And now to return to our commentary a few weeks back about the stultifying impact of ill-thought through rules and regulations (at best) (Brexit has intervened). This is our Regulatory State which broadly attempted to pick winners and losers and modify market behavior, to get an engineered outcome by using the blunderbuss of proscriptive rules and regulation.
We all know about risk retention and we talk about it every single day, but it’s the totality of the regulatory incrustation of the hull of our Ship of State that’s truly, truly worrying. And since it’s really hard to keep up, we thought we would give everyone a Cliff Notes handy reminder of what’s out there. This is, I’m sure, only a partial list (even I forget some of this stuff periodically – possibly a defense mechanism) and regrettably the list will undoubtedly get longer. So here we go:
- The Proprietary Trading Restrictions of the Volcker Rule in Dodd-Frank continue to vastly reduce liquidity across fixed income assets. How does one separate proprietary trading from market making through the lens of the perfect hindsight of a regulator looking at a loss in the future? What’s that mean for banking today? Extraordinarily wide guardrails around where the banks think the line might actually lie. How else can you preserve your deferred compensation? (See below.)
- Risk retention remains a material risk to the CMBS market and the broader structured finance marketplace in the form in which it exists today. No scalable solution is at hand. Regardless of what happens in the long term, credit will get less available and more expensive as 2017 approaches. Some important market participants may just conclude this is too hard and no longer profitable and go home.
- The Net Stable Funding Ratio, the High Quality Liquid Asset Rule, the Supplemental Leverage Rule, the Total Loss Absorbency Capital Rule, in effect now or going into effect during the next several years. Capital on capital. This is all part of what many bankers are now referring to as Basel IV. This is a package of proposed rules, exposure drafts and the like which take Basel III as a starting point and adds more capital, more liquidity, less leverage, more compliance and more regulations. The solution to everything can’t be piling more and more capital on the banks. In a heads I win, tails you lose choice between addressing risk with more capital or trying to pick winners and losers, I guess I’d vote for more capital. That’s what Dr. Greenspan concluded after watching us flail away in our regulatory dog’s breakfast. He had it right. But, we should not be adding capital and ballooning the regulatory state at the same time. Pick A or B, please, not both. In toto, a big step towards Utilityland for our largest banks; stolid, undynamic, not entrepreneurial but … at least in theory, safe-ish. Whether that’s a good trade or not, it’s financial global warming, baby. Don’t go suggesting it’s not the “right thing to do” (or we won’t invite you to our cocktail parties anymore, or maybe have the New York attorney general indict you under RICO).
- RWA Protocols. There is an initiative under way to severely limit the capacity of our largest banks to use their own models to determine their risk weighted assets (RWA) and also to consider material changes in how the banks calculate so-called operating risks. Certainly, to some extent, this is being driven by regulators’ concern about lack of consistency across the banking sector, but the result is more compliance, more compliance costs, less flexibility, less entrepreneurship and less dynamism in our banking sector. Unintended consequences? You bet.
- The Liquidity Coverage Rules and the Step-In Proposal from Basel propose to require banks to hold additional capital against exposures of non-consolidated SPVs which they have organized for one or more specific business purposes, most typically securitization. This is capital against risk for which the banks have no contractual liability. Shadow boxing with the long dead and buried SIVs of 2008. Talk about fighting the last war.
- The Fundamental Review of the Trading Book (FRTB). Now we’re back to picking winners and losers (and more Basel IV). In another effort to specifically affect bank behavior the FRTB adds almost unsustainable levels of capital to trading book assets. When did we decide that trading was bad? I thought trading was good. Don’t our policy elite understand that liquidity is important? There is no liquidity without competent trading markets.
- The Comprehensive Capital Analysis Review (CCAR) process has become the carrier and medium (think bacteria in petri dish) of a wide range in discretionary and intrusive fishing expeditions through our banks, their policies and procedures and historic performance. While the light shed is questionable, the heat is undeniable. It slows processes, breeds inefficiency, encourages uncertainty and fosters a culture of no. The Wall Street Journal recently reported that all this compliance for just our six largest banks is costing $70 billion a year! Yikes. That’s a tax on the system. Do we have any idea what we are getting for all of that? I surely don’t, but I know, with a moral certainty, that none of it will make the business cycle go away, recessions stop or financial crises things of the past.
- The new Proposed Incentive Compensation Rules finally published for comment under Section 956 of Dodd-Frank: As proposed, the rules which would take effect in 2018 or 2019 will cover all institutions larger than $1 billion in assets plus certain broker/dealers and investment advisors and very significantly put at risk, through deferrals and claw backs, the compensation of not just the C-suite, but a significant number of key employees throughout these institutions: One estimate is that over 50,000 employees will be affected at our six largest banks. Did anyone have any idea what an enormous impact this will have on entrepreneurship? Think about it; the only time the deferrals and claw backs will come into play is when the economy turns down. When the economy turns down and commitments, loans and undertakings made several years before go bad, how does one prove the decisions made years ago were not imprudent? Finding the dog that doesn’t bark. It’s a sort of a butterfly wing problem writ large. Our hypothetical bank employee with a copy of the Dodd-Frank bill on his desk considers committing his institution. He weighs asymmetric risks and rewards and decides to pass, let someone else approve this. Happens once, no big deal; happens thousands of times year in and year out, big deal. Did anyone ask what this will really do? Of course not. Will our banking sector push back on this? In this political environment? I don’t think so. So who will engage in the debate that needs to happen on the wisdom and efficacy of this breathtaking and problematic intervention into performance of this month’s human resource and talent? Who is John Galt?
- The Intermediate Holding Company Rule. This Rule looks to require U.S. subsidiaries of non-domestic banks to hold more capital domestically. Its consequence, whether fully intentional or otherwise, is to push foreign banks out of the U.S. market as they in the past kept most of the capital with the mother ship. Is this creating a level playing field? Maybe, but it’s also likely to reduce the supply of capital to U.S. domestic markets. And has anyone thought that through?
- HVCRE or High Volatility Commercial Real Estate, is a very blunt instrument indeed to attempt to make acquisition, development and construction loans safer. The regulators concluded, I am sure after careful and balanced study, that these loans carry more risk than loans on stabilized commercial real estate. Duh. Isn’t that why banks have always underwritten these loans more aggressively, priced them wider than loans on stabilized properties and provided much more intensive management and surveillance? Yup. Here’s a flash: Loans on non-stabilized properties fail first when the market turns down. Here’s another flash: Markets turn down. Bright lines imposing excess capital do not substitute for judgment and it’s judgment that makes safe loans and minimizes losses and not a system that excoriates judgment and relies on capital to absorb losses. This is a badly thought out rule that is chilling broad swathes of the commercial real estate industry. Moreover, and this is true of many of these rules, it has created a massive management and compliance headache, which is evidenced by the widely disparate treatment of HVCRE across the banking system. This one needs to be fixed and fixed soon.
- Almost everything the CFPB is doing. This was supposed to be a consumer-focused organization. Mission Creep is well and truly underway. Let’s talk HMDA as an example. HMDA or the U.S. Home Mortgage Disclosure Act has very little to do with commercial real estate, right? So we thought from its passage in 1974 to very recently. Wrong. Previously reporting under HDMA was limited to only the largest institutions who had a large volume of multifamily loans. Now through the sort of double-speak legerdemain that our regulatory establishment has perfected, the CFPB has “discovered” that HMDA applies to almost all multi-family lending and will require the delivery to the bureau of a massive amount of data which, we most certainly know, the CFPB will turn into grist for regulatory action and litigation. These are apartments, for heaven sakes, where is the consumer mortgage here? Never mind, silly question.
- And now, piling on from our good friends at FASB. Have you looked at the new loan loss provisions that will require a lender to estimate anticipated losses and take charges with respect to loans when they’re initially closed? Loans often have losses. Not all loans will be paid off in accordance with their terms. This is especially true for the long tenured mortgage loan central to the operation of commercial real estate. If a bank has to take modeled notions of anticipated losses into effect when the credit is opened, then all borrowers will pay through lower proceeds, higher spreads and more difficult underwriting. Is that what’s intended? Let’s face it, FASB is a creature of government and for our purposes should be seen as part of government. These rules are not now in effect and perhaps they can get fixed, but while under discussion, it will begin to impact behavior and impact the enthusiasm for commercial real estate lending. That’s just what we need right now, more reasons for the banking system to not provide credit to commercial real estate.
- And God help us, let us not forget the insurance industry. The Board of governors of the Federal Reserve published this past week for comment something called the “Capital Requirements for Supervised Institutions Significantly Engaged in Insurance Activities” as well as “Enhanced Prudential Standards for Systemically Important Insurance Companies” (I really haven’t had the heart to dig into these yet).
- Last, on the domestic front and maybe it should have been first in the order of go, the shot across the bow of the banking industry by the FRB, FDIC and OCC last December that styled itself guidance (in the same way as Don Corleone’s offer you can’t refuse was guidance) strongly suggested that the regulators were concerned with the level of CRE exposure across the banking sector and were watching closely. Guidance, yeah sure.
- Finally, don’t forget all the wonderful regulatory output of the European Community. We’ve got a risk retention rule that no one seems to understand and materially conflicts with the U.S. rule (but, of course!). We’ve got the new version of the Simple Transparent and Comparable Securitization Rule (STC, which continues to sound to me like a sexually transmitted disease) that purports to make it better but will once again be picking winners and losers across the pond.
So there you are; an up to the minute cheat sheet on the encrustation of the Regulatory Estate. I guess I shouldn’t complain because to the extent this doesn’t actually kill the patient, it’s probably good for us lawyers who have to continue to find opportunities in the detritus of the business model after it’s been carpet bombed by our elected representatives and their enabling apparatchiki. But, wow! As we said last week, at some point institutions will ask, “How do I conduct business in this space?” We’re seeing it right now, business is contracting, liquidity is diminishing, capital formation is slowing and all this as the economy perhaps gets to the end of its longest, albeit anemic, expansion in the past 50 years and we’re beginning to see the signs of a recession in front of us. I know, I know. There’s simply no point in whining; there’s certainly no point in expecting anything to get fixed, but we can’t just sit here and watch this happen, can we?