” Read the report.

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What we’re reading in other areas of financial regulation

“A crisis in student loans? How changes in the characteristics of borrowers and in the institutions they attended contributed to rising loan defaults,” Brookings Papers on Economic Activity, BPEA Conference Draft, September 10-11, 2015
By Adam Looney, Deputy Assistant Secretary (Tax Analysis), U.S. Treasury Department and Constantine Yannelis, PhD Candidate, Stanford University

“Most of the increase in default is associated with the rise in the number of borrowers at for-profit schools and, to a lesser extent, 2-year institutions and certain other non-selective institutions, whose students historically composed only a small share of borrowers. These non-traditional borrowers were drawn from lower income families, attended institutions with relatively weak educational outcomes, and experienced poor labor market outcomes after leaving school. In contrast, default rates among borrowers attending most 4-year public and non-profit private institutions and graduate borrowers—borrowers who represent the vast majority of the federal loan portfolio—have remained low, despite the severe recession and their relatively high loan balances.” Read the report.

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“Regulatory arbitrage in action: evidence from banking flows and macroprudential policy,” Staff Working Paper No. 546
By Dennis Reinhardt, Economist and Rhiannon Sowerbutts, Economist, Bank of England

“We find evidence that borrowing by the domestic non-bank sector from foreign banks increases after home authorities take a macroprudential capital action. We find no increase in borrowing from foreign banks after an action which tightens lending standards (such as limits on loan-to-value ratios for house purchase). Evidence on reserve requirements is mixed. Differences in the application of regulation for lending standards and capital regulation for international banks mean that while there is a level playing field for lending standards regulation, this does not always apply for capital regulation, giving foreign branches regulated by their home authorities a competitive advantage. Our results are, at first sight, different from the literature on regulatory arbitrage: we find that foreign banks expand their lending into host countries where regulation is tightened.” Read the report.