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Statement on Re-Opening Comment Period for Capital/Margin/Segregation for Security-Based Swap Dealers

Oct. 11, 2018

Thank you, Mr. Chairman, and thank you to my colleague Commissioner Peirce and the terrific Staff in the Division of Trading and Markets for all of the hard work that so clearly went into this proposal. I’m especially grateful to Tom McGowan from Trading and Markets and Meredith Mitchell from our Office of General Counsel for being so patient with me and my office throughout this process.

Standing up our securities-based swap regime is an important step for the Commission and for the Nation. And our proposal has been sitting on the shelf since 2012.[1] The Commission’s failure to complete the work mandated by Dodd-Frank raises serious questions about our commitment to the rule of law. Doing so is crucial to our credibility with Congress and the American people.

But today’s proposal concerns me for two reasons. First, in the midst of one of the longest bull markets in American history, we are essentially asking market participants whether they’d like to take more risk—and we shouldn’t be surprised by the answer that’s coming.[2] Second, financial institutions have inherent incentives to take excessive risk—which is why we regulators do well to view their comments in light of those incentives. Because I worry that financial institutions may simply urge us to allow them to take excessive risk, I respectfully dissent.

* * * *

First, it’s worth stepping back to consider the economic moment we find ourselves in. It’s been over a decade since the financial crisis. Memories have faded, and the caution that came in the immediate wake of the crisis has gone with them. Having stepped back from the precipice a decade ago, we’re now in the midst of an unprecedented streak of economic growth.

The challenge for regulators at a moment like this is, as the longest-serving Chair of the Federal Reserve Chairman famously remarked, to “take away the punch bowl just as the party gets going.”[3] What’s especially hard about that work is that, in this moment, markets want more.[4] Importantly, that’s not because all participants in our markets are engaging in bad faith. It’s because, in a moment like this one, market participants truly believe that they can handle more risk. I worry that asking markets at this moment whether they need less margin will lead to answers that will make it difficult to protect investors from the next financial crisis.

Second, market participants in this area have strong incentives to take excessive risk. When a swap dealer enters into a contract with large contingent payoffs, its own risk is capped—you can’t lose more than your business—but the risk to the economy is not. When companies hoping for bailouts fail to internalize the systemic effects of their own failure, they take excessive risks, forcing taxpayers to bear the costs of their mistakes.[5] That’s why, after the lessons of the last financial crisis, Congress mandated that we regulate the swaps industry.[6]

That’s the central conflict at the heart of systemic risk: every dealer is incentivized to risk failure. That is how they maximize expected returns.[7] But it is in the public’s interest—and it’s my job here at the SEC—to reduce the risk that taxpayers might someday bear the costs of another crisis.[8] That’s why I cannot support the possibility that we might significantly pare back our capital and margin requirements.

I appreciate the Staff’s hard work on this proposal. And I hope we’ll receive a wide range of comments, from investors and industry alike, that will remind us of the consequences of failing to remember the lessons of the financial crisis—and to resist market participants’ strong incentives to take excessive risk.

[1] Securities and Exchange Commission, Proposed Rule, Capital, Margin and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers, Release. No. 34-68071 (2012).

[2] See Raul Elizalde, No, This is Not the Longest Bull Market Ever, Forbes (Aug. 21, 2018) (noting the need for methodological care with respect to the definition of a bull market); see also Federal Reserve Bank of St. Louis, National Bureau of Economic Research Based Recession Indicators for the United States (Sept. 2018) (noting that the American economy has been expanding, uninterrupted, since 2009).

[3] See William McChesney Martin, Address Before the New York Group of the Investment Bankers Association of America 11 (Oct. 19, 1955) (describing the Federal Reserve as a “chaperone who has ordered the punch bowl removed just when the party was really warming up”). Chair Martin was, of course, referring to the Federal Reserve’s inflationary policies; for a more recent invocation of the aphorism in this context, see N. Gregory Mankiw, How to Avoid Recession? Let the Fed Work, N.Y. Times (Dec. 23, 2007).

[4] See John C. Coffee, Jr., Systemic Risk After Dodd-Frank: Contingent Capital and the Need for Regulatory Strategies Beyond Oversight, 111 Colum. L. Rev. 795 (2011) (arguing that “the political economy of financial regulation ensure that there will be a relaxation of regulatory oversight,” and noting that this “regulatory sine curve” risks repeating the lessons of the 2008 crisis).

[5] Systemic risk externalities in finance come in many forms. Most famously, to the extent that companies expect that they will receive a bailout in the event of a default, they don’t fully internalize the costs of that default. These externalities have been described at great length in the economics literature, but they all have the same effect: companies do not fully internalize the risk of default, and therefore a company’s optimal risk level will be higher than the risk level that would be optimal from a social point of view. Markus K. Brunnermeier and Martin Oehmke, Bubbles, Financial Crises, and Systemic Risk, in 13 Handbook of the Economics of Finance 1221-1288 (2013); see also Daron Acemoglu, Asuman Ozdaglar, & Alireza Tahbaz-Salehi, Systemic Risk and Stability in Financial Networks, 105 Am. Econ. Rev. 564-608 (2015) (describing externalities resulting from contracts not conditioned on the assets of contractual counterparties); Coffee, supra note 4.

[6] See, e.g., President Barack Obama, Remarks on Signing the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) (“For years, our financial sector was governed by antiquated and poorly enforced rules that allowed some to game the system and take risks that endangered the entire economy.”)

[7] See, e.g., Javier Bianchi, Overborrowing and Systemic Externalities in the Business Cycle, 101 Am. Econ. Rev. 3400 (2011) (describing how “optimal borrowing decisions at the individual level can lead to overborrowing at the social level” where “financial constraints give rise to amplification effects.”)

[8] See Coffee, supra note 4 (“Because the quickest, simplest way for a financial institution to increase its profitability is to increase its leverage, an enduring tension will exist between regulators and systemically significant financial institutions over the issues of risk and leverage.”)

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