Our take: financial services regulatory update - February 19, 2021

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Change remains a constant in financial services regulation. Read "our take" on the latest developments and what they mean.

Current topics - February 19, 2021

Regulators and industry continue their focus on climate risk

Yesterday, Fed Governor Lael Brainard gave a speech outlining climate change risks presented to financial institutions, providing an overview of steps taken by the industry and regulators to address these risks, and highlighting areas of future policy consideration. Climate-related disasters have already caused significant damage to the economy through events such as droughts, wildfires, hurricanes, heat waves and flooding, and she stressed that both the physical risks (i.e., damage from continued severe weather events) and transition risks (i.e., changes in policy, technology, consumer behavior or other factors resulting from climate change) will continue to pose threats through increased credit, market, operational, reputational, and liquidity risk.

To address these risks, Brainard noted that financial institutions have built climate-friendly investment options and provided funding for climate-friendly initiatives. However, she explained that these initial steps are just the beginning of the progress needed to address the challenges posed by climate change. Going forward, she highlighted the importance of improved data, disclosures and modelling techniques to better understand risks and reduce related uncertainty. Notably, she mentioned that voluntary disclosures may be insufficient, noting that standardized and mandatory disclosures may help solve consistency and completeness issues associated with existing practices. She also explained that climate scenario analysis could be a helpful tool to assess the implications of climate risks while noting that this tool should be separate from existing stress testing programs that assess banks’ capital adequacy. In considering scenario analysis policy, Brainard explained that the Fed is closely monitoring programs implemented by foreign regulators to learn from their experiences.

Brainard’s speech came the same day as a group of eleven banking, insurance and other financial industry groups released a paper outlining a series of principles for transitioning to a sustainable economy. The paper explains that the industry has made progress in disclosures through the efforts of the Task Force on Climate-related Financial Disclosures and the work of voluntary disclosure initiatives, but it notes that the industry should work toward convergence on international standards. It also highlights the importance of building capacity for climate risk modeling and scenario analysis, explaining that regulators and the industry should work together in the development of these tools. Regarding potential prescriptive policies, the paper notes that the industry groups support policies that directly limit greenhouse gas emissions but any financial regulatory policies should be “proportionate, risk-based, informed by consultation and grounded in robust data-driven analysis” as well as implemented using a cost-benefit analysis.

Our take

Governor Brainard’s speech and the industry paper make it clear that regulatory and private sector perspectives are largely aligned on the risks presented by climate change and, generally speaking, the steps needed to address them. With both Brainard’s speech and the paper emphasizing the importance of standardized disclosures, harmonized data standards and climate scenario analysis, it is an inevitability that progress on these issues will be made. Brainard’s statement that climate scenario analysis should be distinct from traditional stress testing will come as a relief to the industry as it appears that it will be used to understand the risks associated with climate change rather than directly impact bank capital requirements. However, as a greater understanding of risk and sensitivity is reached in the future - and the data to reach this understanding is obtained - we could see the regulators incorporating them into a capital adequacy regime.

Despite the significant amount of overlap between Brainard and the industry groups’ views, the differences highlighted this week indicate that there is still much discussion and debate to be had around the details and approach to climate policy. For example, the industry paper’s emphasis on voluntary, market-based initiatives contrasts with Brainard’s support for mandatory disclosures, and the paper’s suggestion that new policies must undergo careful consultation and cost-benefit analysis contrasts with the more urgent tone struck by Brainard that “it will be critical to make progress, even if initially imperfect.”

Regardless of the timing and details, it is clear that financial institutions should not wait to prepare for the forthcoming new policies, expectations and industry standards to address climate risk. This includes leveraging the work done by any overseas entities to prepare for EU and UK climate risk integration, credit modeling, and scenario analysis. With the regulators exploring what policies to pursue to address the important issue of climate risk, financial institutions that take early action have the opportunity to demonstrate effective market-based practices and help shape the climate policy framework.

House holds hearing on GameStop

On Thursday, the House Financial Services Committee (HFSC) held a hearing on issues surrounding the recent volatility in GameStop stock (GME). The hearing featured the CEOs of Robinhood Markets, Inc, Citadel LLC, Melvin Capital Management LP, and Reddit as well as a financial regulation researcher and a Reddit user who invested in GME beginning in 2019. GME’s volatility originated in an investing subforum of social media platform Reddit and later expanded to other platforms as a response to hedge funds shorting the stock. Around the time that GME peaked at $483 (after ending 2020 trading under $20), certain platforms including Robinhood temporarily restricted GME purchases and officials began to publicly take note of the situation.

The CEOs of Robinhood and Citadel received the most questions in the hearing, particularly from Democrats who scrutinized the “payment for order flow” arrangement by which Robinhood routes its order flow to Citadel in exchange for a rebate. Both leaders defended the arrangement as common industry practice that allows lower commissions and fees for retail investors. Other questions addressed the length of time it takes for trades to settle, the impact of social media on trading and collateral requirements for broker-dealers. On the latter topic, the CEO of Robinhood clarified that its decision to temporarily restrict GME purchases was driven by clearinghouse deposit requirements. In their questions and remarks, Republicans emphasized the importance of market participation from retail investors and indicated that they do not believe that any new regulation is needed in response to last month’s events. HFSC Chair Maxine Waters (D-CA) announced that she plans to hold further hearings to investigate what occurred and whether any response is necessary.

Our take

This week’s hearing was an inevitable consequence of market events that drew numerous headlines and statements last month. While immediate reactions to the GME volatility concerned trading restrictions and the impact of social media on investing and public equity markets, the direction and focus of yesterday’s questions indicates that payment for order flow arrangements and commission-free brokerages have now entered the spotlight. It remains to be seen whether calls escalate for regulating payment for order flow but any actual regulation will be slow and follow lengthy study and comment periods. As Chairwoman Waters indicated, this topic will almost certainly see more discussion by the HFSC and is likely to be raised in SEC Chair nominee Gary Gensler’s eventual confirmation hearing. Further hearings may explore whether there is a need for tighter regulations on short selling and the use of sophisticated trading strategies involving derivatives, such as options, by retail investors. Although GME has now fallen well below its peak, it is clear that the conversations it prompted are far from over.

On our radar

  • Derivative markets participants indicate preference for preemptive conversion of LIBOR-linked trades. A summary of consultation responses, published on Tuesday by the London Clearing House (LCH), shows that market participants were supportive of an LCH facilitated process to convert existing LIBOR trades to compounded in arrears risk free rate (RFR) transactions ahead of the cessation of LIBOR. Such a conversion would reduce reliance on the fallbacks developed by the International Swaps and Derivatives Association (ISDA). One important change arising from the consultation was that market participants preferred to apply a non-compounded spread adjustment to the floating leg of the swaps to account for the economic difference between LIBORs and their RFR replacements. Under the initial recommendation, holders of converted LIBOR swaps would have exchanged cash compensation to account for the present value of the fallback spread.

    The LCH suggests that the conversion would take place shortly before LIBOR’s actual cessation date, i.e. in late 2021 for CHF, EUR, GBP and JPY LIBOR contracts and at a later date for USD LIBOR contracts. The Financial Conduct Authority, LIBOR’s regulator, estimates that cleared interest rates swaps and exchange-traded derivatives account for 80% of all LIBOR-referencing contracts.

    Join the conversation: Register
    HERE for PwC’s upcoming webcast “The move away from LIBOR: Bringing non-LIBOR loans to market” on February 23, 2021.

    Subscribe to PwC’s LIBOR Transition Market Update
    here to read more about these and other developments.
  • Fed expands netting protections. Yesterday, the Fed announced a final rule that expands existing protections for netting contracts to a wider range of institutions including foreign banks without US branches, swap dealers and major swap participants. Under a netting contract, parties agree that they will pay the net, rather than the gross, payment due under the contract’s terms. The Fed’s netting protections provide certainty that netting contracts will be enforced, even in the event of the insolvency of one of the parties.
  • Powell coming to the Hill next week. Next Tuesday, Fed Chair Jerome Powell will appear before the Senate Banking Committee to present the Semiannual Report on Monetary Policy.

 

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Julien Courbe

Financial Services Leader, PwC US

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