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Clarida signals possible changes to Fed bond-buying programme



Richard Clarida, the vice-chair of the Federal Reserve, hinted at possible changes to the US central bank’s bond-buying programme as it seeks ways to keep the recovery going in the world’s largest economy.

“The Federal Reserve is committed to using all of our available tools — not just the federal funds rate and forward guidance, but also large-scale asset purchases — to achieve our dual mandate goal,” Mr Clarida said in remarks to the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution.

His prepared remarks, posted on the Fed’s website, emphasised the word “all”.

Mr Clarida noted that the Fed’s bond purchases — which increased sharply at the start of the pandemic — were already providing “substantial support” to the recovery and this “critical role” was discussed at the central bank’s monetary policy meeting in early November.

“Looking ahead, we will continue to monitor developments and assess how our ongoing asset purchases can best support achieving our maximum employment and price-stability objectives,” Mr Clarida added.

The focus on asset purchases comes as the Fed explores additional measures to help the US economy, which is confronting a surge in coronavirus cases with limited help from fiscal policy.

The Fed in September made a very dovish pledge to keep its main interest rate close to zero until the economy reaches full employment and inflation is at 2 per cent and on track to exceed it for some time.

The Fed is currently buying Treasury securities at a pace of $80bn per month, spread across all maturities. In September, it said the aim of the asset purchases was not simply to improve the functioning of the market but also to support the economic recovery.

Since then, it has faced repeated appeals from investors for more clarity on the future of the programme.

Among the options the Fed could consider are an increase in the total amount of bonds being purchased, or a change to focus its firepower on long-term securities to counter a recent rise in borrowing costs.

Treasury yields, which rise as prices fall, have jumped higher in recent weeks as investors have looked beyond the current rise in Covid-19 cases and new restrictions on business and social activity, to the prospects for an end to the pandemic when vaccines are rolled out.

The yield on the benchmark 10-year note climbed as high as 0.97 per cent at one point last week, although it has since retreated to 0.9 per cent. Some investors believe it could breach 1 per cent in the near term.

In light of the surge of coronavirus cases worldwide, Michael Feroli, chief US economist at JPMorgan, wrote on Monday that the Fed could make an adjustment to its asset purchases as soon as its December meeting.

“While markets are more focused on the medium-term outlook, where vaccine hopes are rising, recent Fed rhetoric has indicated growing concern about the months between now and when a vaccine is widely available,” he said.

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ECB threatens banks with capital ‘add-ons’ over leveraged loan risks




The European Central Bank is threatening to impose additional capital requirements on banks that continue to ignore requests to rein in risk in the booming leveraged loan market.

Policymakers are increasingly frustrated by the lack of action to tighten risk controls in the market at some European lenders, which they fear could lead to repayment problems if interest rates rise.

If industry practices do not change, the EU regulator “won’t hesitate to impose capital add-ons” through its annual Supervisory Review and Evaluation Process process, said a person familiar with internal discussions. 

Leveraged loans are junk-rated debt usually used to back or refinance private equity takeovers of companies. Banks keep little of the risk on their own balance sheets and sell almost all of the loans on to other investors.

Fierce competition has led to ultra-low pricing, a softening of underwriting standards and increasing leverage in private equity buyout loans. The use of “covenant-lite” structures — which strip out many of the usual protections for investors — has surged.

In response, the ECB is planning more frequent “on-site” visits — performed virtually during the pandemic — to evaluate banks’ risk management procedures on recent and current deals and adjust their capital requirements accordingly, said the person.

“Where banks incur risks in leveraged lending that are not adequately addressed by appropriate risk management practices, ECB banking supervision is considering supervisory actions and measures, including qualitative or quantitative requirements as well as capital add-ons,” the ECB said in a statement.

Last summer, Deutsche Bank received a request to suspend part of its leveraged finance business because of shortcomings in its risk controls but it refused, the Financial Times has reported.

A senior eurozone central banker said the issue would be raised as a key concern in the ECB’s next financial stability review in May.

Banks have become more aggressive in investment banking as income from traditional retail and commercial lending activities has plunged because of negative interest rates. More recently, they have also had to contend with a surge in coronavirus-related loan-loss reserves.

Supervisors’ concerns have been prompted by changing market dynamics, one of the people said. Indicators suggest that inflation is picking up and once interest rates around the world start to rise, repayments on some of the most aggressive deals could become difficult. Many banks have been pricing loans on the assumption that negative rates will persist for a decade or more, the person said.

In 2017, the ECB introduced guidance that defines “high levels” of leverage as deals where total debt — including undrawn credit lines — exceeds six times earnings before interest, tax, depreciation and amortisation. 

The regulator said that such transactions and covenant-lite structures “should remain exceptional and [ . . . ] should be duly justified” because very high leverage for most industries “raises concerns”. 

Despite these instructions, the ECB found that by 2018 more than half of new leveraged loans by major eurozone banks were already above this threshold.

Deutsche Bank is among banks the ECB has contacted. Despite receiving a letter from the regulator calling its risk management framework for highly leveraged transactions “incomplete,” Germany’s largest lender refused to suspend parts of the business and said it was “impractical” to follow the request. It was not required to do so because the guidance was non-binding.

Deutsche Bank declined to comment.

As it is for many other big lenders, such as BNP Paribas, leveraged finance is a buoyant and lucrative business for Deutsche’s investment bank. It generated €1.2bn of revenues in the first nine months of 2020, an increase of 43 per cent from 2019.

Recent transactions on the riskier end of the scale include a €4.4bn leveraged loan and high-yield bond package for Swedish alarms company Verisure this month. The deal is more than seven times levered, even when using the company’s own heavily adjusted earnings number, and includes a €1.6bn dividend paid out to its private equity owners.

Deutsche is a joint global co-ordinator of the Verisure debt, with BNP Paribas, CaixaBank, Crédit Agricole and Santander also involved.

Another highly leveraged buyout this year is BC Partners’ takeover of US gynaecology company Women’s Care Enterprises. The deal’s overall leverage is more than nine times its ebitda, according to S&P Global Ratings. Deutsche is again a joint bookrunner.

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Wall Street’s new sheriff is on a mission




Financial markets may soon have a new regulatory sheriff. President-elect Joe Biden, who will be inaugurated on Wednesday, is expected to pick the former head of the US Commodity Futures Trading Commission, Gary Gensler, to run the Securities and Exchange Commission. Given that US capital markets are the broadest and deepest in the world, the chair of the SEC is not only the most important market regulator for America but also, arguably, for the wider world. The good news is that Mr Gensler is exactly the right man for the job. 

As a former Goldman Sachs partner who also served in the Treasury department during the Clinton administration, he is a powerful choice in part because he’s a “born-again” regulator.

After 18 years at the US bank, including time in the risk arbitrage unit, Mr Gensler began his regulatory career working with his former boss Robert Rubin, who had been appointed US Treasury secretary. He then became an under-secretary to Mr Rubin’s successor, Larry Summers, who passed the Commodity Futures Modernisation Act. This was the law that exempted credit default swaps, which exploded the global economy during the financial crisis of 2008, from regulation.

But later, as chair of the CFTC under President Obama, Mr Gensler spent a large portion of his time cleaning up the mess that such lack of oversight created. He passed dozens of new rules to increase transparency and reduce risk in the swaps and futures markets — moving faster and further on financial regulation than any of his peers.

Indeed, Mr Gensler almost seemed to see it as his own personal mission of penance. As he told me in a 2012 interview, “Knowing what we know now, those of us who served in the 1990s should have done more [to protect] the derivatives market.”

Democrats usually decry the revolving door between Goldman Sachs and Washington. But Mr Gensler is both beloved of financial reform types and feared on the Street in large part because of his status as a former insider.

“Gary can’t be intimidated, and he’s usually smarter than you are,” says Dennis Kelleher, president and CEO of Better Markets, a non-profit financial reform organisation. “He’d call baloney on arguments that didn’t withstand scrutiny,” Mr Kelleher adds — recalling Mr Gensler’s tenure at the CFTC, when financial executives would lobby for or against various rules.

Since stepping down from the CFTC, maths-whizz Mr Gensler has been at MIT, studying and teaching on the next big things in finance: blockchain and cryptocurrency. That background will make him even more useful as a regulator at a time when the largest tech platform companies — from Google and Facebook to Amazon and Apple — are moving into the financial industry.

Mr Gensler has so far lauded the convenience and low cost of retail financial services apps while cautioning against the use of decentralised technologies for financial speculation. In a November 2020 MIT paper, he and co-author Lily Bailey discussed the “significant opportunities for efficiency, financial inclusion, and risk mitigation from AI and big data in the financial sector, but also the possibility of ‘regulatory gaps’ that might lead to ‘financial system fragility and economy-wide risks’.” Translation? In a Gensler-led SEC, fintech will be under greater scrutiny.

But he will also have to address past failings. For some years, the SEC has been criticised for not being tough enough on corporate America and not adequately protecting investors. Indeed, scams and fraud have been on the rise during the Trump administration, according to the SEC’s Office of Investor Education and Advocacy.

As head of the SEC, Mr Gensler would therefore have to balance two jobs. First and foremost would be restoring trust in the agency’s ability to accomplish its core mission of protection, financial stability and penalising violations. In addition, though, as a longtime Democratic politico, he would want to help facilitate the Biden administration’s priorities, such as addressing income inequality, racial injustice and climate change.

On the former, progressives will look to the next SEC chair to acknowledge that it is not banks that break laws, but individual bankers. By appointing a tough director of the enforcement division — perhaps a former prosecutor or a consumer advocate — the chair could send a message: there will be no more sweetheart deals for individual executives while organisations write-off their regulatory fines as a cost of doing business. The chair could also revisit Trump-era deregulation, and toughen rules around whistleblower protections, pay clawbacks for illegal gains, and limits on executive pay for high-risk activities.

On the broader Biden agenda, the SEC could meanwhile play a big role in increasing transparency and disclosure around hidden fees, predatory lending and unseen risks from factors such as climate. Imagine, for example, if companies had to disclose their potential litigation risk around lending to the fossil fuel industry or developing waterfront property. This, combined with opening up the black box of algorithmic finance, could go a long way towards mitigating risk at a delicate time for the global economy. 

With a new administration and a new “born again” SEC director, markets may soon get regulatory religion too.

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ESG accounting needs to cut through the greenwash




The writer is professor of business and public policy at Oxford’s Blavatnik School of Government

For investors seeking more focus on environmental, social, and governance issues, 2020 might have felt like a good year as numerous CEOs embraced ‘ESG-speak’. But much of this, I suspect, was to dress up the disappointment of Covid-19-induced losses. And their posturing only seemed real because accountants and standard setters got in on the act.

Before investors take any ESG claims seriously, though, the accounting has to become a lot more serious. That means incorporating the features of high-quality accounting rules — and here are three that I believe could make a difference.

First, prudence. In accounting parlance, that means having a higher threshold for recognising positive claims than for negative ones. As companies laud themselves for wins on the environment or on meeting social responsibilities, the ESG accounting rules should impute scepticism.

To date, however, I have not encountered a single set of ESG standards that requires prudence. UK-based fashion retailer Boohoo waxed eloquent in its 2019 report about its “zero-tolerance approach to modern slavery”, and scored highly on several ESG indices — only to be exposed for using suppliers that paid workers less than the UK’s minimum wage.

Second, dual reporting. If a firm is reporting on its greenhouse gas emissions in a given period — what accountants call a “flow” — then this figure should be contextualised against the corresponding “stock” in accounting terms: ie, cumulative greenhouse emissions over prior periods and, if relevant, any pollution credits for future emissions. After all, It is an accepted principle that a company’s financial reporting should encompass both the flows and stocks of the item being reported on.

Reporting on flows gives users a picture of current-period performance, while reporting on stocks allows users to examine how sustainable that performance has been over time. But, again, I am not aware of any ESG standards that mandate both flow and stock reporting in the unit being reported.

Third, “matching”. This is how accountants set current investments against future benefits. For example, £1bn building cost of a new factory is not simply recorded as an expense on the income statement but held on the balance sheet and gradually recognised in the income statement as depreciation during the asset’s life. ESG accounting needs benefits matching, too.

This matters because it encourages investments in the future. If managers had to take large current losses on capital expenditures, they might think twice about them — especially if the benefits were very long-term, and only enjoyed after their tenure. Accounting rules that set out the matching of ESG investments and their benefits would moderate this problem.

At the same time, if we want corporate managers to make costly pro-social investments in the environment or in community welfare, we need matching rules to assess their impacts in the future. Recently, Nestlé announced that it was investing €3bn over five years to cut greenhouse emissions as part of its 2050 “net zero” commitment. But how do we know this is enough and will make any meaningful difference to the environment? ESG accounting standards should require Nestlé to state more precisely what ESG value it expects its investment to generate and over what period. The investment could then be “matched” to any realised benefits over that period.

These three principles — prudence, dual reporting and matching — are all fairly basic in financial reporting, but virtually unheard of in ESG accounting standards, As the accounting authorities and the auditing firms push for more environmental and social reporting, this situation has to change.

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