Capital Charges and Illicit Indexing

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Too big etc.

Yesterday the Fed released a final rule on capital surcharges for global systemically important banks, and I like how explicit Janet Yellen is here:

In practice, this final rule will confront these firms with a choice: they must either hold substantially more capital, reducing the likelihood that they will fail, or else they must shrink their systemic footprint, reducing the harm that their failure would do to our financial system. 

That seems about right: It would be an odd goal for the United States -- which is after all a big country -- to end up with no too-big-to-fail banks. The point is just to discourage them a bit at the margins, and make them less likely to fail. It is hard to imagine, for instance, that JPMorgan will break itself up just because it needs to go find $12.5 billion in extra capital under the final rule; it has until 2019 to get there, and added $2.6 billion of capital just last quarter (while also returning $2.6 billion to shareholders). It'll manage. Bigness seems to suit JPMorgan. 

Here's the Fed's white paper explaining how it thinks about the GSIB surcharge, which is a fascinating little document; it includes this estimate of the probability of losses for banks as a percentage of risk-weighted assets:

Source: Federal Reserve.

The actual math is then, like, a GSIB's failure is X times more damaging than a non-GSIB's failure, so the GSIB should have enough extra capital to reduce the probability of its default such that the expected loss from its default equals the expected loss of the (more probable, less damaging) default of a non-GSIB. But from that chart it looks like if everyone had 14 percent capital no one would ever default? JPMorgan has a 15.2 percent total capital ratio. We are quite near the promised land.

Index funds are already illegal.

One of my favorite financial-regulatory countercultures is the one that believes that diversified mutual funds should be illegal, because owning shares of multiple companies in the same industry is or ought to be an antitrust violation. This belief -- we talked about it here -- is very very far out of the mainstream (which loves index funds!) and yet oddly appealing to respectable people. For instance, it has seduced Harvard Law School professor Einer Elhauge, who begins his new paper this way:

An economic blockbuster has recently been exposed. A small group of institutions has acquired large shareholdings in horizontal competitors throughout our economy, causing them to compete less vigorously with each other.

That blockbuster is, like, look at the public holdings lists of big mutual fund companies. But the solution is not to ban mutual funds. The solution is to realize that mutual funds are already illegal:

Contrary to the assertion by some that new legislation is required to deal with this new anticompetitive problem, current antitrust law provides ample authority for antitrust agencies and private litigants to attack stock acquisitions that create anticompetitive horizontal shareholdings. The so-called passive investor exception is not to the contrary. It requires complete passivity in influencing corporate management or governance, not a passive investment strategy. Nor is it really an exception because, when established, all the doctrine really does is heighten the burden of proof. Because the empirical evidence suggests this heightened burden can be met, even truly passive horizontal shareholdings could be subject to antitrust challenge. 

Now I am no antitrust expert, and Elhauge is a professor at Harvard Law School, so I am going to assume that he's right. Really it's entirely consistent with how I think about American law that we would have somehow made it a felony to own an index fund without anyone noticing. (I exaggerate, slightly.) But ... you know ... is that ... right? Should it actually be illegal to diversify your investments? I continue to be delighted by the growing number of experts who think the answer is yes, though I also continue to own index funds. What can I say, I like to live dangerously.

People are worried about stock buybacks.

I have worried in the past that the 2016 U.S. presidential election might be all about the Rule 10b-18 safe harbor, so I was pleased to see that Hillary Clinton's plan to tame the growing scourge of stock buybacks actually involves, not amending Rule 10b-18, but instead increasing the holding period required to fully benefit from the lower long-term capital gains tax rate. I am old enough to remember a time when left-wing economic thought involved taxing all capital gains at the same rate as labor income, so this seems like a fairly mild solution to the ravages of unchecked shareholder capitalism. I don't particularly think that this tax change would lengthen investors' time horizons any more than changes to Rule 10b-18 would: Time horizons are (arguably) short because investment intermediaries are measured on their (pre-tax!) daily/quarterly/yearly performance, not because they are constantly harvesting capital gains after a year and a day. Nor am I particularly sure that changing investors' time horizons is a sensible goal for a president, but, you know, elections have to be about something. There's an odd childishness to presidential politics, in which people who've never given the matter any thought have to pretend to have very serious and passionate beliefs about things, like shareholder activism, that don't have much to do with the actual job of the actual president. I guess if I were advising a presidential campaign I'd suggest tacking the other way and building a platform around banning index funds. That seems like a sure winner.

Meanwhile on the Republican side, here is Bloomberg View publisher Timothy L. O'Brien on the time future president Donald Trump sued him for understating Trump's net worth:

Have you “always been completely truthful in your public statements about your net worth,” my attorneys asked Donald. “I try,” was his reply. When they asked him about how he calculated his net worth, he noted that the figure “goes up and down with markets and with attitudes and with feelings, even my own feelings.” Later he added that “even my own feelings affect my value to myself.”

SEC administrative proceedings.

I confess that I do not fully understand why the Securities and Exchange Commission is so gung-ho on bringing its enforcement cases in front of its in-house administrative law judges instead of in actual courts. People are really peeved about it, and there are various plausible legal objections, and I have not noticed any overwhelming sympathy with financial fraudsters in the actual courts. Here is former SEC enforcement lawyer (and my law school classmate) Dan Walfish on "The Real Problem With SEC Administrative Proceedings," which is not that those proceedings occur before an SEC in-house judge but that they are then reviewed de novo by the SEC Commissioners themselves, who have previously decided to bring the proceedings in "a top-level, agency-wide decision to side with Enforcement and against the respondent, prior to any adversarial hearing on the merits." So "the SEC Commissioners act as both prosecutors and judges of their own enforcement actions." Walfish's proposed solution is to "give the SEC’s Enforcement Division the authority to independently institute cases, leaving the Commissioners free to serve as independent and credible reviewers on appeal," which I suppose would lead to more cases brought before in-house SEC judges, but in a less awkward way.

Toshiba.

It's sort of impressive that Toshiba's accounting scandal has led to the resignations of its last three presidents. Like, just that they were all around to resign: The immediate past president, Norio Sasaki, was the vice chairman, and previous president Atsutoshi Nishida "was serving as adviser"; they both resigned along with current president Hisao Tanaka. Really chief executives should have to stay on for a while after they stop being CEO just so that they're available to resign if anything bad comes out of their tenure. It's like a clawback, but instead of money Toshiba is clawing back a pleasant send-off.

And what came out of their tenure is pretty bad! I mean, it's the usual boring accounting stuff, but how they got there is pretty fishy:

All three CEOs pressured managers to achieve high sales targets, especially in the wake of the 2008 global financial crisis, the report said. It said the company had a system under which the CEO would set a “challenge” for subordinates to meet.

Sometimes the “challenge” would come shortly before the end of a quarter or fiscal year, forcing managers to postpone losses or push forward sales to meet the challenge, the report said.

It is generally hard to tell from outside if a culture of noncompliance comes from the top or not. If the boss has high and unforgiving expectations for his subordinates' productivity, that doesn't necessarily mean that he wants them to fudge the numbers. He could just be tough, or optimistic. But, you know, if you actually want people to meet their sales goals, maybe set them in advance? If you set them at the end of the year, they do kind of look more like accounting goals.

Promontory.

When a bank does a bad thing, regulators fine it a lot of money and force it to install a monitor to make sure it's stopped doing bad things. This creates inevitable conflicts of interest. Either the monitor works really hard on behalf of the prosecutors who installed it, in which case it will view everything in the worst possible light and find lots of misconduct to justify its fees, or it works on behalf of the bank that pays it, in which case it will tone down its findings of misconduct in ways that don't satisfy the regulators. Either way the result is new fines. Anyway here's a story about a New York Department of Financial Services investigation of Promontory Financial Group.

People are worried about bond market liquidity.

The liquidity pickings are a bit slim but here is the New York Fed on dealers' strategies in the GCF Repo market, finding that leverage-ratio rules and the Fed's overnight reverse repo facility may have reduced the volume of dealer repo activity. And here, from last week, is Tracy Alloway on Barclays on CDS index options, and the worry that we might "see the 'option tail wagging the index dog.'" If even CDS index liquidity isn't safe, what is? 

Sure, sure.

Here's an article about "Liberland," a new uninhabited micronation founded this year by three libertarians on banks of the Danube, in which all public services "will be run either by private enterprises or through crowdfunding campaigns." Amazingly Bitcoin isn't mentioned until the last paragraph.

Things happen.

Goldman intern blogs! Greek banks are open. Greece's Euro Exit Back on the Agenda Next Year, Economists Say. Municipalities should probably never do swaps. Macro hedge funds are outperforming CTAs. What now for China's stock market? First Data is doing an initial public offering. "The cannibals won’t be impressed by your cost basis in GLD." Luxury pet terminal.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net