CFTC COMMISSIONER O'MALIA'S OPENING STATEMENT AT CFTC TECHNOLOGY ADVISORY COMMITTEE

FROM:  COMMODITY FUTURES TRADING COMMISSION 
Opening Statement of Commissioner Scott D. O’Malia, Chairman of the CFTC Technology Advisory Committee, Washington, DC

September 12, 2013

I would like to welcome our TAC members, members of the Subcommittee on Automated and High Frequency Trading, and other guests. I thank you all for joining us here. Our discussion today will include three panels: (1) SDR data harmonization, (2) the Commission’s recently published Concept Release on automated trading, and (3) SEF registration and compliance, and MAT submissions.

When I reinstated the Technology Advisory Committee (TAC) not long after I joined the Commission, I did so with the goal of providing a means by which the industry and the Commission could work together to discuss and resolve the challenges imposed on the marketplace by the Dodd-Frank Act. For the past two years, I have held regular meetings of the TAC to foster open discussion and find innovative solutions to technological issues with respect to pre-trade functionality,1 data standards,2 automated and high frequency trading,3 and customer protection.4

Panel I: Swap Data Reporting

This year, we have been confronted by serious problems related to the CFTC’s acceptance, aggregation, and analysis of data submitted to the Swap Data Repositories (SDRs). This is not a surprise—one of the first topics addressed by the TAC was data standardization—but the challenges have really hit home now, with SDR reporting fully underway.

In January 2012, the Commission finalized Parts 435 and 456 of Commission regulations for both real-time and regulatory reporting of swap transactions. However, because of inconsistencies and errors in these rules and the data, the Commission has been unable to effectively utilize the reported data.

Accordingly, at the April 30 meeting of the TAC, I asked Commission staff and the three temporarily-registered SDRs to work on harmonizing the data reporting process, field-by-field, in order to ensure that the data submitted to the Commission by SDRs is consistent and usable, regardless of how this data was submitted to the SDRs. This will ensure that we can aggregate data across the SDRs and perform the necessary analysis. Alignment may also identify new reporting requirements that should be considered and implemented in order to improve the data reporting process.

Further, I have asked that this work be carried out through the TAC so that the process can be open to the public and benefit from thoughtful consideration by the industry. In fact, I will use the TAC to demonstrate the harmonization progress that has been achieved so far, and to accept comments on the proposed modifications. Using this feedback, we can hand over the work done by the TAC to the Commission for possible adoption in the future. Today, we will post the data harmonization chart on the TAC website for public review and invite comment. I have also included links to the SDRs’ real-time ticker data as well.

I am pleased that our first panel today will begin with John Rogers, Director of the Office of Data and Technology (ODT), to report on the progress made by the harmonization working group. Next, we will hear from Richard Berner, the Director of Treasury’s Office of Financial Research (OFR), to discuss federal agency coordination. Then, we will hear from Nicolas Gauthier, Policy Officer, Internal Markets and Services with the European Commission (EC), who will provide the European perspective on cross-border data issues. Mr. Gauthier will also provide an international perspective on trading platforms and execution this afternoon as part of our SEF panel. We are honored to have Mr. Gauthier, who has traveled a considerable distance to participate in this meeting, with us today.

Panel II: Concept Release on Automated Trading

Our discussion will next address the Commission’s recently published Concept Release on Risk Controls and System Safeguards for Automated Trading Environments.7 We will begin the second panel with an overview of the Concept Release by Sebastian Pujol-Schott, Associate Director of the Division of Market Oversight (DMO), and then begin general discussion by the TAC members. Given that the Concept Release was published earlier this week and asks over a hundred questions about very specific trading controls and their deployment in the market, I realize that TAC and subcommittee members may not have had the chance to engage in a full analysis. Nevertheless, I encourage you to participate in this discussion by sharing your immediate reactions to the Concept Release generally, addressing any of the questions it poses, and asking questions of the staff—in short, I welcome any input to help make this a productive discussion.

As I noted earlier, the TAC has spent its time and resources to help strengthen the Commission’s understanding of automated markets. I would like to thank all the TAC members, as well as the members of the Subcommittee on Data Standardization and the Subcommittee on Automated and High Frequency Trading, for their hard work on issues related to automated trading systems and pre-trade functionality. This body of work includes a working definition of “high frequency trading,” as well as a recent TAC reference document that compiled existing standards and recommendations in the market today.8

Today, I would like to build on the TAC’s past work and now focus on better understanding the following issues presented by automated trading systems and high frequency trading:

First, I’d like to learn more about the technology that is deployed today, as well as its effectiveness.

Second, I would like to understand whether there is a need for regulatory action with regard to any of the measures currently in the market. In other words, should the Commission federalize any current industry practices/standards?

Finally, it would be beneficial to receive feedback on the possibility of a registration requirement for firms operating automated trading systems that are not otherwise registered with the Commission. The Concept Release cites the definition of “floor broker” as the potential basis for such a requirement. I am interested to get public input on whether this, or any other provision in the Commission’s statute or regulations, can serve as a legal basis for registration.

Panel III: SEFs / MAT Submissions

Last but not least, I have added a special panel to discuss the status of SEF registration applications, as well as to raise various issues that both SEFs and SEF participants are facing because of the fast-approaching SEF compliance date.

We are only twenty days away from October 2. This means that we are only twenty days away from the SEFs’ ribbon-cutting ceremony, and only twenty days away from the official shutdown of Exempt Commercial Markets (ECMs) and Exempt Boards of Trade (EBOTs). As of today, the staff has temporarily registered three SEFs and has to review fifteen more applications before October 2.

In the midst of this transitional period, we have heard many concerns from different market participants (including SEFs, dealers, clearing members, and other SEF participants) regarding various interpretations of the SEF rules and a number of operational challenges. I would like to have an open discussion of a number of issues surrounding on-boarding, clearing certainty, uniformity of SEF rulebooks, and the status of Made Available to Trade (MAT) determinations. To address these issues, David Van Wagner, the Chief Counsel of DMO, is here to answer your questions.

Thank you all for attending today’s meeting of the TAC. I look forward to addressing these important issues as the Commission continues to implement Dodd-Frank and consider its practical and technological challenges.

1 TAC Pre-Trade Functionality Subcommittee of the CFTC Technology Advisory Committee Report, “Recommended Practices for Trading Firms, Clearing Firms and Exchanges Involved in Direct Market Access,” March 1, 2011, available at

http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/tacpresentation030111_ptfs1.pdf;

“Compilation of Existing Testing and Supervision Standards, Recommendations and Regulations,” Technology Advisory Committee Meeting, Oct 30, 2012, available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/tac103012_reference.pdf.

2 See TAC Meetings Transcript for December 13, 2011 and March 29, 2012, available at, http://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.

3 See TAC Meetings Transcript for March 1, 2011, June 20, 2012, and October 30, 2012, available at http://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.

4 See TAC Meeting Transcripts for July 26, 2012, October 30, 2012, and April 30, 2012, available at http://www.cftc.gov/About/CFTCCommittees/TechnologyAdvisory/tac_meetings.

5 See 17 C.F.R. § 43, available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-33173a.pdf.

6 See 17 C.F.R. § 45, available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-33199a.pdf.

7 This document is available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister090913.pdf.

8 This document is available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/tac103012_reference.pdf.

Last Updated: September 20, 2013

COURT ORDERS MAN AND COMPANY TO PAY OVER $2.4 MILLION IN FOREIGN CURRENCY SCHEME

FROM:   COMMODITY FUTURES TRADING COMMISSION 
Federal Court Orders Alex Ekdeshman and Paramount Management, LLC, to Pay over $2.4 million in Restitution and a Fine for Fraudulent Foreign Currency Scheme
Court Order Stems from a CFTC Complaint that Charged Defendants with Solicitation Fraud and Misappropriation of Customer Funds

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) obtained a federal court consent Order against Defendants Alex Ekdeshman of Holmdel, New Jersey, and Paramount Management, LLC (Paramount), requiring them to pay $1,146,000 in restitution to their defrauded customers and a $1,337,000 civil monetary penalty. The Consent Order of Permanent Injunction also imposes permanent trading and registration bans against the Defendants and prohibits them from violating the anti-fraud provisions of the Commodity Exchange Act, as charged.

The Order was entered on September 9, 2013, by U.S. District Judge Colleen McMahon of the Southern District of New York and stems from a CFTC Complaint filed against the Defendants on June 26, 2013. The CFTC’s Complaint charged Ekdeshman, individually and as the agent of Paramount, with solicitation fraud and misappropriating “the vast majority” of customer funds for business expenses. Specifically, the Complaint charged the Defendants with operating a fraudulent scheme that solicited more than $1.3 million from approximately 110 retail customers to engage in leveraged or margined foreign currency (forex) transactions with unregistered off-shore counterparties. The Defendants allegedly advised customers that forex trading accounts would be opened in the customer’s name and would be traded by the Defendants on behalf of the customer.

Furthermore, the Defendants, through a telemarketing sales force and a “Performance Record” linked to their website, touted Paramount’s successful trading record as having yielded an average monthly return of 4.6% over a 20-month period, based on the performance of Paramount’s proprietary trading software system, according to the Complaint.

However, the court’s Order finds that, contrary to the claims made during the solicitations, the Defendants did not manage or trade any customer account, and thus Paramount’s customers neither made actual purchases of any forex nor received delivery of forex. The Order also finds that the Defendants misappropriated all customer funds for Ekdeshman’s personal benefit and failed to disclose to actual or prospective customers that they were misappropriating customer funds. To conceal their fraud, the Order finds that, during all phases of the scheme, the Defendants issued false account statements to their customers, as no individual customer accounts were ever created and no profits were ever generated.

The CFTC appreciates the assistance of the United Kingdom Financial Conduct Authority, the Financial Services Commission Mauritius, and the Financial Services Board of the Republic of South Africa.

Further, the CFTC appreciates the assistance of the Wisconsin Department of Financial Institutions, the National Futures Association, and the Federal Trade Commission.

CFTC Division of Enforcement staff members responsible for this matter are Thomas Kelly, Michael Amakor, Michael Geiser, Melanie Devoe, George Malas, Timothy J. Mulreany, Paul Hayeck, and Joan Manley.

CFTC ORDERS BROKER EMPLOYEE TO PAY PENALTY FOR MAKING FALSE STATEMENTS

FROM:  COMMODITY FUTURES TRADING COMMISSION 
CFTC Orders Futures Broker Employee Susan Butterfield to Pay $50,000 Penalty in Settlement of Charges of Making False Statements to the CFTC During Her Investigative Testimony

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) today announced that it entered an Order requiring Susan Butterfield of New Lenox, Illinois, to pay a $50,000 civil monetary penalty for making false statements of material fact in testimony to CFTC staff during a CFTC Division of Enforcement investigation. The Order enforces the false statements provision of the Commodity Exchange Act (CEA), which was added by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).

According to the CFTC’s Order, Butterfield, an employee of a company registered with the Commission as an introducing broker (the IB), handled various clerical and administrative responsibilities concerning trading on the floor of the Chicago Board of Trade (CBOT). Her responsibilities included accepting and recording customer orders. When done properly, this involved time-stamping paper order tickets contemporaneously with the receipt of a customer commodity futures or options order to accurately record the time of day when the IB received the order.

On January 31, 2013, Butterfield gave sworn testimony in an investigation being conducted by the CFTC’s Division of Enforcement. The CFTC Order finds that during that testimony, Butterfield knowingly made false and misleading statements regarding whether she had improperly pre-stamped order tickets, i.e., whether she stamped order tickets in blank, prior to the time when a customer order was actually received. As the Order states, this testimony was significant in that use of pre-stamped order tickets may violate Commission Regulations and CBOT rules and also may facilitate unlawful trade allocation schemes in which brokers decide who will receive trades only after they are executed, potentially allowing them to profit at their customers’ expense.

The CFTC Order finds that prior to her CFTC testimony Butterfield told her supervisor, who was a principal at the IB, that “we pre-stamp orders and it’s something that is – that we should not be doing.” However, on January 31, 2013, when the Division of Enforcement staff questioned Butterfield on the IB’s pre-stamping practice, Butterfield falsely told the staff that she “never pre-stamped any [order] tickets.” Later during the course of her testimony the same day, Butterfield admitted to various instances of pre-stamping order tickets, but only after she was confronted by documents that plainly contradicted her initial false testimony. Ultimately, having been confronted with evidence that demonstrated her falsehoods, Butterfield admitted by the end of her testimony that it was in fact her daily practice to pre-stamp order tickets from multiple futures commission merchants throughout the trading session, in numbers amounting to dozens of order tickets every day.

David Meister, the CFTC’s Enforcement Director, stated: “When a witness walks into CFTC testimony he or she should plan to tell the truth to every question or face the consequences. We will use the new Dodd-Frank false statements provision against witnesses who provide false or misleading information to make sure it is well understood that lying is not an option.”

In addition to the $50,000 civil monetary penalty, the CFTC Order requires Butterfield to cease and desist from violating the relevant provision of the CEA, to never apply for or claim exemption from registration with the CFTC or engage in any activity requiring such registration or exemption, and to never act as a principal or officer of any entity registered or required to be registered with the CFTC.

The CFTC Division of Enforcement staff members responsible for this matter are Allison Passman, Theodore Z. Polley III, Joseph Patrick, Susan Gradman, Scott Williamson, Rosemary Hollinger, and Richard B. Wagner.

SEC.gov | Statement at the SEC Open Meeting

SEC.gov | Statement at the SEC Open Meeting

SEC CHARGES OWNER OF INVESTMENT ADVISORY WITH DEFRAUDING INVESTORS

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

The Securities and Exchange Commission today charged the owner of a New York-based investment advisory firm with defrauding investors while grossly exaggerating the amount of assets under his management.

The SEC alleges that Fredrick D. Scott of Brooklyn, N.Y., registered his firm ACI Capital Group as an investment adviser and then embarked on a series of fraudulent schemes targeting individual investors and small businesses.  Scott repeatedly touted ACI’s registration under the securities laws and falsely claimed the firm’s assets under management to be as high as $3.7 billion to bolster his credibility when offering too-good-to-be-true investment opportunities.  As Scott solicited funds from investors after promising them very high rates of return, he simply stole their money almost as soon as they deposited it with ACI.  Scott paid no returns to investors and illegally used their money to fund such personal expenses as his children’s private school tuition, air travel and hotels, department store purchases, and several thousand dollars in dental bills.

In a parallel action, the U.S. Attorney’s Office for the Eastern District of New York today announced Scott has pleaded guilty to criminal charges.  Among the charges to which Scott has pleaded guilty is making false statements to SEC examiners when they questioned whether Scott and ACI had accepted loans from investors.  SEC examiners notified the agency’s Enforcement Division, which began investigating and referred the matter to criminal authorities.

“Scott told brazen lies about the value of ACI’s assets under management and its ability to deliver huge returns on various investments,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office.  “Our examination and enforcement staff aggressively pursue investment advisers who flout the registration provisions of the securities laws for their personal gain, especially those who attempt to cover up their misdeeds by flat-out lying to our examiners.”

According to the SEC’s complaint filed in federal court in Brooklyn, one variation of Scott’s fraud was a so-called advance fee scheme – Scott promised investors that ACI would provide multi-million dollar loans to people seeking bank financing.  But investors were told that they first needed to advance ACI a percentage of the loan amount, and once they did so they would receive the remaining balance of the amount that Scott promised to pay.  Scott had no intention of ever returning the money, nor did he repay it.

The SEC alleges that in another iteration of his fraud, Scott offered investors the opportunity to make a bridge loan to a third-party entity.  The investor was told to fund one portion of the loan, and ACI would supposedly fund the remaining balance.  In exchange, the investor would supposedly receive a substantial return on his initial investment.  In this scheme as with each of his others, investors never received returns and Scott stole the money.

The SEC’s complaint charges Scott with violating Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act and Rule 10b-5, Section 207 of the Investment Advisers Act for filing a false Form ADV, and aiding and abetting ACI’s improper registration in violation of Section 203A of the Advisers Act.

The SEC’s investigation was conducted in the New York office by Sharon Binger, Adam Grace, Justin Alfano, Elzbieta Wraga, and Jordan Baker.  The investigation stemmed from a referral by the SEC’s examination staff including Raymond Slezak, Michael O’Donnell, Kathleen Raimondi, and Ken Fong.  The SEC’s litigation will be led by Alexander Vasilescu.  The SEC appreciates the assistance of the U.S. Attorney’s Office for the Eastern District of New York and the Federal Bureau of Investigation.

REMARKS BY FDIC VICE CHAIRMAN HOENIG ON 5 YEAR ANNIVERSARY OF LEHMAN BROTHERS MELTDOWN

FROM:  FEDERAL DEPOSIT INSURANCE CORPORATION 
Lehman Brothers: Looking Five Years Back and Ten Years Ahead
Remarks by Thomas M. Hoenig, Vice Chairman, Federal Deposit Insurance Corporation
Presented to the National Association of Corporate Directors, Texas TriCities Chapter Conference, Houston, Texas 
September 2013 
Introduction

A fundamental principle in economics is that incentives matter.  If the rules of the game provide advantages to some over others, protect players against the fallout of taking on excessive risk, or enable irresponsible behavior, we can be confident that the choices people make will be imprudent and the results of the misaligned incentives will be bad.

In the US financial system these conditions were in force during the decade leading to the Great Recession. It was a decade when monetary policy was highly accommodative; when government protections and subsidies were extended to ever more financial activities; when market discipline became a buzz word rather than a tool; and when the competitive advantage bestowed on some sectors of the industry led to a less competitive market.

More concerning is that five years after the crisis, despite new laws and regulations, we are replicating many of the conditions that contributed to the crisis, but we somehow are expecting things to end differently.   How so?

This morning, I will discuss the parallels between this earlier period and now, and I will make a case for a bolder set of actions to address weaknesses in a system that continues to impede our financial markets and economy.

Setting the Stage: Low Interest Rates

Extended periods of exceptionally low interest rates undermine a sound economy.  Their short-term effects on the economy can be favorable and dramatic, which creates a significant temptation for policymakers to keep rates low for a considerable period.   However, history suggests that extended periods of abnormally low rates often lead to negative long-run effects as they weaken credit standards, encourage the heavy use of credit, and too often adversely affect financial and economic stability.

For example, starting with the Mexican financial crisis of 1994 through the Asian and Russian crises of the late ’90s, aggressive expansionary US monetary policy was used with apparent success.  In each instance, the immediate crisis was staunched, markets continued operating, and the economy bounced back. Such success led to the expectation that monetary policy could clean up the effects of any financial excess or imbalance that the US economy might develop.   Low interest rates became the expected remedy that would stimulate the economy and avoid recession, or that would prevent the proliferation of a crisis.

Having been successful during the ’90s, the Federal Open Market Committee (FOMC), "doubled down" its use of low interest rates during the subsequent decade as it encountered financial and economic weaknesses. Following the collapse of the tech bubble, the real federal funds rate was negative for most of the period 2002 through 2005. It is noteworthy that in June 2003, the nominal federal funds rate was lowered from 1 1/4 percent to 1 percent and remained there for nearly a year, despite the fact that the economy grew at a rate of nearly 7 percent in the quarter following this rate reduction.

Because there were no signs of accelerating inflation, the FOMC felt confident that there was no need to quickly reverse policy, so it remained either highly or relatively accommodative well into the recovery. The first increase in the federal funds rate occurred in June 2004, only after evidence was overwhelming that economic activity had begun to accelerate. Not until March 2006 did the federal funds rate reach its long-term average level.

Within an environment of a highly accommodative monetary policy and sustained low interest rates, credit growth accelerated and serious financial imbalances developed. During the period 2002 to the end of 2007, total debt outstanding for households and financial and non-financial firms increased from $22 trillion to $37 trillion, or almost 70 percent. In hindsight, of course, it seems obvious that problems would result.

This history begs the question, therefore, of how current monetary policy might affect economic and financial conditions in 2013 and beyond. The FOMC again is fully engaged in conducting a highly accommodative monetary policy. The target federal funds rate is currently zero to 25 basis points. Through the Federal Reserve’s Quantitative Easing policy, its balance sheet and bank reserves have ballooned to nearly four times the size they were in January 2008. As a result, the real federal funds rate has been negative for most of the period from 2008 to the present.

As with the earlier period, inflation in the US remains relatively subdued, facilitating continued low rates. However, the US also is experiencing significant price increases in various assets, including, for example, land, stocks, and bonds. Banks and the entire financial sector are exposed, directly and indirectly, to significant negative price shocks in nearly all interest rate-sensitive sectors. Also, as capital desperately seeks out yield, there have been significant US dollar capital flows across the globe, causing what appears to be increased financial vulnerability, uncertainty, and instability.

Thus, the actions the FOMC has taken since the crisis ended are more aggressive and will be in place far longer than those taken in the early part of the last decade.

Those who support current money policy insist that circumstances are different this time - a phrase itself that should cause alarm. They suggest that policymakers have better tools to deal with imbalances in the form of renewed market discipline and macro-prudential supervision. However, as I describe below, financial conditions within the system are not as different than many presume. Market discipline has not been strengthened, and macro-prudential supervision may be a new name but it is hardly a tool that was unavailable in the earlier period.

Extending the Safety Net: Adding Risk to the System

During the early part of the last decade, at the time the US was engaging in a systematic expansion of monetary policy, it had just extended the public safety net to an ever wider set of financial activities and firms. In 1999, the Glass-Steagall Act was repealed, which confined the safety net – defined as access to the Federal Reserve liquidity facility and FDIC insurance -- to commercial banks. In its place, the Gramm-Leach-Bliley Act was passed to allow the melding of commercial banking, investment banking, and broker-dealer activities. These changes were intended to enhance the market's role in the economy, to increase competition, and to create a more diversified, stable system.

In practice, however, Gramm-Leach-Bliley undermined that very goal. It allowed firms with access to the public safety net to control a much wider array of financial products and activities, and it provided them a sizable advantage over financial firms outside the safety net. It enabled firms inside the net to fund themselves at lower costs and expand their use of debt -- that is, to lever-up. Under such conditions, firms outside the net, to survive, found it necessary to join this favored group through mergers or other actions. The result is a more highly concentrated industry that is more dependent on government support and where, in the end, the failure of any one firm threatens the broader economy.

Gramm-Leach-Bliley fundamentally changed the financial industry’s business model. Previously, commercial banking involved principally the payments system that transfers money around the country and world, and the intermediation process that transforms short-term deposits into longer-term loans. That model cultivated a culture of win-win, where the success of the borrower meant success to the lender in terms of the repayment of the loan and growth of the credit relationship.

After Gramm-Leach-Bliley, as broker dealer and trading activities began to dominate the banking model, the culture became one of win-lose, with the parties placing bets on asset price movements or directional changes in activity. Thus, broadening the range of activities and risks that banking firms could bring within the safety net changed the risk/return trade-off and significantly changed the incentive structure in banking. While such non-traditional commercial banking activities are essential to the market's function, placing them within the safety net became lethal to the industry and to the economy.

A related effect of the government’s rich financial subsidy was a significant increase in industry leverage, especially among the largest firms. Between 2000 and 2008, the leverage among the 10 largest US firms reached unprecedented levels, as the ratio of tangible assets to tangible common equity capital increased from 22 to 1 to levels exceeding 47 to 1.1

Once the financial panic was set in motion and confidence was lost, firms were forced to rapidly deleverage their balance sheets, creating a chaotic market. The effects were channeled through a highly interconnected financial system to the real economy, causing significant declines in asset values, wealth, and jobs. Between 2008 and the end of 2009, well over 8 million jobs were lost within the US economy alone, and containing the crisis required enormous amounts of FDIC and taxpayer support.

Now, five years after the crisis, we should not ignore that many of the conditions that undermined the economy then still remain within our financial system. These conditions include: a few dominant financial firms – those that are too big to fail - controlling an ever greater portion of financial assets within the US; continued government protections and related subsidies; and the continued reliance on a business model with its heavy use of debt over equity and increased risk in the pursuit of higher, subsidized returns on equity.

Yes, the Dodd-Frank Act introduced hundreds of regulations designed to control the actions of financial firms. It gives financial supervisors increased oversight of firms and activities, and it requires the Federal Reserve and the FDIC to oversee the development of resolution programs for the largest firms. However, when you work through the details, the law and rules mostly reiterate powers long available to supervisors. It adds numerous rules and moves responsibilities among regulators, but it makes no fundamental change in the industry’s structure or incentives that drive firms’ actions.

Dodd-Frank adds new supervisory and resolution authorities intended to end bail outs of financial firms and related subsidies. However, this is an old promise and has yet to be successfully implemented. Consider that the US financial system is more concentrated today and the largest firms hold more market power than prior to the crisis. The 10 largest financial firms control nearly 70 percent of the industry's assets, up from 54 percent in 2000. The eight globally systemic US banking firms hold in assets the equivalent of 90 percent of GDP, when you place the fair value of derivatives onto their balance sheets. Moreover, given the breadth and complexity of activities of these firms, they remain highly interconnected and the failure of any one will likely cause a systemic crisis, demanding government intervention.

Dodd-Frank introduces new rules designed to check the expansion of the subsidy. The Volcker Rule, for example, is supposed to move bank trading activities away from the insured bank. However, the rule has yet to be implemented, and even if it is fully implemented, it allows broker-dealer activities to stay within the same corporate entity, which itself benefits from the government’s safety net.

Consistent with these observations, there is a long list of studies documenting the existence of a government subsidy unique to the largest firms that extends across their balance sheets. While the industry vigorously argues that no subsidy exists, the preponderance of evidence suggests otherwise.2 Thus, while new authorities designed to mitigate this subsidy have been introduced, they have yet to be used or successfully tested. It is worth noting, for example, that under the Bank Holding Company Act, regulatory authorities have long had the authority to force divestiture of non-bank affiliates if they threaten the viability of the related bank. To my knowledge, this authority has never been used.

Therefore, as before the crisis, too big to fail and its subsidy continue to affect firms’ behavior. They enable the largest firms to fund themselves at lower cost than other firms providing a competitive advantage that facilitates the biggest firms’ dominance within the industry and multiplying their impact to the broader economy.

Also, although the US has introduced a supplemental leverage ratio to the capital standards, these largest firms carry significantly more leverage following from the subsidy than the industry more broadly. Using International Financial Reporting Standards, the average leverage ratio of the eight globally systemic US banks is nearly 25 to 1.3 This leverage is comparable to what the largest US firms carried in the years leading up to the crisis in 2008 and, as events demonstrated, it reflects too little capital to absorb significant shocks that might occur within the financial sector.

These leverage ratios stand in contrast to those for the remainder of the US banking industry. For example, the average leverage ratio for each category of banks -- from community, to regional, to super-regional -- is less than 14 to 1. This lower ratio reflects the fact that creditors of these firms are more directly exposed to loss should failure occur and, therefore, they insist on a larger capital cushion.

Thus, in comparing today’s financial system to that of 2008, I worry that the industry is more concentrated, that the system remains vulnerable to shock, and that the economy remains vulnerable to crisis. Even within the confines of Dodd-Frank, the industry’s structure, incentives and balance-sheets are more similar to 2008 than different. And, as always, we can’t anticipate the source of the shock until it strikes.

Rethinking Status Quo Solutions

It has been noted that, “We cannot solve our problems with the same thinking we used when we created them.”4 The economy has struggled through this recovery in a post Dodd-Frank environment perhaps because the public realizes that while we have more rules, too little has changed. It is my hope that people remain cautious so that five years from now – ten years after the collapse of Lehman Brothers – we will not be in an all-too-familiar place, facing an all-too-familiar banking crisis.

We need to regain our economic footing by rethinking our solutions. As I have been suggesting since before joining the FDIC, the US requires a monetary policy that better balances short-term and long-term policy goals. We need to rationalize, not consolidate, the structure of the financial industry and narrow the federal safety net to its intended purpose of protecting only the payments and intermediation systems that commercial banks operate.5 At a minimum, simplifying the structure would enhance the FDIC’s ability to implement its new authorities to resolve institutions should they fail. In addition, the US must lead the world in strengthening and simplifying the capital requirements for regulated financial firms, particularly for the largest, most systemically important firms.6 A strong capital base for individual firms and the industry is essential to a strong, market-based financial system.

A decentralized financial structure supported by a strong capital base and market accountability, too long ignored but fundamentally correct, would further change industry incentives and strengthen its performance. Finally, and importantly, these conditions would make the industry more responsive to the market, providing opportunity for success and failure -- both of which are essential elements of capitalism.



The views expressed are those of the author and not necessarily those of the FDIC

1 Tangible common equity capital is total equity capital less non-Treasury preferred stock, goodwill and other intangible assets.

2 http://www.fdic.gov/news/news/speeches/litreview.pdf
http://www.richmondfed.org/publications/research/special_reports/safety_net/pdf/safety_net_methodology_sources.pdf

3 The International Financial Reporting Standards (IFRS) approach to financial statement reporting is set by the International Accounting Standards Board.  A significant difference between U.S. GAAP and IFRS is IFRS only allows the netting of derivative instruments on the balance sheet when the ability and intent to settle on a net basis is unconditional. http://www.fdic.gov/about/learn/board/hoenig/capitalizationratios2q13.pdf

4 The quote is widely attributed Albert Einstein, though scholars have not verified its authenticity. http://www.albert-einstein-quotes.org.za/

5 “Restructuring the Banking System to Improve Safety and Soundness” white paper by Thomas M. Hoenig and Charles S. Morris - http://fdic.gov/about/learn/board/Restructuring-the-Banking-System-05-24-11.pdf
“A Turning Point: Defining the Financial Structure” speech by Thomas M. Hoenig to the Annual Hyman P. Minsky Conference at the Levy Economics Institute of Bard College. April 17, 2013 - http://fdic.gov/news/news/speeches/spapr1713.html

6 “Basel III Capital: A Well-Intended Illusion” speech by Thomas M. Hoenig to the International Association of Deposit Insurers 2013 Research Conference in Basel, Switzerland. April 9, 2013 - http://fdic.gov/news/news/speeches/spapr0913.html