Events keep happening that really do make it clear that we are about to enter a period of enhanced regulatory intrusion into the financial services space. Shocking! And entirely unexpected, right? (You’re winning, sir) While that is in many respects troubling, it’s also the stuff of opportunity for the creative and nimble. I’ll explain.
Along Pennsylvania Avenue and its tributaries, there is ubiquitous mischief afoot. As we have often said on these pages, people are policy and butts in seats will define the regulatory topography. As elections matter, seats are now being filled by folks with a strong belief in the power of the government to do good, the ability to achieve specific outcomes through governmental action and a conviction that the capital markets are, if not broadly suspect, at least the principal residents of lots of dodgy customers for whom we need many strong and a well-armed sheriffs in town.
You doubt? Look at what Mr. Gensler, the chairman of the SEC, is talking about at the Fed. He wants stronger oversight of private firms and is talking up a storm. Then there is Rohit Chopra at the Consumer Financial Protection Bureau, which agency and whose leadership is causing considerable unease in the finance industry circles.
How about Sarah Bloom Raskin, who looks like she’s on the rails to become the Fed Vice-Chair for Supervision? She has repeatedly and quite publicly said that the Fed should broadly embrace ESG goals and really ought to embrace a credit allocation function in pursuit of a range of policy goals including climate, social justice, etc. (In case you were wondering, I went back to take a look at the act creating the Federal Reserve and as far as I can tell, its legal mandate remains protection against inflation and maximizing employment. Oh well, these days, pesky little things like actual statutory language apparently don’t often matter.)
Then there’s a whole panoply of folks cast from the same mold in this new administration. Just as a for instance, we see two very clear anti-trust crusaders, Tim Wu at the White House and Lena Khan at the FTC, who may well look askance at any concentration in the non-banking sector, and ironically, enhanced regulation may make such concentration necessary. Then there’s Michael Regan at the EPA and Jared Bernstein at the Council of Economic Advisors and K. Sabeel Rahman, at the powerful but obscure Office of Information and Regulatory Affairs, and the list goes on and on. Senator Warren has proffered a list of 87 progressives to the White House which it is using to source candidates. (At the outset, let’s take a moment for thankfulness that we did dodge the proposed candidacy of Professor Saule Omarova for the OCC chair, and thank goodness for that. Anyone who could even muse over drinks, let alone write a scholarly paper that the world would be better if the US Post Office ran all our banks, should clearly not be allowed anywhere near the levers of power).
So, what do we see so far? Mr. Gensler wants stronger regulation and oversight of private equity. While the mass media may translate that as a focus on perfidious SPACs and other opaque structures, the entire non-bank market is largely composed of private firms. We are in the frame. Enterprises far away from the relatively small cohort of firms actually earning the SEC’s ire due to lack of transparency will be affected as this mosquito-sized problem is dispensed with a proverbial sledgehammer of broad regulation.
As another for instance, last week, the Financial Stability Oversight Council (FSOC) issued some interpretative guidelines dealing with its authority to supervise non-bank financial companies. While on its face, this is focused only on the extraordinarily large non-bank lenders, mission creep is an honorable tradition in Washington. FSOC will inevitably turn its Sauron’s eye to smaller enterprises. If anyone doesn’t see the camel’s nose under the tent flap here, they are sorely misled.
What else to expect? A motivated apparatchik hardly needs an invitation to regulate (birds gotta fly, fish gotta swim). There are several open invitations remaining in the statutory midden heap of Dodd-Frank, available to those interested in enhanced regulatory action.
You might remember that at the time of the promulgation of the final version of Reg AB, there was precatory language in the commentary, perhaps the wistful suggestion that the SEC might consider extending the full panoply of Reg AB disclosures to non-public securitizations. That was a bad idea then, it’s a bad idea now, but it remains an open invitation for regulators looking for something to regulate.
In a somewhat similar vein, Dodd-Frank required the regulatory agencies to consider alternatives to the existing issuer pay ratings agency model. After much back and forth, it’s pretty clear that much as how Churchill defined democracy, the current ratings agency model is the worst possible model…except for all the alternatives (rather reminiscent of the death of LIBOR, isn’t it?). Consequently, the ratings agency model has survived in the face of considerable concern that it does not serve the public good.
Should we expect the SEC to wade in here again? Certainly, a risk. The regulators in the past have considered such alternatives as randomly allocating ratings assignments to NRSROs or finding some way to make the investors into customers, but all have failed some element of common-sense assessment of functionality. Would changing this model help investors? Doesn’t seem likely. Would it serve the interests of the transparency initiatives? Doubtful, but it could hurt certain infelicitous industries (and that’s not a bad thing, is it?).
So, we have a lot of new sheriffs, all inclined and now empowered to look for trophies for their newly tricked out digs. As regulatory issues are usually done with a broadsword and not with a scalpel, we should expect initiatives around transparency, reporting and disclosure will intentionally, and unintentionally, significantly raise costs, increase transactional friction, and diminish capital formation and deployment.
The progressive legislative agenda largely lies in tatters at this point, leaving the administration little space to move the needle except in the regulatory sphere. Progressive frustration will turbocharge efforts by the administration to establish its chops by doing something, almost anything, making something happen with the levers of power they still control. Moreover, as those currently in power are staring at what appears to almost all observers to be a fraught and challenging election cycle, the frustration over a failed legislative agenda will be turbocharged by the urgency of timing.
Together, that signals imminent regulatory change and considerable sloppiness. Ready, fire, aim!
I see three basic strains of incoming regulatory change relevant to us: The first is reporting, transparency and compliance; the second is punishing the unloved (or unlovely); and third is the actual intrusion into the allocation of capital
Increased compliance and increased reporting represent real costs, burdens and compliance risks. It matters. It will impact how business is conducted. Much like Dodd-Frank, in hindsight, another wave of compliance will represent a competitive advantage for large enterprises with the capacity to shoulder the burden while conducting business as usual. For smaller to even mid-size players, another bout of regulatory enhancement will be bad. Whether you are a small bank, a small closed-end fund, or a small public or private REIT, increased regulatory burden is meaningful, and at some point, and in some cases, could become an existential threat to the ability of these enterprises to continue to conduct business.
One might see this as a threat to viability or one might see it as a prod to further acceleration of the existing drivers behind concentration across the non-bank, and indeed the prudentially regulated bank industry. Risk or opportunity? Probably depends on your scale and balance sheet. Where you stand so often depends on where you sit.
What is also embedded in this initiative is the ability to embarrass, to affect behavior by shaming and shunning institutions whose disclosure falls short, or whose disclosure highlights behavior of which the regulatory elites and their disciplines and proselytes may not approve. All such prescriptive rules turbocharged by disapprobation have wide penumbras. It’s never actually clear how to comply, how to avoid unwarranted attention and greater scrutiny. This chills enterprises and entrepreneurship. How much is not done because it might actually or even optically appear to be “close to the line?” How many decisions are made on the basis that the conduct might attract some regulatory attention or even a Twitter storm?
This brings me to a strain of the regulatory instinct at play right now which might simply be to punish. If you can’t make it better, at least you can make life for those that are perceived as villains harder. Sorry, but that’s a thing.
The last strain of this likely regulatory tsunami is capital allocation. And how attractive! Dispensing with the pesky need to rely on such indirect tools as transparency and disclosure, let’s just tell the damn institutions how to allocate their capital! Remember the effort to crush the payday loan business, a program with the perfectly straightforward name of Operation Choke Point? The instincts that gave us Operation Choke Point have not abated and indeed are super consistent with the current regulatory gestalt. This instinct is expressed in two ways, the first is to redline market segments. Hydrocarbons come to mind. The second is to criticize capital deployed to non-favored sectors of the economy, such as commercial real estate, as the view of our governing elites is that such deployment absorbs capital needed elsewhere.
We may indeed find that the entire commercial real estate industry might be such a place.
Our governmental elites and their regulatory servants may simply believe that there’s too much money allocated to commercial real estate already (perhaps they are consulting with Chairman Xi Jinping). While there is certainly some E and even some S and G in commercial real estate, perhaps the dollars supporting this business might be better allocated to more favored sectors, maybe more aligned with the current government’s view of the public good.
At a minimum, I foresee pressure on the prudentially regulated banking sector (and perhaps even the newly FSOC regulated super-sized non-bank lenders) to reduce their commitment to commercial real estate and shift dollars to more public good uses.
So that’s the environment (no pun intended) we confront. Opportunities? First is the most obvious – get with the program. Get big, embrace the increased regulatory burden, use size to achieve competitive advantage then allocate capital to governmentally favored market segments. It’s obviously ESG, but that’s not all. How about domestic chip manufacturing? That could be a winner. How about infrastructure in general? Bingo! A lot of bridges are going to fall down like the one in Mr. Biden’s recent photo-op in Pittsburgh. We will see many more public/private partnership opportunities develop and expand in the next year or two. That very much smells like opportunity.
Doing what our government elites want you to do could be a crowded trade. While the doing-good-equals-doing-well calculus might not turn out to be particularly remunerative, it’s a thing and it’s an easy place right now to raise money and deploy capital in ways favored by those in the regulatory heights. Do enough of this and you will indeed get invited to the best parties and rub shoulders with our governing elites and those giants of political philosophy …Hollywood actors.
The other opportunity, and this is only for the bold, is to counterprogram. When everyone else is watching the Super Bowl, you can actually earn a decent return on Pride and Prejudice. Raise a fund to finance the oil patch. Double down on commercial real estate. Be ready to finance non-LEED quality building stock. If the GSEs are forced to devote more of their capital to public goals, how about high-end multifamily? How about just going out the yield curve and be damned the tut-tutting? Check out Santa’s naughty and nice lists and focus some real energy on the naughty.
It’s likely that money can be raised here, albeit somewhat quietly. Not every investor buys the doing-good-equals-doing-well calculus and those contrarians will be interested in allocating funds, to sectors that are unloved in the new environment. An argument can be made that by returning the best and highest return to your investors, you really are doing the right thing. What an oddly old-fashioned notion. Maybe the answer is stapling a naughty and nice fund together and give folks opportunities to invest in both, and allocate and re-allocate dollars between those two funds as the political winds shift.
Look, our industry has always been good at understanding how to play the game, once a set of rules is handed to us, but we’re at an inflection point where it seems that the game might be changing over the next several years. Moreover, the government’s footprint gets larger and larger and so the consequences of the regulatory action or inaction become magnified. (By the way, I don’t think much of this goes away even if there is a change of administration over the next couple of election cycles. The era of small government is indeed gone. We have an endless supply of apparatchiki with confidence in their ability to do good and an almost willful blindness to the possibility of the adverse consequences of well-intended regulatory action). The world is changing and will not go back to where it was.
The point of all this, I guess, is to urge everyone to devote resources, in the first instance to a program of sustained and persistent attention to regulatory change and potential regulatory change. You gotta see it coming if you want to adapt folks. Simultaneously, recognize that change is already here and it’s high time to think strategically about what the market will look like as regulatory change rolls across the economy. You need to be nimble enough to adjust the business model for this new regulatory world.
It does smell like opportunity, doesn’t it?