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    FinTech Rising: Navigating the maze of US & EU regulations
    FinTech Rising: Navigating the maze of US & EU regulations
    FinTech Rising: Navigating the maze of US & EU regulations
    Ebook267 pages5 hours

    FinTech Rising: Navigating the maze of US & EU regulations

    By alasdair gilchrist

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    About this ebook

    This book, FinTech Rising aims to be an introduction to both Financial services generally and more specifically to Financial technology (FinTech). The book explores the financial Services environment, the booms and crashes, before FinTech's provenance and how it has come to prominence and why it is so important. It will also examine in details why FinTech firms are both thriving in the current economical climate yet are stifled by regulations and state laws.

    LanguageEnglish
    Publisheralasdair gilchrist
    Release dateOct 2, 2017
    ISBN9781386735427
    FinTech Rising: Navigating the maze of US & EU regulations

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      Book preview

      FinTech Rising - alasdair gilchrist

      Chapter 1 - the fall and rise of the Financial Services Industry

      The fallout from the Great Recession where banks collapsed despite being said to be ‘too big to fail’ resulted in a tsunami of new safety regulations being imposed upon the Financial Services industry. Ultimately, the consequences of that period, which witnessed the largest banks operating under bizarre behaviour, tactics and strategies both leading up to and inexcusably following the financial meltdown of 2007-2008 continues to haunt Financial Services institutions to this day.

      Prior to 2007-2008 the Financial-Sector’s supervision and regulation, or the lack thereof, over several decades played a role in the demise of the traditional banking establishments. However, it should be understood that without the benign economic and preconditioned financial conditions that prevailed in the early 2000’s - due to the wake of the dot-com boom and bust and the associated belief that this time it is different, - the 2007-2008 crisis may well have taken a different format.

      If we fast forward to the financial crisis of 2007-08 it becomes clear that not only were the banks at fault but that the Shadow Banks the private sector’s non-bank financial firms had developed an unhealthy and unregulated appetite for high-risk, short-term profit. The emergence and proliferation of the shadow banks during the 2000s was a major contributory factor to why the industry collapsed.

      For example, lets consider the state of the nation at the time, back in 2006 more than 84 percent of the sub-prime mortgages issued were provided by private lending, and this may indicate where the failure may ultimately lie. These private nonbank firms made nearly all of their sub-prime loans to low and moderate income borrowers that year (2016) and some will argue that was not only reckless but at the behest of congress in the US.

      An additional problem is that many emerging private financial firms were not subject to regulations and where offering loans and mortgages based on unproven and unregulated underwriting terms. (This might sound topical if not familiar)

      Hence, out of the top 25 sub-prime lenders in 2006, there was only one which was subject to the usual mortgage laws and regulations and as a result the non-bank underwriters, free from the constraints of industry regulations made more than 12 million sub-prime mortgages with a value of nearly $2 trillion. The new entrants into the financial markets, the lenders who made these loans, were exempt from any federal regulations, but how did this come about and why was this allowed?

      The story of the 2008 financial crisis

      In order to understand the circumstances that preempted the financial collapse let’s look back upon how the financial crisis of 2008 came about and examine some of the basic facts: first of all we must examine the question as to why we had a financial crisis in 2008 in the first place?

      After all everything was supposedly going so well, despite the Asian crisis in the late 90s, and then the UAE, Dubai melt down in the mid 2000s, confidence was high. Well if we do some research and look at some excellent articles in the Washington Post we can see that Barry Ritholtz understands the history and can relate it in the following terms:

      Back in 1998, almost a decade before the collapse the seeds were sown and banks got the green light to gamble: What Barry Ritholtz is eluding to here is that the long standing Glass-Steagall legislation, which separated regular retail banks and investment banks’ was repealed in 1998. In effect repealing the bill allowed banks, whose deposits were guaranteed by the FDIC, i.e. the government, to engage in highly risky business which mounts to gambling for their own profit with customers deposits.

      The introduction of low interest rates fueled an apparent boom: by introducing this mechanism following the lunacy of the dot-com boom and bust in 2000, was a recipe for disaster. Indeed, the Federal Reserve dropped rates to 1 percent and kept them there for an extended period of time unfortunately this created the illusion of a financial boom. The issue is that low interest rates cause a vicious spiral in anything priced in dollars (i.e., oil, gold) or credit (i.e., housing) or liquidity driven assets (i.e., stocks).

      Asset managers sought new ways to make money: Furthermore, when you restrict traders to gains of just 1% it is hard to make money, let alone their bonuses through traditional financial instruments. Therefore, trading in standard products could no longer make sufficient profit due to the low rates so this meant asset managers could no longer get decent yields from municipal bonds or Treasury’s. As a result Asset Managers instead turned to high-yield mortgage-backed securities or new innovative products, which returned high yields but were ultimately poorly understood such as derivatives

      The credit rating agencies gave their blessing: The credit ratings agencies — Moody’s, S&P and Fitch placed triple A (AAA) rating on these junk securities, claiming they were as safe as U.S. Treasuries bestowing on them a credit rating that encouraged consumer confidence and in practice bestowing on the market a false sense of security.

      Fund managers showed little due diligence and didn’t do their homework: Fund managers, even though they may have been skeptical of the financial instruments such as derivatives relied instead on the ratings of the credit rating agencies, or external research companies to evaluate their products. However, the traders failed to do adequate due diligence before buying and selling these instruments to their clients as they clearly did not understand these instruments or the risk involved.

      Derivatives were unregulated: Derivatives had become a uniquely unregulated financial instrument that many reputable financiers were suspicious of due to the fact they were not only exempt from all oversight, counter-party disclosure, exchange listing requirements, state insurance supervision and, most important, reserve requirements. But probably most importantly how the underpinning assets were valued and how change could affect the value. Because of this oversight AIG an insurance company in the US in 2008 were able to overwrite $3 trillion in derivatives while astonishingly maintaining reserves of precisely zero dollars against future claims.

      The SEC loosened capital requirements and leverage rules: The leverage ratio is the ratio of a bank’s core capital to some measure of its total amount ‘at risk’, traditionally taken as the bank’s total equity, which is assets (loans) – liabilities (deposits). Other things being equal, the higher the leverage ratio, the stronger the bank. In 2004, the Securities and Exchange Commission changed the leverage rules for the majorWall Street banks. This exemption replaced the 1977 net capitalization rule of a 12-to-1 leverage limit. This allowed unlimited leverage for Goldman Sachs [GS], Morgan Stanley, Merrill Lynch (now part of Bank of America [BAC]), Lehman Brothers (now defunct) and Bear Stearns (now part of JPMorganChase—[JPM]) to raise their leverages under their own recognizance.

      Free from such regulations these banks then ramped leverage to 20-, 30-, even 40-to-1. This was extremely risky and by all accounts little more than gambling as this level of extreme leverage would result in huge wins but also huge losses but they left little room for error. By the time the dust was to settle in late 2008, only two of the five banks provided with this leverage had survived, and those two did so with the help of the taxpayer’s bailout.

      The federal government overrode anti-predatory state laws. In 2004, the Office of the Comptroller of the Currency, the OCC, federally preempted state laws regulating mortgage credit and national banks, including anti-predatory lending laws on their books (along with lower defaults and foreclosure rates). Following this change, national lenders sold increasingly risky loan products in those states. Shortly after, their default and foreclosure rates increased exponentially.

      Compensation schemes encouraged gambling: Wall Street’s compensation system was—and still is—based on short-term performance, all upside and no downside - the Heads I win, Tails the Taxpayer loses belief. This mindset creates tremendous confidence and acts as an incentive to take excessive risks. The bonuses are extraordinarily large and they continue—$135 billion in 2010 for the 25 largest institutions and that isafterthe meltdown. Whereas the losses can always be seen to be paid by the tax payer – as indeed they ultimately were in 2008.

      Traditional Financial Institutions became creative: The demand for higher-yielding products and short term profits led banks to begin bundling mortgages. The highest yielding were sub-prime mortgages. This market was dominated by non-bank originators exempt from most regulations but banks bought from them in order to gain a foothold.

      Private sector lenders fed the demand: These non-bank mortgage originators’ that operated a lend-to-sell-to-securitizers model were actually holding mortgages for a very short period and this reduce their risk. By selling onwards and upwards to traditional financial institutions (banks) the tactic allowed the private non-bank lenders to relax underwriting standards, abdicating traditional lending metrics such as income, credit rating, debt-service history and loan-to-value, as the repayment of the long term debt was no longer their problem.

      Financial gadgets milked the market: Innovative mortgage products were developed to reach more sub-prime borrowers. These ingenious products included 2/28 adjustable-rate mortgages, interest-only loans, piggy-bank mortgages (simultaneous underlying mortgage and home-equity lines) and the notorious negative amortization loans (borrower’s indebtedness goes up each month). These mortgages defaulted in vastly disproportionate numbers to traditional 30-year fixed mortgages.

      Commercial banks jumped in: Banks however were not blind to these non-bank financial upstart’ tactics and their seemingly highly successful and productive product lines so in order to keep up with these newfangled originators, traditional banks jumped into the game. As a result traditional underwriting was relaxed and employees were compensated on the basis of loan volume, not quality. The failures of the Asian Financial Market less than a decade before in 1978-79 should have been a severe warning to the dangers of following that path.

      Derivatives exploded uncontrollably: CDOs provided the first infinite market; at the height of the trading tsunami prior to the crash, derivatives accounted for 3 times the global economy and as many financial experts such as George Soras had predicted they were a disaster waiting to happen.

      Traditional Players jumped in the game late to protect their profits: Nonbank mortgage underwriting exploded from 2001 to 2007, along with the private label securitization market, which eclipsed the major players such as Fannie and Freddie during the boom.The vast majority of sub-prime mortgages — the loans at the heart of the global crisis — were underwritten by unregulated private firms. These were lenders who sold the bulk of their mortgages to Private Investors via Wall Street or through Stock Exchange, not initially to the traditional incumbents. Indeed, these private financial services firms had no financial or asset deposits, this was actually a prerequisite for their business model so they were not under the jurisdiction of the Federal Deposit Insurance Corp or the Office of Thrift Supervision.

      Fannie Mae and Freddie Mac market share declined: More than 84 percent of the sub-prime mortgages in 2006 were issued by private lending institutions indeed the relative market share of traditional lenders such as Fannie Mae and Freddie Mac dropped from a high of 57 percent of all new mortgage originations in 2003, down to 37 percent as the bubble was developing in 2005-06. The government-sponsored enterprises were concerned with the loss of market share to these private lenders — As a consequence firms such as Fannie and Freddie were chasing lost profits, not trying to meet low-income lending goals. Note: Fannie Mae (officially the Federal National Mortgage Association or FNMA) is a government-sponsored enterprise (GSE) – that is, a publicly traded company which operates under Congressional charter. It does not originate loans or provide mortgages to borrowers. Instead, it keeps funds flowing to mortgage lenders such as credit unions and banks by purchasing and guaranteeing mortgages made by these firms. Freddie Mac (the Federal Home Loan Mortgage Corporation) is another Congress created and sponsored company. By investing in the mortgage market, Fannie Mae creates more liquidity for lenders, such as banks, thrifts and credit unions, which in turn allows them to underwrite or fund more mortgages.

      It was primarily private lenders who relaxed standards: Private lenders not subject to congressional regulations collapsed lending standards as can be seen by the fact that conforming mortgages had rules that were less profitable than the new so called innovative loans. These private securitizers, the predecessors of FinTech and the direct competitors of Fannie and Freddie subsequently grew from 10 percent of the market in 2002 to nearly 40 percent in 2006. Furthermore, of all the mortgage-backed securities, private securitization grew from 23 percent in 2003 to 56 percent in 2006. As we can see the driving force behind the 2018 financial crisis may well have been based upon the private sectors thirst for short term profits in an unequally regulated market.

      Now it is probably true that Congress in the US or the Parliament in the UK, amongst others did not initially or even intentionally provoke private financial institutes to go and give mortgages to people who were on the verge of financial solvency, although that was the unintentional consequence. After all even back in 2006 it was becoming apparent that the millennial generation may never be able to afford the first step on the property ladder without some considerable assistance.

      Hence, it wasn’t simply banks that failed the community; many other players in the financial services industry obviously played a role in the collapse of the financial markets. For example it wasn’t really down to the proliferation of new unregulated private sector firms, as not all failed financial institutions were in the private sector some of the main players that failed were in the public sector. Additionally, we must be clear that many off the public sector agencies were acting at behest of the institutes in the private sector, and both parties should have been aware of the risks they were undertaking.

      After all it was not the banks or the new breed of financial organizations, it was the government and regulatory offices that ultimately paved the way for the private sector banks to become so powerful that they believed they could not fail. In addition it was government agencies that were being strenuously lobbied to do the very things that would benefit the managers and traders in the private financial sector under the false flag of innovation. Ultimately the goal was the desire for short-term profits – but why did no-one speak out?

      Indeed some luminaries of the financial industry did speak out. Back in 2004, the deputy governor of the Bank of England (the UK Central Bank) Sir Andrew Large did predict the coming financial catastrophe. Sir Andrew’s speech when presenting at the London School of Economics which was described as powerful and eloquent was a clear warning about the coming financial crash and it was also was published on the bank’s website - however it was almost universally ignored by the financial, commercial or popular media. Undeterred, Sir Andrew continued to make similar speeches despite the fact that his speeches infuriated the then UK Chancellor, Gordon Brown as they warned of the dangers of excessive borrowing. Unfortunately, Sir Andrew seems to have finally given up trying to persuade his contemporaries of the dangers and he retired in January 2006.

      However, Sir Andrew was not the only one to raise a red flag, as a contemporary and subject expert back in 2005, the chief economist of the International Monetary Fund, Raghuram Rajan, made a speech to some of the most prominent bankers and financiers in the world. Raghuram Rajan, explained to the assembled financial experts that technical change, institutional moves and deregulation had made the financial system unstable. Incentives to make short-term profits were encouraging the taking of risks, which if they materialized would have catastrophic consequences. Needless to say Raghuram Rajan speech did not go down well indeed it was generally considered that the speech was largely misguided.

      But that would not be the end to the warnings, in 2006, Nouriel Roubini issued a similar warning at an IMF gathering of financiers in New York which was along the same lines. The Bankers’ audience reaction was similar to their reaction to Raghuram Rajan speech in that they were at best dismissive.

      It appears the consensus of the bankers present was that Roubini was non-rigorous in his arguments but perhaps unintentionally Roubini may have suggested that the central bankers did not know what they were doing.

      To clarify some of the concerns being raised at the same time it is necessary to understand some of the financial products and instruments in use during this period. Financial instruments are simply monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity (share), or a contractual right to receive or deliver cash (bond).

      A derivative on the other hand is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index, or security. Common underlying instruments include: bonds, commodities, currencies, interest rates, market indexes, and stocks.

      A derivative is referred to as the security or financial instrument that depends or derives its value from an underlying asset or group of assets. They are simply contracts between two or more parties. The value of such a contract is determined by changes or fluctuations in the underpinning asset from which it derives its value.

      The derivatives market is where these instruments are traded and these are typically over-the-counter (OTC) or exchange-traded derivatives where usually the underlying assets are bonds, stocks, commodities, currencies, market indexes, and interest rates. However with derivative trading it is important to understand one major difference between types of derivatives. The OTC derivative exchanges which are more like swaps do not need to run through an intermediary while the exchange-traded derivatives do need to go through derivatives exchanges. Consequently, the two types of derivatives are very different in the way they are traded and in their legal nature. To confuse matters and compound the problem is that many market traders are active in both types. As a result of this anomaly in regulation and legal nature, derivatives were a cause for concern for many economic and financial analysts,

      For instance many economists argued that some of the financial instruments in use, especially derivatives, were not fit for purpose. Some examples, of those experts who were outspoken towards derivatives, are the prominent financier, George Soros, who avoids using the financial contracts known as derivatives, because we don’t really understand how they work.

      Another prominent investment banker, Felix G. Rohatyn, described derivatives as potential hydrogen bombs. And Warren E. Buffett the famous management guru and financier also agrees as he remarked in a similar vein over five years before the financial collapse of 2008 that derivatives were financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

      However on the other side there are supporters of derivatives and one of the most prominent financial figures has long defended their use. For more than a decade, the former Federal Reserve Chairman Alan Greenspan has fiercely supported derivatives when ever they have come under scrutiny in Congress or on Wall Street.

      What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so, Mr. Greenspan told the Senate Banking Committee in 2003. The problem with that though is that often there was little transparency into the underpinning instruments that constituted

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