Last week I wrote about the dangers of vacant seats at the financial regulatory agencies. But sometimes there’s just as much danger from the seats that happen to be occupied.
Bloomberg reported this week that regulators are privately discussing giving the biggest Wall Street firms a break on rules guarding against excessive leverage. Those rules were enacted right after the crisis, forcing banks to finance their operations with less borrowed money. Just looking at the Chinese stock market crash, fueled by “margin trading” funded through borrowing, reveals the hazards of excessive leverage.
Why, then, are regulators relenting? Support for the change is coming from Timothy Massad, the head of the Commodity Futures Trading Commission. Since Massad replaced Gary Gensler at CFTC, the agency has consistently given ground to the banking industry on rules about derivatives, where trillions of dollars in risky bets played a role in the 2008 financial crisis. And now Massad wants to do it again.
Specifically, banks want to change the formula by which regulators calculate leverage ratios. Currently, the international regulatory process known as “Basel III” defines the leverage ratio as Tier 1 capital — primarily retained earnings or common stock — divided by total assets on the balance sheet.
Those assets include the collateral that banks receive from customers for whom they clear derivatives transactions. The banks believe customer collateral shouldn’t be part of the equation, allowing those that broker derivatives — mostly the big Wall Street firms like Goldman Sachs and JPMorgan Chase — to dramatically reduce their capital requirements. That means they could borrow more to finance their operations, boosting their profits but also increasing risk.
Derivatives-clearing banks argue that customer collateral is kept in segregated accounts that they cannot use, and therefore poses no risk. They warn that their clients would suffer with higher prices for clearing derivatives trades, and that their derivatives clearing operations would be put out of business. But Federal Deposit Insurance Corporation Vice Chair Thomas Hoenig, a supporter of stronger leverage rules, noted that derivatives clearing actually increased 170 percent last year.
In the Financial Times, Hoenig argued that limiting leverage-fueled derivatives growth makes the global economy safer. “Asking to remove properly accounted-for assets from the leverage ratio is completely contrary to accounting standards and basic accounting principles,” Hoenig wrote. “The usefulness of the leverage ratio would be directly undermined.”
U.S. banking agencies already rejected this request to exempt customer collateral once before. But Massad, a former corporate lawyer and Treasury official under Timothy Geithner, has openly lobbied for the change, taking the side of the largest bank brokers. He has argued that banks would stop processing client trades if the rules weren’t loosened, mirroring the claim from the industry.
This is not an isolated incident. Since taking over CFTC in June 2014, Massad has carried a “softer tone” with the industry than his predecessor. The agency eliminated real-time reporting and other record-keeping requirements for commodity traders, eased rules on smaller swap dealers and delayed a provision to extend Dodd-Frank regulations to overseas affiliates of U.S. banks.
Those delayed “cross-border” provisions, which former CFTC Chair Gensler called critical to 70-80 percent of all Dodd-Frank derivative rules, have led to a massive shift of derivatives trades overseas, according to a blockbuster report by Reuters. Major banks changed their contracts so the parent companies didn’t guarantee trades made by the overseas affiliates. This sent over 90 percent of their trades outside CFTC jurisdiction, where regulation is weaker.
Banks won the loophole initially by targeting bank-friendly CFTC personnel. According to the Reuters story, 50 CFTC staffers met with representatives of the top five banks more than 10 times between 2010 and 2013. At least 25 of those staffers now work for those big banks, or law firms that represent them. And Mark Wetjen, a Democratic CFTC commissioner, sided with the banks on the loophole, using his power as the swing vote to weaken derivatives rules.
Wetjen announced his resignation from CFTC this month, after a job well done for the banks. And Massad, continuing in this tradition, has done little to reverse the massive leakage of derivatives trades out of the U.S. He did try to close one element of the loophole, but the driving force — the lack of jurisdiction when domestic banks de-guarantee their foreign affiliate trades — remains.
Massad’s appointment occurred mostly out of the headlines. But if it leads to breakdowns in global financial stability, it will have monumental significance. “Given that they can literally make or break the security of the world financial system, presidential appointments to run agencies like the CFTC are among the greatest legacies of any president,” said Jeff Hauser, who runs the Revolving Door Project at the Center for Effective Government.
Progressive reformers often talk of the influence of “lobbyists” as if they can snap their fingers and force changes to laws and regulations. But it takes someone on the other side of the table to listen to the lobbyists and make the changes they seek. The personnel a president chooses, and the policies they set, matter far more than the amount of money a bank spends to woo them.
This week, eight progressive groups asked Hillary Clinton whether she would allow members of her administration to collect bonuses from their former Wall Street firms after entering government service. It’s part of a larger effort, backed by Sen. Elizabeth Warren (D-MA), to close the revolving door between Washington and the financial industry. “When we elect a president, we are not electing a single person, but instead that person's team of rule writers and law enforcers,” said the Center for Effective Government’s Jeff Hauser. “That's why it is more important to know the practical realities of whom a presidential candidate would nominate for key jobs than what bills they would like to see Congress pass."
Concern that the financial regulatory personnel accompanying the next president will come from the same pool as this one’s has made executive branch appointments a growing issue in the Democratic nomination campaign. To see why, just look at Tim Massad.