July 2010 Archives

Hedge Funds after Dodd-Frank

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By Stephen Brown, Anthony Lynch, and Antti Petajisto

Now that the Dodd-Frank Act has been passed by both houses of Congress, we finally know its broad implications for hedge funds. As expected, it requires all large hedge fund advisers to register with the SEC. Also the new rules on derivatives trading have an additional impact on many hedge funds. However, since the Act leaves many specifics up to the regulators, considerable uncertainty remains about the exact form of the new rules. The main tradeoff is between the government's desire to learn more about hedge funds, both to assess systemic risk and to protect investors, and the compliance costs this imposes on funds and investors. Overall, how economically sensible is hedge fund regulation in the Act, and how well does the Act resolve this tradeoff?

by Roy C. Smith

After two years of effort, the US Congress last week gave President Obama a massive and very ambitious financial reform bill, the Dodd-Frank Act, to sign.

The 2,300 page law in 15 sections affects all financial service activities in various ways but it does little to improve systemic risk control. It strengthens the hands of regulators, but relies on them entirely to identify and avert future crises, things they have not been successful in doing in the past.

Too-big-to-fail financial firms (those with more than $50bn of assets, of which there are about 40 in the US) are largely left alone, free to be as large and complex as before.

However, if one of these financial firms faces a liquidity crisis in the future, which is likely given their aggressive business strategies, rescuing it with taxpayer funds to avoid a systemic crash will be much more difficult. Precluding bailouts when they are necessary will severely limit the government's ability to manage the next crisis.

Read the full opinion editorial on eFinancialNews.com

Dodd-Frank and the Fed

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by Kermit Schoenholtz and Paul Wachtel

The Federal Reserve System was born of a financial crisis, the Panic of 1907, so it is not surprising that the global crisis which began one century later should lead to changes in the authority and responsibilities of the Fed. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandates the most important changes at the Fed since the Great Depression. The legislation explicitly expands the goals for the Fed to include financial stability in addition to the traditional goals of price stability and full employment.

Consequently, the central bank will have enhanced responsibility for systemic risk assessment and regulation, and it will house and fund a new Consumer Financial Protection Bureau. Yet, in addition to expanding the powers of the Fed, the Dodd-Frank bill also significantly narrows the Fed's emergency lending authority and subjects this lending to greater scrutiny. 

The actions of the Federal Reserve in the recent financial crisis highlighted the extraordinary powers that many central banks have to intervene in an economy in a crisis. Not surprisingly, the interventions led to a vigorous public debate about the choices the Fed made, the proper role of the Fed in a crisis, and the transparency of its actions.  Although Dodd-Frank expands the Fed's responsibilities regarding financial stability, it also seeks to rein in an independent and powerful financial institution with unelected leadership and limited accountability. 

The role of a central bank in financial crises is a topic with a long history. With the help of Walter Bagehot, the Bank of England learned in the 1860s and 1870s that proper behavior on the part of a lender of last resort is to furnish liquidity to the market by discounting freely when presented with good collateral, at a penalty rate of interest that incentivizes borrowers to repay. In the recent crisis, the Fed developed a range of facilities to deliver liquidity. The Fed intervened to an unprecedented degree, reacting quickly to create vast reserves and shoring up institutions in novel ways to prevent a wholesale collapse of the U.S. financial system.

But the Fed and some other central banks also went well beyond what Bagehot taught a century and a half ago. In addition to lending to the market, they lent to particular institutions in trouble, sometimes on dodgy collateral, thereby attracting great political criticism.  Even in lending to the market, the Fed expanded its traditional role as lender of last resort to become an investor of last resort as well. One could argue that this was an appropriate means to prevent a widespread systemic collapse of the financial system. Yet, it was bound to add to concerns about the range of Fed powers. 

Not surprisingly, Congress has turned its attention to ways to improve financial sector regulation and avert future crises. The changes to the role of the Fed that are introduced by the Dodd-Frank bill arise mostly out of serious thought about the role of central banks and the appropriate scope of their activity. But, there also are lingering reflections of the public anger triggered by the crisis and the Fed's role in it. 

There are three aspects of central bank activities - monetary policy, financial institution regulation and systemic risk oversight.  In our view, the strong linkages among the three functions are sufficiently compelling that, with proper oversight, the central bank should have broad authority in all three of them. The Dodd-Frank bill takes some steps in this direction. It gives the Fed a role in maintaining financial stability and sets the stage for its use of macroprudential tools to tame systemic risks. It does not diminish the Fed's responsibility for monetary policy. Finally, it leaves the Fed explicit responsibility for some aspects of bank regulation and, importantly, creates new supervisory authority over all financial institutions that are deemed officially to be systemically important.

A strong and independent central bank is indispensable for effective monetary policy. However, it also is an anomalous entity in a constitutional democracy that emphasizes accountability and the responsibility of elected officials. Fortunately, the Dodd-Frank bill leaves the independence of the Federal Reserve reasonably intact. Some specific challenges to central bank independence that were introduced in earlier Congressional discussion were misguided and potentially counterproductive expressions of public anger regarding the recent financial crisis. Anger is a poor basis on which to make effective reforms. The Dodd-Frank bill dropped the most egregious attacks on the Fed. 

With regard to regulatory and systemic oversight, the Fed's enhanced powers to use macroprudential tools and the policy focus provided by its new Vice Governor for Supervision may help prepare both the central bank and the government for systemic risks.

However, the Dodd-Frank bill also prohibits or delays the use of selected Fed crisis management tools that played an important role in mitigating the recent crisis. In particular, aside from broad-based programs of liquidity provision, the Fed may no longer lend to individual nonbanks whose solvency is in doubt. Instead, the bill relies heavily on new, complex, and potentially unwieldy regulatory and resolution mechanisms to prevent and tame future crises. 

It is far from clear that this new apparatus will prove effective in countering crises when they occur, and may even increase their likelihood. The Financial Stability Oversight Council is an umbrella group of policymakers with a staff housed in the Treasury that will seek to identify systemic risks and instruct the Fed to respond. This loose structure is untested and far from streamlined. It does not appear well suited to foster the strong leadership, clear chain of command, and timely interventions that have characterized successful policy responses over the long history of financial crisies. In addition, the bill's new resolution mechanism - which aims to protect taxpayers and impose the costs of financial failures on unsecured creditors -- may unintentionally increase the probability of a run by such creditors in response to a shock that weakens the financial system.

Ultimately, the combination of new restrictions on Fed emergency lending and the new structures for responding to systemic risk and financial crises will have to be judged when tested by events.  If the new structures prove ineffective, the Dodd-Frank bill's elimination of emergency authority for some forms of Fed lending could make future crises even more devastating than the recent one.

by Viral V. Acharya and T. Sabri Öncü

Although one of the main concerns of the Dodd-Frank Wall Street Reform and Consumer Protection Act soon to be signed by President Obama to law is systemic risk, it is disconcerting that the Act is completely silent about how to reform one of the systemically most important corners of Wall Street: the repo market, whose size based on daily amount outstanding now surpasses the total GDP of China and Germany combined. The financial crisis of 2007-2009 to which the Dodd-Frank Act is a response was a crisis not only of the traditional banks, but also of the shadow banks, those non-bank financial institutions that borrow short-term in rollover debt markets, leverage significantly, and lend and invest in longer-term and illiquid assets. Unlike traditional banks, shadow banks did not have access to the safety nets designed to prevent wholesale runs on banks - namely, deposit insurance and the central bank as the lender of last resort - until 2008. Although there was no wholesale run on the traditional banking system during the crisis of 2007-2009, we effectively observed a run on shadow banks that led to the demise of a significant part of the shadow banking system. Since repo financing was the basis of most of the leveraged positions of the shadow banks, a large part of the run occurred in the repo market. Indeed, the financial crisis of 2007-2009 was triggered by a shadow bank run on two Bear Stearns hedge funds speculating in the potentially illiquid subprime mortgages by borrowing short-term in the repo market.

by Vicki Morwitz and Robert Whitelaw

The Senate today approved the Dodd-Frank Wall Street Reform and Consumer Protection Act. Soon President Obama will sign it, and the Act will become law. One notable aspect of this sweeping financial regulation is the creation of a new Bureau of Consumer Financial Protection (BCFP) as an independent bureau within the Federal Reserve System. The BCFP is charged with aiding consumers in understanding and using relevant information; protecting them from abuse, deception, and fraud; ensuring that disclosures for financial products are easy to understand; conducting research; and providing financial literacy education. But will the new law accomplish these goals? And who will be the winners and losers under the new law?

Failures of the Dodd-Frank Act

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by Viral Acharya

Last month, Friedrich Hayek's classic "The Road to Serfdom", a warning against the dangers of excessive state control, was the number one bestseller on Amazon. At the same time, the foundation of much modern economics and capitalism - Adam Smith's "The Wealth of Nations" - languished around a rank of ten thousand. It is a telling reflection of the uncertain times we are in that precisely when confidence in free markets is at its all time low that scepticism about the ability of governments and regulation to do any better is at its peak. It is thus no trivial task for Messrs Dodd and Frank to put up the Wall Street Reform and Consumer Protection Act and convince the suspecting audience that financial stability will be restored in the near future.

The backdrop for the Act is now well understood. When a large part of the financial sector is funded with fragile, short-term debt and is hit by a common shock to its long-term assets, there can be wholesale failures and disruption of intermediation to households and corporations.

Read the full opinion editorial on the Financial Times' website.
by Matthew Richardson, Roy C. Smith and Ingo Walter

As part of any effort to seriously address excessive systemic risk, the logic of limiting government guarantees to core banking activities - and segregating non-banking risk-taking businesses - is fundamentally sound and in the public interest. This is especially true if other efforts to bolster safety and soundness, like increases in capital buffers, are delayed in a fragile economy or eventually end-run by the banks.

While we do not favor breaking up of the large, complex financial institutions based on arbitrary size restrictions, we do favor market concentration limits as a matter of competitive structure as well as systemic risk exposure. We also support targeted scope restrictions on functional activities conducted by systemic financial firms, essentially in line with the Volcker Rule as originally proposed. There have been two alternatives.

One is to require a complete separation of proprietary trading and asset management businesses - activities that facilitate high-powered and opaque risk-taking and are also highly cyclical - from commercial banking operations, which have access to government-guaranteed deposits and lender of last resort support in crises, and which provide financial intermediation services to the real economy. Any commingling of these activities is harmful to the public interest.

The second is to assess guarantee insurance premiums on financial conglomerates that encompass commercial banks - premiums which are commensurate with the systemic risk contributions of their various activities, and then let financial firms break themselves up organically if they find it profitable to do so. This approach considers that commingling of different activities may be socially desirable for some firms but not for others, and faced with higher premiums for riskier activities, the latter (or some of them) may carve-out these activities as a matter of strategic redirection. 

While the commingling of commercial banking with investment banking activities such as underwriting and market-making was ruled out in the financial reforms of the 1930s, such commingling did not contribute to the recent financial crisis. The Volcker Rule, as originally proposed, banning proprietary trading and sponsoring hedge funds and private equity funds by firms benefiting from access to the government safety net, was significantly watered down in the Financial Reform and Consumer Protection Act of 2010, which has now been passed by both houses of Congress. 

We supported the original Volcker proposals as the best chance for limiting the spillovers and systemic risk by banning proprietary trading, correctly defined, and prohibiting banking conglomerates sponsoring and investing in proprietary hedge funds and private equity funds. We continue to believe this approach makes a lot of sense, tailored to modern financial products and markets, when combined with the ready availability of financial specialists to conduct proprietary activities in a way that can be effectively regulated. It is an initiative unlikely to trigger significant social costs in terms of financial efficiency, innovation and competitiveness. Indeed, based on a careful analysis of the unintended consequences of the Glass Steagall restrictions of 1933, quite the opposite could well turn out to be the case.

In the event, only a mild version of the Volcker Rule survived the legislative process and allows banks to continue proprietary trading in certain public obligations as well as sponsorship with limited equity interest of hedge funds and private equity funds. It seems to us like a defensible second-best solution. The same is true of the limited requirement for trading high-risk derivatives through separately capitalized subsidiaries. Whether these reforms are robust enough to withstand the next crisis remains to be seen.

So the legislating breakup of systemically important large, complex financial institutions didn't happen this time around - institutions that many observers believe to be not only too big to fail, but also too big to management and too big to regulate. So the structural basis for significant systemic risk exposure in the US financial system likely to remain pretty much as before, which places an enormous premium on the other safeguards built into the Financial Reform and Consumer Protection Act of 2010. They had better work.

The key benefit of this week's US regulatory outcome, despite its limitations and loopholes, is that it may cause key firms to rethink their business models and the population of less systemic financial specialists in the financial system will increase. Chances are the surviving businesses would be far simpler and their accounts far more transparent (and more easily subject to regulation) than those of today's dominant financial conglomerates. This, in turn, would give banking regulators a better shot at understanding and containing the risks that might result in future bailouts. As well, financial conglomerates ability to abuse government guarantees intended for one activity by supporting riskier ones will be limited - so that the endemic problem of government guarantees' compromising market discipline and engendering future crises will have been alleviated.

by Jennifer Carpenter, Thomas Cooley and Ingo Walter

Now that the Financial Reform and Consumer Protection Act of 2010 has been passed by both houses of Congress, one of the key aspects that bear watching will be its impact on compensation of senior management and highly compensated risk-taking employees - who generally take home around half of financial firms' earnings from wholesale banking activities.

Almost every investigation of the financial crisis has provoked a fresh round of public and political outrage as more details about compensation levels and practices at financial institutions have come to light.  The increase in executive pay relative to median pay throughout corporate America has been a focal point of media and investor attention for some time, but compensation policy in the financial industry is among the most extreme.  Regulators and politicians have been quick to count compensation in the financial sector as a major cause of the crisis, and many have advocated punitive taxation and direct regulation including caps on cash bonuses and floors on the proportion of share-based pay.

Our view is that compensation policy in the financial industry was not, by itself, a real cause of the crisis.  Although astronomical levels of pay may offend most people's sense of fairness -- and wealth-redistribution as opposed to wealth-creation -- they are not in themselves destabilizing.  What matters for financial stability is not the level of compensation, but rather the risk incentives it creates.  Compensation structures during the period leading up to the crisis undoubtedly did create incentives to take risks that were excessive from society's viewpoint. But the source of this problem is that incentives for taking excessive risk are built directly into bank equity itself and consequently are a key responsibility of the board.  

It's long been recognized recognized that holders of highly-levered equity, protected by deposit insurance or too-big-to-fail guarantees, have incentive to maximize the value of that equity at taxpayer expense by taking big bets. Capital requirements and restrictions on banking activity were supposed to address this conflict of interest between financial firm shareholders and taxpayers. But deregulation of banks and innovation in financial products either explicitly or effectively loosened these constraints.  In retrospect, it seems clear that shareholders, and their boards, condoned and even encouraged many of the risky activities for which high-profile managers and traders have been blamed, such as accumulating large inventories of dodgy but profitable assets.

Some compensation practices, such as paying bonuses based on "fake alpha" (excess returns determining current bonuses that later turn out to be illusory), induced systemic risk at the expense of both shareholders and taxpayers.  However, shareholders of the major financial firms evidently were largely supportive of compensation policy.  Indeed, in the face of supervision that might have strengthened their hand at the bargaining table with highly compensated employees and managers, boards of bailed-out financial firms scrambled to pay back government loans primarily to regain freedom to grant the signing bonuses and pay guarantees they felt were necessary to attract and retain the talent they felt added value.

While we are in favor of compensation reforms in the financial sector, we argue that the solution is not direct pay regulation, involving hundreds of thousands of contracts between firms and highly compensated staff with heterogeneous preferences and skills, but rather a rewriting of the basic contract between taxpayers and the financial firms themselves. With new regulatory initiatives that place restrictions on lines of business that are protected by federal guarantees, correct pricing of deposit insurance, taxation of systemic risk, higher capital requirements, and other measures discussed in this book, much of the compensation problem is likely to resolve itself. If the incentives facing shareholders at financial firms can be better aligned with those of taxpayers, for example, through correct pricing of guarantees and taxation of systemic risk, then it remains only to strengthen shareholder rights as much as possible and leave shareholders representatives on boards to provide managers with the right incentives.

For this reason, we favor many of the G-20 and US legislative provisions for executive compensation.  These strengthen shareholder rights by mandating nonbinding shareholder votes on executive pay and better disclosure of compensation policy and the permissibility of managerial hedging, yet do not tie boards' hands with more rigid regulation of compensation structure.  We also strongly support the Federal Reserve's plans for regular review of compensation in the financial sector, and hope that it will generate a large database on compensation in the financial industry that will spur compensation reform in the future.

With sufficient alignment of taxpayer and shareholder interests, and sufficient strengthening of shareholder rights, we expect to see compensation reform emerge largely on its own.  What might elements of sensible compensation policy at financial firms include? 

• Stock-based or other performance-based pay, without predetermined minimums, to create an incentive to add value through efficiency and innovation;

• Ex-ante risk adjustment of performance measures, to discourage the pursuit of illusory "fake alpha" profit;

• Deferred cash compensation, or "inside debt," to give managers an interest in the long-term solvency of the firm;

• Claw-backs, or "maluses" to give managers a tangible personal interest in controlling downside risk;

• Guaranteed cash compensation (the G-20 recommendations notwithstanding) to attract and retain talented personnel and compensate them for the risks they may personally be forced to bear.

Note that our list does not preemptively include caps on cash compensation or floors on the proportion of stock-based compensation.  More stock-based compensation might only aggravate the perverse incentives problem if taxpayer/shareholder conflicts persist.  Capping pay also seems heavy-handed.  For example, financial firms may need to raise cash compensation to managers in return for forcing them bear more downside risk in stock-based compensation and lock-ups.  And we have noted that average pay levels at these institutions could very well decline on their own if the Volcker Rules and other restrictions on banking activity ultimately mean these firms find less use for high-priced talent, and the affected employees depart for better opportunities elsewhere.

Is endogenous compensation reform too much to hope for?  Perhaps.  But fixing the obvious conflicts between shareholders and taxpayers, strengthening shareholder power, and then giving market discipline a chance seems like the best place to start. 
by Roy C. Smith

The financial overhaul bill set for passage sometime next week is supposed to "bring accountability to Wall Street." In announcing an agreement between the House and Senate last week, Senator Christopher Dodd noted that "the American people have called on us to set clear rules of the road for the financial industry to prevent a repeat of the financial collapse that cost so many so dearly."

The final bill, though, does little to prevent a systemically important bank from failing, and makes it far more difficult for regulators to assist one seeking to avoid failure. This all but insures that the system-wide calamity the bill should be trying to prevent will, in fact, occur again.

Read the full opinion editorial on Bloomberg.com

About RegulatingWallStreet.com

The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

About Restoring Financial Stability

Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

About the Authors