How Do We Know if Higher Capital Requirements Really Will Make US Banks Less Competitive?

The Federal Reserve

The Federal Reserve

Federal Reserve Governor Dan Tarullo is reportedly set to reveal to the Senate Banking Committee today that the Fed is planning to boost capital requirements for too big to fail (TBTF) banks. Wall Street objects, saying it’ll place US banks at a competitive disadvantage to their European counterparts. This is said to be causing US banks to consider moving some trading operations out of the US. I may be missing something, but to me this is an unsatisfying debate, from both an epistemic and policy standpoint.

The postcrisis drive to boost capital requirements—in the main, an effort to require TBTF banks to hold more cash relative to their riskiest liabilities, so as to reduce the chance that they will go under—has been a mixed success. Basel III (not in force till 2019) is the leading international effort in this regard, but it has been widely attacked as weak, including for imposing too-low capital requirements. And so when some agency or commentator calls for new capital requirements in the US or another jurisdiction that exceed Basel minima, banks often say the proposed rule will place US banks at a disadvantage relative to European banks and hint that it will be self-defeating (since many regulations can be dodged by financial engineering or by moving the regulated activity overseas, though the latter can actually be quite difficult).

As regulators, finance professionals, and scholars begin to think about the new proposed rule, let’s stop and define our terms. If I were working for the Senate Banking Committee, I’d be curious about the following question today:

Do we know, in fact, that if this rule is adopted, banks in the US will be required to hold more capital than their European counterparts?

On the surface, the answer appears to be “yes,” because the proposed ratios in the Fed rule are higher than those in Basel III. But by itself this is not terribly revealing. The Fed’s new rule will presumably determine capital ratios on the basis of Generally Accepted Accounting Principles, or GAAP (which is mainly used in the US). Europe and most of the rest of the world use the International Financial Reporting Standards accounting system, or IFRS. This distinction can have systemic consequences when it comes to calculating capital ratios, because apples are not always being compared to apples. As this note from Ernst & Young explains (PDF):

IFRS and US GAAP differ substantially in their treatment of what is included in the exposure measure (i.e., the denominator of the leverage ratio [of assets to liabilities]).

This is largely because of differences in GAAP and IFRS netting rules, which in turn mean the volume of liabilities that need to be backed by a given percentage of assets differs. The International Swaps and Derivatives Association further explains (PDF):

The different offsetting requirements [imposed by IFRS and GAAP] result in a significant difference between amounts . . . [calculated] in accordance with IFRS and amounts [calculated] in accordance with U.S. GAAP, particularly for entities that have large derivative activities.

According to these FDIC figures, GAAP is overstating US bank capitalization ratios relative to IFRS, sometimes by 50% or more. In other words, differences in accounting treatment may be painting an unduly rosy view of the health of US banks, and it could be that new rules like the one the Fed is proposing are a corrective, or at least are not going to make Europe as appealing as opponents contend, because of IFRS.

Public and political debates over bank capital requirements should address the role of these accounting differentials. The banks themselves and the organizations that have a role in overseeing the implementation of capital requirements, like the Bank for International Settlements, clearly appreciate the challenges of measuring assets using two different metrics (see discussion of “calibration”). The political debate over the possible flight of trading operations should likewise consider these crucial accounting differences rather than assuming that a given ratio in Europe is automatically equivalent to that ratio in the US.

Photo: Wikipedia

The Undead Norm of Unenforceability in Sovereign Debt

True story: two years ago, U.S. hedge fund NML Capital seized an Argentine navy vessel in Ghana. NML recently won an important series of rulings in US courts on defaulted sovereign bonds issued by the Latin American nation.

True story: two years ago, U.S. hedge fund NML Capital seized an Argentine navy vessel in Ghana. NML recently won an important series of rulings in US courts on defaulted sovereign bonds issued by the Latin American nation.

As the Argentina sovereign debt litigation hurtles towards its thrilling conclusion (or at least a new phase), I’ve sketched this proposal for a new paper and welcome any thoughts:

The Undead Norm of Unenforceability in Sovereign Debt

Historically, sovereigns have repaid their debts not because they feared court orders if they didn’t but to preserve their good name in global capital markets. Courts played along, tolerating transgressions of their enforcement authority even beyond what sovereign immunity would require. This dance has allowed courts to lend their expressive support to the fiction of enforceability while avoiding the downsides—for courts and markets—that aggressive attempts at enforcement against foreign sovereigns would bring. However, in NML v. Argentina, the latest round of litigation over Argentina’s 2001 default, the SDNY signaled a shift: it issued an unprecedented injunction prohibiting the world payments network from processing Argentina’s bond payments unless the sovereign also tendered payment in full to a group of holdout creditors. This ultimately pushed Argentina into default in July 2014, prompting some legal scholars and the financial press to declare that the episode would seriously impair future efforts to restructure sovereign debt.

In The Undead Norm of Unenforceability in Sovereign Debt, I intend to argue that the NML decision (which was upheld on appeal) is poised to close the gap between the rhetoric of obligation and the reality of enforcement, but only temporarily, and that the systemic effects many fear are unlikely to materialize. NML provides a clear example of some of the dangers I write about in Boilerplate Shock: Sovereign Debt Contracts as Incubators of Systemic Risk: standard terms in private, foreign-law contracts—in this case, a provision known as the pari passu clause—are driving macroeconomic events to a degree that no one anticipated.

However, the magnitude of the harm here will probably be contained. The near-term systemic impact has not been (and was unlikely to be) great in part because, unlike Greece (whose bonds I use as an example in Boilerplate Shock), Argentina is not a member of a monetary union. On a longer horizon, the effects seem even likelier to dissipate. Argentina’s contract-driven default is just the type of salient event that will prod the market to update boilerplate terms, in this case probably by restricting the reach of pari passu in future bond issues and perhaps in existing ones (by adding Collective Action Clauses, for example, which virtually eliminate the holdout problem). This should allow restructurings to continue on the flexible, ad hoc basis on which they currently occur—which is to say, without excessive judicial interference at the enforcement stage. Far from demonstrating that the norm of unenforceable sovereign debt is dead, this episode suggests it can’t be killed.

For this article, I’ll be standing on the shoulders of a rich literature on the Argentina dispute and drawing on research I’ve done at the intersection of commercial law, private international law, and financial regulation. In Boilerplate Shock, for example, I argue that currency and governing law clauses in Eurozone sovereign bonds are magnifying systemic risk in ways no one imagined when they selected those contract terms. In Ending Judgment Arbitrage: Jurisdictional Competition and the Enforcement of Foreign Money Judgments in the United States, I argue that fragmentation in the U.S. judgment enforcement regime post-Erie renders that system ripe for manipulation by savvy judgment creditors via a process I call “judgment arbitrage.”

Undead shares many commonalities with these two articles (particularly Boilerplate Shock). Perhaps most important, together they posit that private contracts—combined with choice of law rules and expansive conceptions of jurisdiction that make it possible to secure and actually enforce judgments based on them—are driving international economic events to a degree that no one anticipated. This is mainly a story of cascade effects, amplified by standardization: the interpretation of a given contract term impacts other actors (whose rights are determined by similar contracts) in the relevant market, and where that market is systemically significant, it can affect the global financial system.

As I suggest above and in the Boilerplate Shock abstract, I think the risk of contract-driven systemic failure (which I call “boilerplate shock”) is far more manageable today in the case of Argentina than in the Eurozone sovereign lending market. Let’s hope the risk does not materialize in Europe either; we already live in pretty exciting times.

Photo: Reuters/NYT

The Latest in the Bank of America “Mortgage-Settlement-Industrial Complex”

That choice phrase, which describes a $16.65 billion BofA-Justice Department settlement announced today, comes courtesy of Bloomberg’s Matt Levine.

I discussed the implications of the case with Law360 (paywall). 

From DealBook:

The landmark settlement, announced by Attorney General Eric H. Holder Jr. in Washington on Thursday morning, requires Bank of America to pay a $9.65 billion cash penalty and provide about $7 billion in relief to homeowners and blighted neighborhoods.

“The size and scope of this multibillion-dollar agreement go far beyond the ‘cost of doing business,’” Mr. Holder said in a prepared statement. “This outcome does not preclude any criminal charges against the bank of its employees. Nor was it inevitable over these last few weeks that this case would be resolved out of court.”

The Typical in the Unusual: Non-Disparagement Clauses in the Cooley Law School Layoffs

Last week, I wrote about an unusual non-disparagement provision a hotel in upstate New York sought to impose on its guests, under which newlyweds could be fined $500 if any of their guests wrote negative reviews of the hotel on Yelp. Today we have an example of a more typical non-disparagement clause: Western Michigan University Thomas M. Cooley School of Law is reportedly conducting massive layoffs of faculty and conditioning severance packages on agreements not to disparage the school or divulge details about the firings. Some sources say the school may be letting go 50-70% of its faculty.

The inclusion of the non-disparagement and confidentiality provisions here may seem like overkill, but it’s not.

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Manhattan DA Brings Criminal Charges Against Out of State Payday Lender

In a groundbreaking move that is being watched nationwide, Manhattan District Attorney Cyrus Vance brought criminal charges this week against, an online payday lender based outside New York that offers loans over the internet.

I discussed the case with Law360 (paywall), which has some interesting implications that I elaborate on here.

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It’s Not Every Day that the Supreme Court Gets Sued

Meredith Miller at the ContractsProf blog has written a fun post about this breach of contract lawsuit against the U.S. Supreme Court,* which was recently settled. The dispute centered on $750,000 of work that the contractor claims it shouldn’t have had to do and thus should be compensated for. This work stemmed from a need to remake windows for frames that had appeared to be rectangular but were in fact trapezoids. Best of all, this deception was actually an optical illusion intended by the architect! It appears to have fooled everyone, from the Court to the contractors.

Trapezoids win, 9-0.

This made for an interesting contract dispute…

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Petty Tyrants Rejoice

Today, Yelp appears to have removed almost 1,000 reviews of the Union Street Guest House, many of which were negative and stemmed from the controversy that was the subject of my post this morning. As of about 4:15PM ET, the hotel’s average Yelp review was up to 2.5 stars, from 1.5, and there were 15 total reviews, down from almost 1,000 as recently as yesterday.

I can’t say I like this outcome. Much like the original dispute between consumers and the Union Street Guest House, any grievance over Yelp’s decision is likely to sound in contract law. While I argued that that body of law would probably produce a “pro-consumer” result (by prohibiting USGH from enforcing its policy), I think in any dispute over Yelp’s decision contract law would not be of much help to consumers.

Henry VIII was a not-so-petty tyrant.

Henry VIII was a not-so-petty tyrant.

Review controversies are a flashpoint for Yelp. Both the company and individual Yelpers have been sued repeatedly over reviews, often by business owners annoyed by what they regard as unfairly negative or even defamatory reviews (or alternatively, for fluffy Yelping by the friends and family of competitors). A few weeks ago, a businessman-plaintiff notched some progress against Yelp in a California appeals court.

Some of this litigation turns on fine distinctions that only matter to those who follow this stuff – for example, the California lawsuit alleges that the company misrepresented the accuracy and efficacy of its review filter, not that it improperly filtered reviews in the first place – but to the average consumer or business, that will seem like hair-splitting. The key question for most people is the scope of Yelp’s discretion in deleting or promoting reviews.

Yelp’s discretion is vast, by design. The company is publicly held and, as one would expect, it appears to use seasoned lawyers to draft important disclosures and agreements.

Yelp’s Terms of Service are characteristically broad for a social media company. They tell users that “you hereby irrevocably grant us . . . rights to use Your Content for any purpose(emphasis mine). Just to make the definition of “use” completely clear, they specify that “[b]y ‘use’ we mean use, copy, publicly perform and display, reproduce, distribute, modify, translate, remove, analyze, commercialize, and prepare derivative works of Your Content” (emphasis mine). In other words, the right “to use . . . Your Content” includes the right “to remove” your reviews, or for that matter do just about anything else they want to with them. Well then.

It’s possible these terms could be held to be unenforceably vague or unconscionably broad in some instances, but I doubt that would happen here. (If Yelp sought to “use” your profile picture to market pornography, you might have a case.) So if a private citizen or regulator complains about Yelp deleting Union Street Guest House reviews, you can expect the company to cite these terms while gesturing in the direction of higher principles, like improving accuracy by working to ensure that its reviews are written only by actual customers. If you were to note that many reviews of actual customers appear to have been deleted as well – which I strongly suspect has happened in this case, given that (as sorting by date reveals instantly) Yelp has removed all reviews posted between April 3, 2014 and August 5, 2014, inclusive – they would surely lean on their prerogative, under the ToS, to delete any of Your Content. This is before considering the effect of any statutory privileges that may protect Yelp.

Abstracting back from Yelp’s rights to first principles, it seems sensible, on one hand, for a company to limit reviews to actual customers (if that’s what Yelp is trying to do); one can see why Yelp wouldn’t want a ton of random people with no connection to a place commenting on it. Cf. hearsay. On the other hand, it’s a shame that reviews that discuss an official policy of the establishment aren’t allowed unless someone has patronized it. And what does “patronize” mean, anyway? Buy something? Stay the night? Surely a review site would want to let someone who walked in, or called, and was denied service because of his appearance or accent say as much in a review. How to answer these questions is up to Yelp. Whatever their internal policies, I suspect they have to make a lot of judgment calls. In the end, a contract-based analysis is unlikely to do a lot of “pro-consumer” work here.

But not all is lost. If you patronized Union Street Guest House and wrote one of those now-deleted reviews, you can feel a sense of pride in “Your Content” being nobly sacrificed in the war against petty tyranny.