I support the Commission’s efforts for strong capital requirements and financial reporting to help ensure the safety and soundness of swap dealers whose activities could affect U.S. markets, including through this proposed Capital Comparability Determination for Japan.  The proposal promotes financial stability and the benefits of global harmonization with a like-minded regulator for the global swaps markets.  Thank you to the staff for their hard work, and for their thoughtful engagement with me and my office on changes to improve the proposal.

The 2008 Financial Crisis and TARP Capital Injections

A key cause of the financial crisis was the failure of bank regulators to require financial institutions to have high quality capital in a sufficient amount to serve as a buffer against risk.  This included the lack of capital requirements that would ensure that financial institutions that were swap dealers, and other major participants in swaps markets, had adequate capital to absorb losses.  The devastating result of this undercapitalization swept rapidly through the highly interconnected financial system.  The default or margin failure of one counterparty triggered another, and then another – which led to a short-term liquidity crisis.  Risk and losses also cascaded from subsidiaries and affiliates to bank parent companies and/or bank holding companies, including across borders.     

The financial contagion was not limited to major players in the markets.  The entire economy suffered, with Main Street bearing the consequences of Wall Street.  The federal government made unprecedented capital injections of hundreds of billions of taxpayer dollars into more than 700 financial institutions through the Troubled Asset Relief Program (“TARP”).  For the last decade, I served as the Special Inspector General for TARP (“SIGTARP”), providing oversight over TARP programs.  I have testified before Congress and reported publicly on lessons learned from inadequate capital requirements pre-crisis and the need for strong levels of high-quality capital to lower systemic risk in the financial system. 

The Dodd Frank Act’s Capital Requirements for Swap Dealers

Swap dealer capital requirements are one of the most critical reforms in the Dodd-Frank Act for derivatives markets.  These reforms led the CFTC to allow nonbank swap dealers to use a capital framework similar to what prudential banking regulators apply to banks.[1] 

Capital protects the solvency of the swap dealer from unexpected losses, such as counterparty defaults and margin collateral failures.  Capital requirements are aimed at ensuring a swap dealer has the ability to absorb losses, and they prevent market disruption by helping to ensure that swap dealers continue to perform their critical function to provide liquidity and market making.  Capital along with margin requirements for uncleared swaps reduces the potential for contagion, thereby lowering systemic risk in the financial system, and promoting financial stability.

The CFTC’s First Substituted Compliance Determination for Capital Requirements

The global nature of the financial crisis also highlighted the need for the CFTC to coordinate with foreign regulators, as swap activities in a foreign jurisdiction may have an impact here in the United States.  For example, risk of a foreign subsidiary can flow to their U.S. parent company. 

The CFTC’s “substituted compliance” framework leverages a second regulator, a like-minded foreign regulator that has rules, supervision and enforcement that are comparable in purpose and effect to the CFTC’s.  Under this global harmonization, the CFTC would allow a non-U.S. entity to be deemed in compliance with CFTC requirements if the non-U.S. entity complied with the foreign regulator’s comparable rules. 

I am mindful that this proposal is the first of its kind – the first substituted compliance determination for the CFTC’s capital rules.  Therefore, we should proceed carefully, as we are establishing precedent.

The proposal today is for nonbank swap dealers that are domiciled in Japan, where we have a Memorandum of Cooperation and a long history of cooperation with the Japanese Financial Services Agency.[2]  Currently, this proposal would apply to Japanese affiliates of Bank of America, Morgan Stanley and Goldman Sachs – three systemically important institutions and three of the largest TARP recipients having collectively received $60 billion in TARP capital injections.  Therefore, it is vital that the CFTC ensures that these swap dealers have adequate amounts of high-quality capital.  Public comment will be helpful on whether the CFTC is correct in its preliminary determinations of comparability.

I highlight, and express my appreciation for, the involvement of the Japanese Financial Services Agency in this process.  CFTC staff’s engagement with our regulatory counterparts in Japan has helped to ensure the accuracy of the staff’s assessment of Japanese capital and financial reporting requirements, along with supervisory and enforcement programs.[3]

Substituted compliance does not require an all or nothing determination.  The CFTC may continue to require compliance with certain of its rules, and impose any terms or conditions that it deems appropriate.[4]

The CFTC proposes to continue to require that Japanese nonbank swap dealers comply with the CFTC’s $20 million capital requirement, as Japan has no minimum requirement.[5]  I strongly support retaining the $20 million capital requirement.  However, the CFTC is not requiring compliance with our requirement that the $20 million be in the form of common equity tier 1 capital – one of the strongest forms of capital.  Instead, the proposal would allow the $20 million requirement to be satisfied with types of capital defined in a category called “Basic Items” under Japanese regulation.  I look forward to commenters’ response on whether allowing the $20 million capital requirement to be satisfied with this category of “Basic Items” is comparable in purpose and effect to the CFTC’s requirement that only common equity tier 1 capital be included in the $20 million.

Japan also does not have a minimum requirement for capital that is tied to the margin for uncleared swaps entered into by the nonbank swap dealer.  The CFTC requires an aggregate of common equity tier 1 capital, additional tier 1 capital and tier 2 capital equal to or greater than 8 percent of the nonbank swap dealer’s uncleared swap margin amount.  I look forward to commenters’ response on the question as to whether Japan’s capital requirement in an amount equal to 25% of operating expenses is comparable in purpose and effect to the CFTC’s capital requirement equal to 8% of the uncleared swap margin amount.

It is a priority for me to ensure that the CFTC guards against complacency with post-crisis reforms, particularly after market stresses from the pandemic and geopolitical events.  We should remember that our capital rules serve as critical pillars of Dodd-Frank reforms to help ensure the safety and soundness of financial institutions and to protect the market from serious risks and contagion.  The CFTC has a duty to ensure that our comparability assessment is sound and that the foreign regulator is like-minded in not only rules but in their approach, supervision and enforcement.  Substituted compliance must leave U.S. markets and our economy at no greater risk than full compliance with our rules. 

[1]  This bank-based approach is consistent with the Basel Committee on Banking Supervision’s international framework for bank capital requirements.

[2]  As noted in the proposal, in making a Capital Comparability Determination, the Commission may consider any facts or circumstances it deems relevant, including whether the relevant foreign regulatory authority has a memorandum of understanding or similar arrangement with the Commission that would facilitate supervisory cooperation.  See 17 CFR 23.106(a)(3)(iv). 

[3]  The Commission may consider all relevant factors in making a Capital Comparability Determination, including the ability of the relevant foreign regulatory authority to supervise and enforce compliance with the foreign jurisdiction’s capital adequacy and financial reporting requirements.  See 17 CFR 23.106(a)(3)(iii).  The proposal also makes a preliminary determination that the Japanese financial reporting rules are conditionally comparable in purpose and effect with the CFTC’s financial reporting rules.

[4]  See 17 CFR 23.106(a)(5).

[5]  Japanese capital requirements are consistent with Basel bank capital standards, similar to the CFTC.