Perspective on Risk - Feb. 20, 2025

Fed Independence and Humphry’s Executor; Delaware Law; Source of Strength; Race To The Bottom Has Begun; The Changing Financial System (and Chesterton's Fence)

Disclaimer: I’m not a lawyer, I don’t play one on TV, and I don’t even tend to watch legal dramas. So I am venturing into territory way beyond my zone of knowledge and comfort here. Apologies if my takes are bad (and please correct me if they are).

Hyman Minsky wisely pointed out that as memories of crises past recede, so attitudes towards regulation change. To paraphrase the historian Tony Judt, it is wise to avoid the idea that regulation is the best solution to any problem, but let’s not fall into the opposite notion that it is by definition and always the worst available option. (Andrew Bailey)

Fed Independence and Humphry’s Executor

As we’ve discussed before, regulatory consolidation is clearly on the table, and the Fed’s primary concern (by far) will be maintaining its monetary policy independence. They would likely sacrifice almost everything else to maintain this.

There is a reason for the Fed to care about bank supervision; banks are ultimately the mechanism through which monetary policy is implemented. Banks literally create the money in the economy. The Fed has a vested interest in insuring that this mechanism works.

On Feb. 18 the President issued an Executive Order Ensuring Accountability for All Agencies. The stated reason for the order is:

[Previous] administrations have allowed so-called “independent regulatory agencies” to operate with minimal Presidential supervision. These regulatory agencies currently exercise substantial executive authority without sufficient accountability to the President, and through him, to the American people. Moreover, these regulatory agencies have been permitted to promulgate significant regulations without review by the President. 

The order applies specifically to the non-monetary functions of the Fed.

This order shall not apply to the Board of Governors of the Federal Reserve System or to the Federal Open Market Committee in its conduct of monetary policy. This order shall apply to the Board of Governors of the Federal Reserve System only in connection with its conduct and authorities directly related to its supervision and regulation of financial institutions.

We can quibble that this doesn’t cover all of the Fed’s functions, such as operating Fedwire or acting as custodian for foreign central bank gold, but the above is reasonably clear.

What this mostly does is constrain the ability of the financial regulators to promulgate rules (and perhaps interpretations of existing rules) without consulting with the Attorney General or President. Not sure how it applies to mergers and divestitures (I’m not a lawyer after all).

Is Regulatory Independence Valuable

As a general rule, it’s been accepted wisdom that regulatory independence is beneficial. Steve Kelly of Yale posted a link to a new paper Does regulatory and supervisory independence affect financial stability?

In this paper we introduce a new indicator of regulatory and supervisory independence for 98 countries from 1999 to 2019. We combine this index with bank-level data to investigate the relationship between independence and financial stability. We find that greater regulatory and supervisory independence is associated with improved financial stability… . Overall, our findings indicate that increasing the independence of regulators and supervisors is beneficial for financial stability.

The key mechanism they propose is that independent regulators are better at enforcing policies that prevent excessive risk-taking by banks. They measure financial stability through three main risk indicators at the bank level: Non-Performing Loans (NPLs), Volatility of Return on Assets (ROA), and a Z-score (bank insolvency risk) which is a factor of capital solvency, leverage and ROA volatility.

It is a reasonably good paper - it attempts a strategy to get at causality rather than just correlation. They address endogeneity well, but really don’t check for multicollinearity across their three main measures.

Reiterating my long-held position: there is room for significant regulatory consolidation and reform. The UK has evolved over a few iterations to a better structure. Not just banks, but credit unions, and GSEs should all be within scope. The Fed should have some role in order to assess that monetary policy can be effective.

• Trump Advisers Eye Bank Regulator Consolidation After Targeting CFPB (WSJ)

• Survey: Bankers split on consolidating bank regulatory agencies

• Bankers want agency independence, but split on consolidation

Humphrey’s Executor

I learned something new this week. Regulatory independence rests upon a 1935 Supreme Court case, Humphrey's Executor v. United States. From Wikipedia:

Humphrey's Executor v. United States, 295 U.S. 602 (1935), was a Supreme Court decision regarding the United States President's power to remove executive officials of a quasi-legislative or quasi-judicial administrative body for reasons other than what is allowed by Congress. The Court unanimously held that the President did not have this power.

President Calvin Coolidge appointed William Humphrey as a member of the Federal Trade Commission (FTC) in 1925, and Humphrey was reappointed for another six-year term in 1931. After President Franklin Roosevelt took office in 1933, he became dissatisfied with Humphrey and viewed him as inadequately supportive of the New Deal.

Roosevelt twice requested Humphrey to resign from the FTC, but Humphrey did not yield. Finally, in 1933 Roosevelt fired Humphrey. Nevertheless, Humphrey continued to come to work at the FTC even after he was formally fired.[1] The Federal Trade Commission Act permitted the President to dismiss an FTC member only for "inefficiency, neglect of duty, or malfeasance in office." Roosevelt's decision to dismiss Humphrey was based solely on political differences, rather than job performance or alleged acts of malfeasance.

Here is a link to the referenced letter.

In the letter, Acting Solicitor General Sarah Harris stated that the DOJ would no longer defend the constitutionality of statutory provisions that protect members of multi-member regulatory commissions from at-will removal by the President.

Structurally, the Federal Reserve has aspects similar to the FTC, which was the original plaintiff in Humphry’s.

The FOMC technically has a balance of politically-appointed Board members and Reserve Bank Presidents, which, in theory but not practice, are more protected from Presidential pressure.

Chris Walker’s comment raises a real risk - should the DOJ not distinguish the Fed in the ways he suggests, or should the Supreme Court findings overturn fully even Fed independence, all bets are off.

Policy Variability

Very interesting observation from Powell, and directly linked to the above discussion. When bank supervision is politicized, you get more serious changes in priorities administration-to-administration. You do not get thoughtful, evidence-based reforms.

Consolidating regulators, putting them directly under Treasury control rather than in “independent” agencies runs the risk of increasing policy volatility.

Delaware Law

Most large corporations are chartered under Delaware law due to a combination of legal, structural, and practical advantages that make the state particularly attractive for businesses. Among the many reasons for this is that Delaware has a Court of Chancery, a specialized business court that handles corporate disputes without juries. This court is highly experienced in business law, leading to faster and more predictable rulings. Judges (called chancellors) are appointed based on merit, ensuring expertise in corporate governance and financial law.

However, the special place Delaware holds is under threat. There are several reasons:

1. Private equity-backed firms capital structures often result in higher tax burdens under Delaware’s franchise tax system.

2. In recent years, Delaware courts have taken a more interventionist approach in corporate governance, particularly in cases involving CEO compensation (Tesla/Musk), shareholder rights and M&A transactions(Dell),

   1. The “interventionist” approach increasingly includes corporate social responsibility (such as ESG) and governance reforms.

   2. While Delaware has historically protected boards and management through the business judgment rule, shareholder litigation has increased in the state, particularly around “appraisal lawsuits” where dissenting shareholders challenge the price of a company’s shares in a M&A deal.

What we are seeing play out are the tensions in a messy version of a Principal-Agent framework. We are seeing that all Principals, in this case the shareholders, are not always aligned.

Historically, Delaware courts favored a specific set of principals: controlling shareholders. Senior management, with Board oversight, were presumed to be aligned with controlling shareholders. However, the controlling shareholders and senior management were given deference that came at the expense of minority shareholders (such as small institutional investors or dissident shareholders).

In both the CEO compensation cases and the “appraisal” cases, the courts appear to have reduced the discretion of boards and majority owners. Minority shareholders have been given more influence. Delaware’s intervention is not necessarily empowering "agents" (management) but rather redistributing power among different sets of principals.

Bank boards and executives may now be more constrained. They can no longer easily rubber-stamp compensation or approve insider-led mergers without risking litigation.

On balance, I think this is probably a good developments.

Source of Strength

The original foundation of the source-of-strength doctrine lies in the Bank Holding Company Act (BHCA) of 1956, which established the regulatory framework for BHCs. However, this law did not explicitly include a source-of-strength obligation. Instead. it is the Federal Reserve that interpreted the BHCA as implying that holding companies must act as a source of strength to their subsidiary banks.

One good thing that came out of the GFC was that the source-of-strength doctrine was placed on a stronger footing. Dodd-Frank explicitly codified the doctrine, stating:

A bank holding company shall serve as a source of financial strength to its subsidiary banks.

The law defines a source of strength as:

The ability of a company to provide financial assistance to a subsidiary bank in times of financial distress.

In litigation between the FDIC and the holding company of SVB, SVB Financial Group (“SVBFG”), SVBFG is asserting they had no affirmative duty to serve as a source of strength to Silicon Valley Bank because … the regulators failed to

direct the bank to submit a capital restoration plan, recapitalize itself, or enter into a contractual agreement with the bank holding company.

They are asserting that Dodd-Frank and the Fed’s Reg. Y places an obligation on the regulators, not the holding company.

Contrary to Defendants’ allegations, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) and Regulation Y (“Reg. Y.”) (id. ¶¶ 110-13) do not automatically impose an obligation for bank holding companies to act as a source of strength. Instead, the Federal Deposit Insurance Act (as amended by the Dodd-Frank Act) and the Federal Reserve’s Regulation H (applicable to state member banks such as SVB) and Reg. Y (applicable to bank holding companies such as SVBFG) imposes an obligation on regulators to take action when a bank becomes undercapitalized, including requiring the relevant regulator to direct the bank to submit a capital restoration plan, recapitalize itself, or enter into a contractual agreement with the bank holding company. … Here, Defendants do not allege that any such directions were imposed or contractual agreement executed with respect to SVBFG. Nor could they; none existed.

I mean, again I’m no lawyer, but I certainly hope this argument falls on deaf ears. It’s management’s responsibility, not the supervisor’s, to run the bank in a safe and sound manner.

The Race To The Bottom Has Begun

The US can’t get Basel III done. The UK puts its revision on pause pending the US outcome. Now Top European Central Bankers Push for Simpler Banking Rules (Bloomberg).

Four of the European Union’s top central bankers urged the bloc’s regulatory arm to simplify the mass of rules that commercial lenders blame for increasingly putting them at a disadvantage to international competitors.

A “comprehensive analysis” of the requirements could help ensure a “level playing field with other major jurisdictions,” the governors of the Spanish, German, Italian and French central banks wrote to the European Commission in a letter seen by Bloomberg News.

They may be right. Probably are. But it’s the direction of motion I’m after.

It’s notable that it is from the central bankers and not the regulatory bodies.

I’ve told my former colleagues many times, Basel III and other regulations are agreements by the BANKS to play on a level playing field. The regulators just negotiate what those rules will be.

Changing Financial Markets

Andrew Bailey (BofE) recently gave an interesting speech. It both relates to the above discussion of the Federal Reserve’s interest in supervision and regulation, and to the broader topics of financial structure changes we have been discussing.

Are we underestimating changes in financial markets? - speech by Andrew Bailey

I am going to spend most of the time today setting out the scale and significance of changes in financial market activity in recent years, and what this means for financial stability. My main message is that the significance of these changes has not been fully taken on board in many assessments of the challenges facing financial stability and the tools we need to assess the risks the changes have created.

… central banks have two core purposes, monetary and financial stability, and that while policies in respect of each need to be focused and thus separate, they are dependent on one another to a very high degree.

And hence the need for the Fed to have a role in supervision and regulation.

… central banking is inherently a counter-cyclical activity.

And hence the need for independence.

… central banking policy making has to incorporate a substantial global context. Ultimately, the policies are national ones, but they have to reflect and incorporate global risks and events. … Global standards are an anchor for national standards. Set right, they facilitate openness and economic growth.

Hence my statement above on level playing fields.

… one of the orthodoxies of central banking is that we act as the ultimate providers of liquidity to our banking system.

Hence my constant and forever links to Corrigan’s Are Banks Special?

Recent Changes In The Financial System

The key theme here is how much activity and risk in core financial markets now largely resides outside the banking system. This is not a new theme, given the post GFC changes, and it was the correct response to the dangers realised in the GFC of inappropriate risk inside the banking system.

Three non-bank business models stand out as dominant players in this rapidly evolving landscape.

• multi-manager hedge funds

• systematic strategies which trade based on complex statistical models and rules and market signals rather than fundamentals … [that] were at one time the preserve of the FX and equity markets but are now becoming more prevalent in the fixed income world

• non-bank market makers, notably high frequency and principal trading firms

… the market looks very different to what it was only five years ago. It involves large shifts in leverage, pricing power, speed of trading and liquidity provision. To be clear, these changes are not inherently bad, but they could create a new set of financial stability vulnerabilities which we need to understand …

Among these potential vulnerabilities, I would highlight a number:

• An increased likelihood and severity of procyclical jumps to illiquidity and large market moves that are unexplained by fundamentals. …

• Second, there is a tendency towards increased concentration and interconnectedness given that these large hedge funds and market makers operate across all significant financial markets and represent the bulk of banks’ prime brokerage balance sheets;

• Third, there is greater evidence of correlated activity. … both their trading and risk management strategies tend to be quite similar, increasing the prospect of common responses. While multi-managers are well placed to avoid correlations within each fund, correlation can still emerge across different funds as different multi-managers are often attracted to similar types of strategies; and

• Fourth, opacity and limited visibility in certain markets tends to lead to crowded trades, impairs risk management, and is more likely to prompt a rush to the exit in times of stress. …

There are good reasons why moving activity out of the banking system has happened. There are areas of risk taking that are not suited to being directly backed by deposits, and thus putting those deposits at risk. That was a lesson of the financial crisis. They are better being directly backed by what I would describe as investment capital…

… we seem to be more reliant on market-making and market liquidity provision from firms which are not so directly wired into the more assured forms of backstop liquidity, including from central banks.

He goes on to discuss the Bank of England’s System-Wide Exploratory Scenario Exercise (SWES), and their development of the Contingent NBFI Repo Facility (CNRF). For those interested in this discussion, I’ll leave it to you to read the speech.

He concludes with a caution Trump, Musk and others would be wise to consider.

Finally, there is a reaction taking place against regulation, and the responses to the GFC. We must not forget the lasting damage done by the GFC. There is no trade off between economic growth and financial stability. That said, there are usually choices about how we deal with evidence of vulnerabilities. It is critical that we have and develop tools of assessment and intervention. But these interventions may not always need to be more regulation. They can be liquidity facilities, and they can be to improve areas of the financial infrastructure, such as introducing clearing for gilt repo, a conclusion of our SWES. We should approach the response to vulnerabilities with an open mind.

Remember the lesson of Chesterton’s Fence.¹

1. The principle comes from a parable by G.K. Chesterton.

There exists in such a case a certain institution or law; let us say, for the sake of simplicity, a fence or gate erected across a road. The more modern type of reformer goes gaily up to it and says, “I don’t see the use of this; let us clear it away.” To which the more intelligent type of reformer will do well to answer: “If you don’t see the use of it, I certainly won’t let you clear it away. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.”