No surprises in that statement, the show must go on.
Financial markets are incredibly complicated. While manageable by a central authority to some degree, the best-laid plans of mice and men often go awry. The regulatory bodies of various countries have drafted tens of thousands of pages of financial regulations to minimize fraud and penalize immoral behavior in financial markets. Unfortunately, the complicated and occasionally conflicting nature of these various regulations often gives larger institutions with deep pockets access to loopholes. The majority of smaller institutions and individuals lack the financial means to accurately interpret these loopholes, leading to asymmetrical outcomes.
Recently, section 619 of the Dodd-Frank Act, also known as the Volcker Rule, was augmented for clarification purposes. Exacted in the wake of the 2008 Great Financial Crisis (GFC), the Dodd-Frank Act seeks to regulate financial markets more efficiently to prevent another cascading collapse. While the Volcker Rule still disallows proprietary trading, it now allows for banks to fund credit-worthy investment funds.
“For example, banking entities would be permitted to invest in qualifying venture capital funds and credit funds, subject to important safeguards. In addition, the rule would improve several existing exclusions from the covered fund definition to provide clarity and simplify compliance.” –FDIC Chairman Jelena McWilliams
Banking stocks such as JP Morgan and Goldman Sachs jumped by as much as 2% following the announcement of this rule revision. This change will allegedly provide much-needed liquidity to a market struggling with both a global pandemic and nose-bleed valuations. However, consideration regarding what is meant by “qualifying funds” is crucial. As we’ve explored in previous articles, the rating scales for investment-grade instruments vary between major auditing institutions. Moody’s designates any instrument that receives a rating of Baa3 or above as investment-grade while Standard and Poor offers the same threshold to instruments that receive BBB or higher. Systemically Important Banks (SIBs) will now have access to a broader range of investments due to the Volcker Rule’s augmentation, providing (hopefully) ample liquidity to companies in need. This new opportunity for capital inflows is occurring at the same time that the Federal Reserve is purchasing ETFs and corporate paper, with $1.8 billion in corporate ETFs secured just last week. When taken in conjunction with one another, these developments paint a picture of an increasingly worried Federal Reserve that is haphazardly providing a firehose of liquidity to institutions, credit-worthy or otherwise.
Regulators don’t always live up to their mandates. The prevailing issue of regulatory mismanagement is as real today as in the years leading up to the GFC of 2008. Take, for example, the recent demise of WireCard. Now ex-CEO Marcus Braun was arrested and is currently being charged with gross mismanagement and misleading investors. Recall that auditors recently found that WireCard is missing over $2 billion, with the company admitting that the funds likely never existed in the first place. This level of gross mismanagement can rarely occur in isolation. German regulator BaFin shielded WireCard on numerous occasions while the company implemented its fraudulent accounting practices, going so far as to ban short-selling of the company in 2019.
“That is a documented failure of supervision to intervene when there was clear evidence in this case,” –Florian Toncar, German Parliament
Regulatory bodies such as BoFin are stalwart, dispassionate arbitrators of justice in the financial markets. Their mandate is to clarify and enforce what is permissible and what is illegal behavior in financial markets. At least that’s how things are supposed to be. When regulatory bodies like BoFin favor certain mammoth corporations over other companies to the point of defending and enabling fraudulent accounting practices, the veracity of the institution’s integrity comes into question.
This lack of oversight extends far beyond Germany. Recall that Moody’s was fined $864 million for their role in the 2008 GFC. Considering the potential billions of dollars that may have been made using backdoor deals and the aforementioned loopholes, one wonders if the rating agency truly felt the intended sting of the fine. The scope and scale of this mismanagement is staggering. Once the house of cards began to crumble, Moody’s downgraded 83% of all 2006 Aaa-rated mortgage-backed securities and 100% of the Baa tranches. Of all the mortgage-backed securities issued in 2006, 76% experienced a downgrade to junk status. That figure is even higher for 2007, with junk-level downgrades passed down to 89% of all ratings issued that year. One of the most respected rating agencies in the world has a hit rate of one in ten.
This rampant mismanagement impacts regulatory and rating agencies around the world. It demonstrates the fallibility of human nature. Gargantuan regulatory agencies, often heralded as bastions of objectivity, are just extensions of the individuals that run them. Comprised of human beings, these agencies are subject to the same biases and incentives that we all experience. In a world where the Federal Reserve and other central banks are now actively supporting markets via direct financial intervention, we should consider the question of creditworthiness with great care. In what looks like the most significant asset bubble in over a century, central banks and regulators are laser-focused on assuring ample liquidity. They must tread carefully so as not to recreate the same conditions that led up to the 2008 GFC—assuming that we’re not already there.