Cui Bono From Financial Regulation?
In 125 BC, Roman politician and prosecutor Lucius Cassius introduced the legal principle of cui bono, which roughly translates to "who benefits?" It intends to cut through distractions and irrelevant details of a case to focus on motive – especially financial motive.
In modern day, critics of the current financial regulatory agenda have focused on what they consider its flaws:
- The breakneck pace of SEC rulemaking. SEC Chair Gary Gensler's tenure to date have seen 60 proposed rules, with more than 9,000 pages of text and shorter windows for public comment.
- Significantly higher bank capital requirements. The Basel III Endgame rules could increase borrowing costs to homeowners and businesses and reduce liquidity in fixed income capital markets.
- The potential for stricter oversight. According to U.S. Treasury Secretary Janet Yellen, the Financial Securities Oversight Committee is looking once again at whether certain non-bank financial institutions should be declared "significantly important" and subject to stricter oversight.
- Implementation overload. Firms needing to comply with new regulations will likely find themselves rushing to build out technology, compliance policies and operational processes.
- An increased risk of unintended consequences. Given just how extraordinarily complex, interconnected and interdependent the modern financial system has become, the risk that something will "break" increases dramatically (see chart).
The potential impacts of major SEC regulatory actions on market liquidity, risk, borrowing costs and investing costs. Source: NERA Economic Consulting, SIFMA.
Not to mention the potentially deleterious effect regulatory overreach could have on economic growth.
But American Securities Association CEO Chris Iacovella, who has successfully sued the SEC, offers a novel perspective: Cui bono from today's financial regulation?
"What's going on is that the Administrative State is supporting the agenda of derivative players – accountants, consultants, lawyers – who are advocating for more and more regulation," Iacovella told me in a recent interview. "This has created a self-perpetuating cycle."
"This doesn't just apply to financial services – it applies across all sectors of the economy," Iacovella said. "But in finance, one thing is clear: The implementation of an unprecedented regulatory agenda will result in a significant transfer of wealth from regulated market participants – including retail investors and small businesses who use their own capital to take risks – to a professional class who does not."
Ironically, the world view behind regulatory activism is often that financial services intermediaries are extracting too much economic rent from the economy: Their share of GDP is too high, activists claim, and needs to be squeezed down by increasing transparency and competition.
Iacovella suggests that exactly the opposite is happening. "Regulators are imposing enormous costs on financial institutions that are ultimately a tax on the investor base," Iacovella told me.
As one example, the Consolidated Audit Trail – the subject of ASA's current litigation against the SEC – has racked up $540 million in start-up costs, with another $240 million slated to be spent this year. 80% of those costs will be passed on to financial services firms. "Those incremental costs disproportionately affect smaller firms," Iacovella told me. "They are putting pressure on independent players to look at acquisitions, which ultimately will reduce competition, not increase it."
"We're looking at a transfer of wealth from risk takers, entrepreneurs and businesspeople operating in the real world – from investors putting their savings on the risk/reward line in financial markets – to a progressive, pro-regulation administrative state. The net result is a drag on economic activity."
Whether you agree with Iacovella or not, there is no denying that the modern world leans toward regulation and bureaucracy. It may well be born from good intentions – human beings' innate belief that they can exercise significant control over what can go wrong with their environment. Some attempt at control is prudent. But after a certain point, the unintended negative consequences of a bloated administrative and bureaucratic state – and the much-larger-than-needed professional class that surrounds and undergirds it – outweigh the benefits.
In finance, we may have already reached that point.
Stewardship: Lessons Learned From the Collapse of FTX
Since the collapse of FTX earlier this year – and the subsequent criminal trial in New York City – I and many others have been parsing what this extraordinary chapter in finance history reveals about the current state of stewardship. By "stewardship," I mean the ethical imperative: "Responsibly managing what others have entrusted to your care" – which is, or should be, the core principle undergirding finance.
On one level, it's easy. Under founder Sam Bankman-Fried, FTX and its sister company Alameda Research appear to have engaged in unethical behavior at almost every level and in every way imaginable in a financial services enterprise, decimating the savings of a million investors in the process. As FTX successor CEO John Ray put it in the company's bankruptcy filing in November 2022, "Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here." Ray elaborated in a second investigative report in June 2023 (boldface mine):
"Bankman-Fried along with FTX.com's co-founder, Gary Wang, and Director of Engineering, Nishad Singh (the 'FTX Senior Executives'), and others at their direction, used commingled customer and corporate funds for speculative trading, venture investments, and the purchase of luxury properties, as well as for political and other donations designed to enhance their own power and influence. ... [They] lied to banks and auditors, executed false documents, and moved the FTX Group from jurisdiction to jurisdiction, taking flight from the United States to Hong Kong to the Bahamas, in a continual effort to enable and avoid detection of their wrongdoing. In doing so, they showed little of the concern for customers that they publicly professed."
It's also possible that one of the simplest and most common dynamics in financial fraud was at play here – the slippery slope. "There's people that are born criminals, and there's people that become criminals," Ray told Michael Lewis in an interview for Lewis' recently released book, Going Infinite: The Rise and Fall of a New TyCoon. "I think he became a criminal."
But in other ways the FTX/Bankman-Fried saga is more complicated.
Bankman-Fried and his co-conspirators, as human beings, sat so far outside the scale of "normal" that it's possible to ask: Did they even understand the concept of ethics? (As Ray shared with Lewis, "I looked at his picture and thought, 'There's something wrong going on with him.'") If so, what ethical construct permitted them to engage in behaviors that applied to them?
Ironically, Bankman-Fried and most of his leadership team at FTX subscribed in an almost cult-like way to effective altruism, a utilitarian philosophy popularized by Oxford University professor William MacAskill that encourages adherents to optimize their long-term expected value to society by earning as much money as possible and giving it away to causes that improve humanity.
Considerable controversy exists as to what extent Bankman-Fried truly believed in effective altruism, or whether, as one commentator put it, he used "the do-gooder ideology ... as a sleek vehicle for immense social harm."
But this much is clear: To whatever extent Bankman-Fried and his acolytes adopted effective altruism, it was only from the neck up – as only an intellectual construct that fit with the trader's mindset of "expected value."
"It's quantifying philanthropy, quantifying the effect of the goodness you do," Michael Lewis recently told an interviewer on vox.com. "It becomes a mathematical exercise. ... Not doing it because he feels any real human feeling or cares about people. He just likes the math exercise. He likes the reason behind it."
Ethical principles certainly need to be understood at an intellectual level. But, critically and far more importantly, they need to be felt in the heart – which requires a connectedness to and a concern for others. An emotional understanding of ethical imperatives can only be learned from a lived experience as a member of a community. Lewis' book captures the extent to which Bankman-Fried surrounded himself with a community, yes, – of effective altruists, yes – but a community comprised of extraordinarily intelligent emotionless gamers who had little if any lived experience, as we understand it, and who were weirdly unable to and uninterested in relating to others.
"He [Bankman-Fried] has absolutely zero empathy," former FTX chief operating officer Constance Wang shared with Michael Lewis. "He can't feel anything."
Ethics without empathy is the world's oldest oxymoron.
Wealth + Wellness = WHealth
If your financial advisor told you there was a surefire way to build and protect your wealth that had nothing to do with the financial markets, would you listen?
Wealth and wellness are inextricably linked – and anyone looking to increase and preserve their wealth would be wise to focus on their well-being. Getting proactive and taking care of your health save you money at every age and can help you minimize ongoing and catastrophic care expenses in a variety of ways. This is particularly true in retirement. Post-age 65 healthcare expenses have doubled over the past two decades. Medical expenses are the single largest – and most unpredictable – type of expense retirees need to navigate as they get older. And they are directly correlated to a range of health and wellness metrics.
But improving your health doesn't just minimize your healthcare expenses. It can also improve your ability to develop and enjoy your wealth.
"Preemptively improving, maintaining and safeguarding your health can significantly improve your wealth creation and earning capacity," says Pilar Gerasimo, health journalist and author of The Healthy Deviant: A Rule Breaker's Guide to Being Healthy in an Unhealthy World. "It's easy for busy, driven and highly successful individuals to overlook the fact that their health is essential to their ongoing success. But your energy, focus, creativity, influence and endurance – as well as your mood and mindset, and cognitive function – are all a direct result of body-mind health."
For all these reasons, it's important to focus on actively optimizing and preserving our health and vitality – instead of only managing symptoms and deficits once our physical and mental health start to break down.
“Health and financial well-being are closely intertwined. People with financial instability often develop significant health issues, and likewise, significant health issues can create financial instability. ... A basic understanding of what is required to maintain good health goes a long way towards improving your chances of financial security." - Carolyn McClanahan, CFP®, MD, President of Life Planning Partners
A Valuable Exchange
Of course, the causality arrow of the health-wealth connection points in both directions: Like any source of overwhelming stress, financial problems can take a toll on your mental and physical health, your relationships and overall quality of life. Money worries can adversely impact your sleep, self-esteem and energy levels, and potentially lead to more serious physical and mental health issues.
Perhaps the most direct link between wealth and health is in longevity. According to one study from the University of Wisconsin, those with few or no assets had only a 51% chance of surviving from age 65 to age 85, compared to a 70% chance of survival for those with at least $300,000. And this difference exists well before retirement: A 2021 article in the Journal of the American Medical Association found that those who had accumulated a higher net worth by midlife had significantly lower mortality risk over the ensuing decades – even after accounting for hereditary and shared environmental factors.
Plus how long you live affects more than yourself – it impacts the well-being of your loved ones and can influence the direction of intergenerational estate planning, which can extend beyond two generations to three or even four generations across multiple families.
Beyond mere dollars, the "wHealth" connection can also be measured qualitatively. Your level of vitality and health directly impacts how fully you will get to enjoy the wealth and resultant freedom you have built. Maintaining a high level of vitality, mobility and autonomy as you age lends your financial stores vastly more purpose, potential and value.
No matter how much money you have, it's not much fun being in assisted living or the hospital when you could be traveling, launching legacy-focused endeavors, discovering new joys, playing with your partner, goofing off with grandkids, mentoring younger folks, serving on boards and otherwise doing good deeds.
A 65-year-old retiring in 2023 can expect to spend $157,500 on average in health and medical costs over a roughly 20-year retirement. Source: The New York Times
How "old" you feel and function – and the life choices you might make about everything from retirement scenarios to later-life partnerships – is often directly tied to factors like metabolism, digestion and immune and neurological function.
The more chronic conditions and diseases you are suffering from, Pilar points out, the more your daily life becomes consumed by disease management – doctor's office visits, hospital stays, medical interventions of all kinds. And the less room there is for you to enjoy the life of your choosing. "Really, health is our first human freedom," Pilar notes. "It is by far our most valuable asset. Too often, we take it for granted – and in many cases, once it is lost, no amount of money can buy it back."
Taking Preemptive Action
So what can you do if you decide you want to live the best, most dynamic and joy-filled life for the longest period of time and better manage your money with all this in mind?
- Start by listening to your body. Pay attention to early warning signals, those pesky indicators of what Pilar affectionately labels "Pissed-Off Body Syndrome". (Want to explore what your body might be telling you? You can start by filling out her Weird Symptom Checklist.)
- Challenge conventional assumptions, beliefs and tropes. "I'll rest when I'm retired," "I'll start getting healthy when I make partner," "Feeling fatigued is just a part of aging," "All I have to do is take my meds and I'll be fine," "My doctor says my labs are normal, so ..." Limiting thoughts like these likely didn't help you build your wealth – and they won't help you improve your vitality.
- Aggressively invest in your health. Treat your health like a retirement asset: Invest in it the same way you invest in a 401(k) or IRA – sustainably, over a long time. Plan to spend more money on things like nutrition-dense food, sustainable fitness, functional health counsel, mental health support, coaching and behavior change. Embrace health education and life redesign in the service of staving off major problems before they happen – and enjoying more of your full potential, starting now.
Above all, rather than focusing your financial planning on your post-retirement lifespan, focus on investing in and extending your "healthspan" – the number of years you can expect to enjoy full health. Because there is no greater return on investment than that. A recent survey of retirees found that, compared to amount of retirement assets, "health actually appears to be the more important driver of well-being in retirement."
Finally, if you have a hard time justifying investments in your own health and well-being, consider your proactive self-care a service to others – including the people who love you most and who may, someday, need to help care for you.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNERTM and federally registered in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
It’s Time To Plant a Tree
“Taking advantage of this near-term opportunity involves creating an estate planning strategy that will benefit others over many years to come.”
There’s a saying attributed to Warren Buffet that goes, “Someone's sitting in the shade today because someone planted a tree a long time ago.” What appeals to me most about this quote is the motivation behind planting a tree: It’s not an act that will benefit you right away, or perhaps even in your lifetime – but someone, someday, will be grateful that you did.
When done well, wealth management incorporates that same generosity of spirit and long-term intergenerational thinking. It’s the reason a 529 savings plan opened upon the birth of a grandchild can blossom into a college tuition 18 years later. But wealth management also requires navigating personal and financial currents over the course of years, even decades, to put yourself in a position to achieve what matters to you the most.
Two of those currents are intersecting right now, and in a way that hasn’t yet come into focus for many families:
The first is the unprecedented amount of money in motion. Until recently, the baby boom generation was both the largest living adult generation in history and the most prosperous, controlling 56% of the country’s $140 trillion in wealth. With the youngest baby boomers passing age 65 by the end of the decade, we are witnessing perhaps the biggest transfer of wealth in this nation’s history as the wealth from this generation flows to the next.
The second current isn’t so much generational as it is economic. In December 2017, President Trump signed into law the Tax Cuts and Jobs Act, legislation that (among other things) increased the gift and estate tax exclusion amount – that is, how much you can transfer, in life or at death, without incurring gift or estate tax – from $5 million per individual in 2017 to nearly $13 million today. But this provision is scheduled to sunset after 2025. Barring a legislative extension, this exclusion amount will revert on January 1, 2026, to levels more in line with what they were prior to 2017.
The confluence of these two events gives families with significant wealth a once-in-a-lifetime opportunity to transfer it to future generations free from gift or estate tax. But understand that this window might be closing. Taking advantage of this opportunity will involve working with a planning team to create a multiyear, multigenerational estate planning strategy – and not waiting until the last minute to do so.
Don’t Be Afraid To Take the Initiative
If the need and opportunity for significant wealth transfer are there, what’s keeping families from putting a forward-looking estate plan into place? Probably the same thing that causes 70% of high-net-worth families to see their wealth dissipate within three generations: family dynamics. Especially in the United States, discomfort and social mores can stifle family discussions on wealth – and when it does, that inability to have a meaningful conversation around the family’s finances often leads to misplaced assumptions, misunderstandings and decisions that don’t consider the full picture.
So how can you overcome the odds and take advantage of this impending opportunity? Our friends in Baird Family Wealth have been guiding families with issues like these for decades, and they have written extensively on how families can come together around their values, communication and what defines a legacy. Their experience and guidance speak for themselves. One piece of advice I would add is that when considering these discussions, don’t hesitate to take the initiative. Your family, like many others, is likely relying on you for your leadership in this very important area. The longer you put off these conversations on transferring wealth and building a legacy, the fewer options you leave yourself and your family. Your Financial Advisor has the expertise, resources and relationships to facilitate these conversations and help you plant a tree that can grow strong for future generations.
Direct Indexing: The Next Big Thing?
There are times in the asset and wealth management industry when you can see the future begin to unfold. Consider the evolution in how financial advisors meet the needs of their clients: The past 10–20 years have seen the emergence of fee-for-advice pricing models, the resurgence of trust services that optimize the transfer in wealth from baby boomers to younger generations, and the explosive growth of ETFs. Now set beside them a relative newcomer in direct indexing and ask: Are custom index solutions the next big thing?
Lorraine Wang certainly thinks so.
Lorraine is the MIT-educated founder, President and CEO of GAMMA Investing, a San Mateo-based startup asset management firm offering investors personalized index investments strategies through separately managed accounts.
I recently sat down with Lorraine to ask her why she left a 30+ year career at established financial firms like JP Morgan Chase, Morgan Stanley, the New York Stock Exchange, PowerShares and Invesco to brave the challenges and opportunities of starting an investment advisory business.
JT: A recent report by Cerulli Associates projects that direct indexing is poised to grow at a faster rate than ETFs, mutual funds and separately managed accounts over the next five years. Do you agree with that assessment?
LW: I absolutely do. I believe direct indexing may play a significant role in the future of asset management. It’s just getting started in terms of usage and adoption. Even though direct indexing had been made available to investors since the 1990s, we are still in the very early innings of its growth.
I spent two decades in the ETF industry, mostly working at PowerShares. I’ve seen the growth of ETFs. I believe direct indexing is going to take a similar trajectory. Where we are today reminds me of the ETF industry in year 2000, when ETF assets under management were only $500 billion. When I talked to advisors back then and asked them, “Do you use ETFs?” they would respond, “No, I don’t use them” or even “What are they?” That’s where I see direct indexing is now.
JT: What will drive the growth you believe we are going to see in direct indexing?
LW: Several things. First, direct indexing helps advisors provide something that differentiates them from what others are doing.
In addition, investors are increasingly incorporating passive investing strategies in their portfolios, and direct indexing is benefiting from that. Direct investing enables broad-based exposure to the market while still providing some degree of customization, and often for a lower fee than what you’d pay with active management. In certain market environments it can be an incredibly useful strategy.
Finally, there are taxes. Mutual funds and active equity separately managed accounts are “serial capital gains distributors,” and taxes can wipe out much of the returns these products can generate.
Of these features, by far the most compelling is the tax impact – the ability to generate losses through selling to offset gains and then, as the portfolio is being rebalanced, to defer gains. While most investors are focused on alpha and chase excess return, they can pay more in taxes than they need to because other investment strategies can generate taxable gains. Direct indexing can help minimize that tax liability.
JT: Forgive me for asking, but how is that different from what advisors have been doing for decades?
LW: Previous versions of tax loss harvesting were 1 to 1: If an investor’s Apple holdings had a loss, an advisor could sell Apple to harvest the loss, replace it with something similar and then buy Apple back a month later. Advisors would often execute this 1:1 approach only once a year, typically toward end of the year. Compare that to direct indexing, which uses optimization software to opportunistically harvest losses across a portfolio of many stocks all at once and all the time. Continuously.
As an example, so far this year, most U.S. large-cap indexes were up nearly 17% through the first half of the year, but because of how narrow the market’s been, more than half of the stocks in those indexes were down during the same time span. Using the continuous harvesting capabilities of direct indexing across a portfolio of at least 300 stocks, our data shows that an investor would have been able to harvest at least 5% in losses through the year. That’s not something individual advisors were able to do in a scalable way. Now, thanks to technology, they are able to offer it en masse and at scale through direct indexing.
JT: A Morningstar white paper titled Sizing Up the Potential Tax Benefits of Direct Indexing studied the performance of a hypothetical tax-loss harvesting strategy applied to a broad market index. It found that direct investing generated a tax alpha of 1.04% over the period of January 1999 to March 2022. Does that seem about right to you?
LW: Yes, that is what our historical back-tested analysis shows as well. For a portfolio of U.S. large cap stocks, tax alpha can range between 1% to 2% annualized. For a portfolio of smaller cap stocks, tax alpha can be higher than 2%.
JT: It's interesting you emphasize the tax benefits of direct indexing because most people would associate what GAMMA does with customizing an index – adding or subtracting individual securities based on an individual's values or their exposure to particular sector through the company they work for. Is customization an attractive feature?
LW: We’re finding that while customization is a differentiating feature, it’s not as much as taxes. Also: What kind of customization are we talking about? Most people see it as excluding stocks or industries or applying an ESG screen. We don’t see a lot of that. What we do see is advisors liking the ability and flexibility we afford them to offer a broad range of investment strategies to their clients – the ability to offer diversified exposure across asset classes through a customized comprehensive investment strategy.
JT: What's the biggest challenge facing GAMMA and direct indexing in general?
LW: It’s still a new concept to many advisors. They see the benefits, but they’re not sure. It’s all about education – case studies and one-on-ones showing advisors how to use it. Some are opening accounts for themselves to see how it works before going out to clients. We’re spending a lot of time on education.
JT: GAMMA is one of the few independent direct indexing providers – and the only one that's woman-owned and -led. Are those advantages?
LW: It’s true, there’s been a lot of consolidation in the industry because many people see the benefits of direct investing and are betting on its future. Parametric was acquired by Morgan Stanley. Aperio by Blackrock. Just Invest by Vanguard. O’Shaughnessy by Franklin. 55iP by JP Morgan. We ourselves have great, supportive capital partners in Riverfront Investment Group and Baird. As far as being woman-owned and -led, it’s not a factor: You need to prove yourself.
JT: Thank you, Lorraine.
Lorraine Wang is the President and CEO of GAMMA Investing LLC ("GAMMA"), a registered investment adviser with the state of California. Baird Financial Corporation and RiverFront Investment Group LLC have acquired minority ownership interests in GAMMA Investing LLC. GAMMA is operationally independent of RiverFront and Baird.
Discussions of tax alpha or efficiencies are hypothetical and do not represent the long-term results of an actual investment. No representation is being made that any portfolio will achieve tax alpha that Morningstar's research described. The effect of taxes on an investment should be a consideration when making in an investment decision within a taxable (i.e. a non-qualified) account but should not be the sole determinant. With respect to the description of investment strategies or investment recommendations described herein, there are no assurances that they will perform as designed. Past performance is not indicative of future results. Every investment program has the potential for loss as well as gain.
Investors should consider the investment objectives, risks, charges and expenses of an exchange-traded fund carefully before investing. This and other information can be found in the prospectus or summary prospectus. A prospectus or summary prospectus may be obtained by contacting your Baird Financial Advisor. Please read the prospectus or summary prospectus carefully before investing. A direct investment cannot be made in an index.
Monsters in the Closet
After serial failures in the regulated banking system – Signature Bank, Credit Suisse, Silicon Valley Bank, First Republic – it's reasonable to ask: What other systemic risk monsters are hiding in the closet of our financial system?
Most fingers are pointed at lightly regulated (or unregulated) segments of the financial markets known as the “shadow banking system.” That’s certainly where train wrecks have happened in the past – the most devastating of which were the derivatives-laced mortgage-backed securities excesses that led to the global financial crisis of 2007–2009. But let’s not forget hedge fund Long Term Capital’s leveraged fixed income convergence trading bets in 1998, the Reserve Money Market Fund “breaking the buck” in 2008 or Archegos Capital’s total return swaps in 2021, which resulted in billions in losses for its counterparties. Not to mention the UK pension fund’s use of leveraged Gilt LDI strategies last year as well as FTX and other crypto meltdowns.
In its 2022 annual report, the Financial Stability Oversight Council (FSOC) declared its top priority was addressing the risks of nonbank financial intermediation. Regulators have been working on proposals to do just that, such as the U.S. Treasury Department considering a “systemically important financial institution” designation for nonbanks, the SEC adopting a Form PF regulation that requires private funds to provide more robust disclosures, and new liquidity management rules for open end funds.
Two key factors are driving this fear over what might be lurking in the closet:
- The enormous growth of activity and assets in the nonbank segment of the financial markets. Increased capital requirements and tighter regulation have made certain activities unattractive to banks, leading to an explosion of growth in the nonbank segment. The private credit industry alone has grown six-fold over the past decade to over $850 billion. Gross assets managed by hedge funds and other private funds have grown to $21 trillion, just slightly less than assets in the commercial banking sector. As a whole, nonbanks ended 2021 controlling more than $293 trillion in global financial assets, according to the Financial Stability Board – nearly 47% of the world’s wealth.
- Fundamental shifts in the market and monetary policy. The transition from decades of easy-money monetary policy and the end of a decades-long bull market in strategies driven by low interest rates have sent shockwaves throughout the economy. As Gillian Tett put it in the Financial Times, “Quantitative Easing has distorted things so deeply that there will be unexpected chain reactions, if not in banks, then in other corners of finance.”
Inadequate risk management around rising interest rates rattled the regional banks – and the signs that similar problems still await us are everywhere. In addition to asset/liability mismatches, higher interest rates will mean increased debt service costs for borrowers, threatening the credit quality and solvency of lenders. (For example, two auto finance companies just recently went out of business.) Baird Global Investment Banking reports the leveraged loan distress ratio reached 8.75% in March, compared to 1.87% just one year earlier. More than 200 fund managers in a recent Bank of America survey cited a potential “credit event” as the biggest economic risk right now. On the eve of Berkshire Hathaway’s annual meeting, Charlie Munger warned of “a brewing storm in the U.S. commercial property market.”
With all these monsters in the closet, why worry about shadow banking? After all, U.S. taxpayer money is not directly on the line, as it is with banks, whose deposits are insured by the FDIC. The answer is contagion risk.
Moving risks out of the regulated banking system doesn’t eliminate them: As the International Monetary Fund noted in its 2023 Global Financial Stability Report, “risk adheres to any institution engaged in financial intermediation in financial volume.” As I wrote in a 2021 post about systemic risk, the extraordinary complexity and interconnectedness of the modern financial system means that a shock anywhere in the system goes deeper, travels faster and affects other players around the world far more quickly and dramatically than ever before. Historically, when push came to shove and the risk of systemwide conflagration was imminent, the U.S. government has chosen to intervene. For example, during the global financial crisis and the COVID-19 pandemic, it deployed “shock and awe” levels of monetary and fiscal support. But those were disinflationary times, when there was less concern those actions would spark inflation. Today, the Fed seems much more reluctant to protect investors from losses by flooding the market with liquidity because of its efforts to wage war against stubborn inflation.
Instead it seems like the Fed is trying to thread the needle: My colleagues at Baird Advisors believe their remedies would be more surgical in nature, like its recent Bank Term Funding Program, which provided much needed cash to regional banks by allowing them to borrow and post underwater Treasury issues at face or par value as collateral. Such remedies provide relief to affected institutions and help prevent the spread of a contagion, but they will not prevent losses to some investors. Indeed, in the cases of Silicon Valley Bank, Credit Suisse and First Republic, we’ve seen equity holders and some bondholders experience total wipeouts.
While we agree that the Fed will take necessary action to prevent contagious failures in the banking system, we believe their rescue plans could be much more limited going forward. Investors should be mindful of exposure to – and potential losses from – higher risk financial assets in the shadow banking system.
For more on the perils in shadow banking, I highly recommend reading Reshma Kapadia’s recent article in Barron’s, “‘Shadow Banks’ Account for Half of the World’s Assets – and Pose Growing Risks.”
Lessons From the 2023 Banking Crisis
I recently had an opportunity to discuss the recent bank closures and how in times of financial crisis, financial advisors have a singularly important role to play. As the dust continues to settle, many people are coming to terms with the realization that – despite the euphemism's connotations – "money in the bank" is only secure up to a certain amount. And those with cash holdings above the FDIC threshold ($250k for individuals and $500k for assets held in joint accounts) are wondering what they can do to protect the rest. Fortunately, there are some learnings they can take from what we all just experienced.
Lesson 1: Stress-Test Your Assets
Stress tests aren't just for multinational financial institutions anymore. Especially in dynamic market environments, any assumptions we might normally make about the relative safety and return of an investment should be continuously evaluated and re-evaluated. Cash is no exception: When you think about the money you've deposited in a savings account with a commercial bank, you'd do well to remember that it's essentially a loan. As we've just been reminded, given certain circumstances, even a bank can default on a loan.
If you have a financial advisor, they should be running the "what-if" scenarios for you and advising you if certain investment holdings are too concentrated or somehow at risk in the current environment. You can also run your own scenarios in relation to your financial plans and how those might be impacted if certain holdings were suddenly depleted or taken off the table entirely.
Lesson 2: Diversify, Diversify, Diversify
Many investors are familiar with portfolio diversification and understand how a broad and varied equity and fixed income asset allocation can help smooth out what is often a bumpy investing journey through periods of cyclical and unpredictable volatility. But diversification isn't a strategy reserved for stocks and bonds: If you have a lot of cash, diversifying among multiple banks can help limit your losses should any one bank fail.
If you're a basketball fan, you may have read about the financial zone defense employed by Milwaukee Bucks star Giannis Antetokounmpo, who stashed his cash holdings with multiple banks to maximize FDIC protection (the limits apply to your holdings with a single institution, and there is no limit on how many different banks you can use).
Milwaukee-based Baird employs a similar strategy for our clients' cash holdings. Our Cash Sweep Program automatically directs the cash allocation of your investment mix to up to five separate lending institutions. Doing so builds in the benefits of diversification and increases your FDIC protection from $250,000 to up to $1,250,000 ($2,500,000 for couples). Better still, because this is done automatically, our clients can receive this increased protection without having to open five different bank accounts themselves – plus they get a return on their cash investment many times greater than what a savings account at a bank is currently generating.
Lesson 3: Good Financial Advice Is Worth Having
The banking crisis also showed that even very successful people aren't always aware of how their assets are protected – and the limits of those protections – should the unanticipated happen. But for a financial advisor with a fiduciary responsibility to act in your best interests, such considerations have to be on their radar. A financial advisor can also evaluate the appropriateness of your cash holdings relative to other assets given current market conditions and can even recommend alternate ways to invest those holdings so they are working their hardest toward your financial goals.
The counsel of a trusted financial advisor shouldn't be taken lightly. Silicon Valley Bank and Signature Bank were two of the largest banks to fail since the FDIC started keeping track in 1934 – and when they fell, they fell quickly, within two days of each other. When financial calamities happen, they tend to happen fast, giving investors and consumers little time to think, not to mention act, in a thoughtful, purposeful way. Having a trusted partner who understands "the rules of the road" and is invested in your success can prove invaluable.
Are Buyback Taxes a Policy Mistake?
Buybacks: Much debated, increasingly in-focus and – perhaps – soon to be subject to new taxes. Corporate stock buybacks have been all over the financial news recently, capturing the attention of investors and decision-makers alike. Recently, President Biden highlighted a proposal in the State of the Union address to quadruple (to 4%) the 1% tax on buybacks imposed last year by the Inflation Reduction Act. We also saw Warren Buffet share an uncharacteristically salty quip in his annual letter:
"When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive)."
And in recent days, U.S. Commerce Secretary Gina Raimondo said companies that voluntarily give up buybacks for five years will be treated preferentially when the agency distributes $52 billion under the CHIPS and Science Act.
Like many of the negative narratives around finance, skepticism of and criticism directed at buybacks has some basis in fact. There is no shortage of examples where buybacks have diminished, rather than enhanced, shareholder value. As Buffett has acknowledged, "when a company overpays for repurchases, the continuing shareholders lose." Furthermore, short-sighted executives using buybacks solely to engineer a boost in EPS to meet compensation targets is harmful to shareholders.
But as columnist Peter Coy put it in the New York Times this week, "It's good for companies to give back money to their shareholders when they don't see productive uses for it. Are buybacks always good? No. Are they always bad? Also no."
Regrettably, policy proposals to discourage buybacks are surfacing at a time when cash flow distributed by companies to their shareholders is becoming, and will continue to be, an increasingly important part of the return stock market participants receive from investing their capital in productive enterprises. As macro research firm Strategas, a Baird company, wrote in a recent note, "During a period in which multiple expansion may be difficult to generate, shareholder yield – the combination of dividends and share buybacks as a percentage of net income – will likely be a significant source of the total return equity investors may expect to receive in the coming years."
We're talking big numbers. Even with dividends and buyback proceeds exceeding $1.5 trillion in 2022, cash on corporate balance sheets is still well above the long-term average – 5.3% vs. 3.8%, according to Strategas. In other words, there's plenty of dry powder to potentially distribute to shareholders.
Among the key factors driving stock market volatility are the rising interest rates the U.S. Federal Reserve is imposing in an effort to reduce the post-pandemic inflation rate. Interest rates are a proxy for the discount rate investors us to value future cash flows from corporations. The higher the interest rate, the higher the discount rate, and the lower the multiple stocks will command.
In this environment, so-called "low-duration stocks" – stocks of companies that distribute cash currently via dividends and buybacks – should offer something of a safer haven for investors. Discouraging buybacks leaves investors between a rock and a hard place. It would rob them of one of the few levers they have to navigate through elevated inflation and multiple/valuation-driven volatility on the other.
To use the kind of direct language Buffett might use – taxing stock buybacks is a policy mistake.
Returns vs. Values: The Fiduciary Experience of the Catholic Church
While controversy over ESG investing and fiduciary duty has only recently reached a fevered pitch in the media and legislative and policy forums across the nation, the Catholic Church has been quietly and consistently practicing its own version of values-based investing for decades. Longstanding investment policy guidelines adopted by the U.S. Conference of Catholic Bishops (USCCB) cite two bedrock principles:
- Principle 1: "Exercise responsible financial stewardship over its economic resources ... This means obtaining a reasonable rate of return on investments."
- Principle 2: "Exercise ethical and social stewardship in investments ... based on Catholic moral principles."
Does this mean the Catholic Church has solved the conundrum of return vs. values in its investing practices?
My colleagues Michael Swope and Kathryn Nusbaum, both in Baird's Institutional Consulting Services division, advise Catholic institutions on how to follow the principles articulated by the USCCB while optimizing investment portfolio return. I asked them for their insights:
How long has the Catholic Church been formally practicing values-based investing as a matter of policy?
Michael: The U.S. Conference of Catholic Bishops first issued investment guidelines in 1991 – so formally for more than three decades. The guidelines were updated and expanded upon in 2003 and, more recently, in November 2021. The updates provide further clarity on investment policies that align with Catholic values (including expansion into broader areas such as the environment) and a "modernization" of the guidelines.
The Vatican late last year also published Mensuram Bonam (which translates to "good measure") as its written principles for Catholic investors globally. In either doctrine, it is apparent that the guidelines are not intended to be hard-and-fast rules but rather a flexible framework that can be interpreted (within reason) and implemented based on different religious organizations' unique circumstances.
Kathryn: When discussing values-based investing, it is important to remind our audiences that this is a broad umbrella term that encompasses different, and often personal, interpretations. Although the Catholic Church has been successful in defining a doctrine to assist in aligning investment implementation to Catholic values, given the personal interpretation of socially responsible investing, we have found most investors continue to struggle with identifying and implementing investment portfolios that align to a strict set of socially responsible and ESG investing guidelines.
What can both sides in the "return vs. values" debate learn from the fiduciary experience of the Catholic Church in exercising the dual mandates of its investment policy guidelines?
Michael: I think there are multiple takeaways from this debate:
- Values investing will continue to evolve. Both ESG and Catholic values investing have evolved over time and will continue to grow and change in the interpretation of intent and definition. For example, the latest USCCB guidelines incorporate environmental issues and even, for certain uses, military equipment.
- There is a better understanding of the nuance in how these are implemented. We've seen a greater acceptance of various definitions of ESG topics and understanding around the nuances of what makes a company investable or uninvestable. Take fossil fuel companies, for example. Do you not own any? Or is it okay to own oil companies that are champions of change and in the process of "transitioning" to a less carbon-intensive business model?
- The implementation of values-based investing is driven in part by technology. Technology has dramatically improved the ability to implement all forms of socially responsible and values-based investing. You can see this not only on an investable opportunity level, but also in how data is sourced, collected, validated and disclosed, as well as the financial products that are created to capture the investment.
- The details of the investment matter. The scope of the opportunity, the capabilities of the platform, the size of the investment – it all comes into play. A values-based investing opportunity needs to be scalable to a certain size to be implementable in custom portfolios. However, if the assets to be invested are too small, products with predefined interpretations will likely need to be used. In this case, the screening criteria might not meet the exact desired values or ESG outcomes.
As someone who works with religious organizations, how do you help your Catholic clients address the dual return/values mandate of the USCCB guidelines?
Kathryn: We are laser-focused on helping our investment committees maximize long-term, risk-adjusted returns that achieve the investment objectives outlined in their investment policy statement. We do that by (1) ensuring their investments abide by their interpretation of USCCB's guidelines and (2) designing and implementing an investment strategy that optimizes returns within the committee's agreed-upon interpretation of stated value-investing guidelines. This includes implementing custom portfolios, using passively managed products and accentuating active management where alpha generations are viable long-term.
What's the key ingredient to successfully implementing a balanced approach to the stewardship of financial assets?
Michael: The key ingredient to successful financial stewardship is a clear understanding of the client's desired outcome and goals.
To achieve best outcomes, a disciplined approach combined with a best-effort mentality are critical. Defining the guidelines upfront and recording them into an investment policy statement results in a level of discipline around the intent and implementation. "Best-effort mentality" means understanding that there is a point at which an overly strict interpretation and implementation of the guidelines can be counterproductive and potentially compromise the investment integrity of the portfolio without significantly increasing the resulting "good" to its community. Materiality and nuance are important concepts here.
Let's cut to the chase: From your experience working with Catholic values investing, is it possible to achieve the highest possible return within the constraints of social or moral values?
Michael: It would be disingenuous to convey conclusively that one does not have to give up return when implementing a "values-based" investment strategy or to claim that the Catholic values investors have proven that possible. I think this debate – like the one around active vs. passive investing – will be argued for a long time.
Having said that, there are differences between Catholic values investing and ESG investing. It can be reasonably argued that ESG can add some underlying value-adding features to an investment thesis. But Catholic values investing is a bit more challenging, not least because it necessarily excludes large swaths of the market, specifically within pharmaceuticals.
The concept of reasonableness applies here. After all, the USCCB guidelines call for "a reasonable rate of return," which is defined as "one that matches the level of the market or at least allows the [Church] to meet its fiduciary responsibilities and maintain its mission." Is it possible for a values-based investment strategy to do that? Absolutely.
It's Time to Corral Finance's Wild West
SEC Chairman Gary Gensler has come under fire recently for the pace and breadth of his aggressive regulatory agenda. But based on recent and recurring issues, regulation of crypto assets is one area where financial regulators, in the U.S. and elsewhere, aren't moving nearly fast enough.
This is a critical investor trust and confidence issue that affects a broad base of participants in financial markets – particularly the 12% of Americans estimated by the U.S. Treasury Department to own crypto assets.
For one thing, outright criminality – fraud, theft, market manipulation and scams of all flavors – is rampant in the sector. While debates rage in the regulated part of the market over arcane points like whether a "fiduciary standard" or a "best interests standard" should apply to financial advisors, in the crypto world there are no standards. It truly is the finance equivalent of "the Wild West."
According to a recent whitepaper published by the U.S. Treasury Department, criminals stole $7.8 billion from crypto investors in 2021. Collectively, the FBI, Consumer Financial Protection Bureau (CFPB) and Federal Trade Commission (FTC) received over 80,000 crypto-asset related complaints or fraud reports in 2021 and the first quarter of 2022. There are few protections available if a digital platform runs into trouble, which happens with alarming frequency. Only recently, Binance, one of the larger and more established platforms in digital finance, lost more than $100 million to hackers who infiltrated its Smart Chain blockchain network. Last May, a so-called "stablecoin," TerraUSD which purported to peg its value to the U.S. dollar using an algorithmic "game theory based economic system," imploded and lost nearly 100% of its value. Unlike bank deposits, TerraUSA and less dicey dollar-value products are not insured against loss. Investors there are not likely to recoup their money. Cred, Voyager, Three Arrows, Celsius – these are names of crypto enterprises that have declared bankruptcy in the past two years.
Flawed design and misrepresentation of product features are common in the crypto space. Commenting on platforms that lend against crypto assets, the U.S. Treasury Department warns that some "may attract users by promising to pay returns that are far greater than those offered by traditional banks... and inappropriately use bank-like terms like 'savings account,' 'deposit' or 'annual percentage yield' and other promotional tactics that can obscure the associated risks."
Unregulated crypto activities are also a growing source of systemic risk to the financial system, particularly as crypto platforms grew at one point to almost $3 trillion in value and as the number of points at which they intersect with the traditional financial institutions have increased.
The Financial Stability Oversight Council (FSOC), a consortium of U.S. regulators created after the last financial crisis to scan for, spot and make recommendations about how to mitigate systemic risk, earlier in October stated, "The financial stability risks of crypto would be substantial if... the scale of crypto-asset activities and interconnectedness with the traditional financial system were to grow rapidly." As they have, even with the recent meltdown in crypto assets.
U.S. Treasury Secretary Janet Yellen recently warned, "As we have painfully learned from history, innovation without adequate regulation can result in significant disruption and harm to the financial system."
Lack of regulatory clarity and certainty ultimately makes it hard for investors, particularly retail investors, to access crypto assets, which is something that must occur if they are ever to evolve into an asset class whose properties can be quantified for the purpose of including them in portfolios in ways that improve investor outcomes. There are few products that track the price of crypto cleanly, and custodying crypto assets is onerous for traditional financial institutions (though not impossible, as firms including BNY Mellon, NASDAQ and Blackrock are endeavoring to prove).
It is high time for what SEC Chairman Gensler calls "one rule book" – "a market integrity rule book" for crypto assets.
"The public deserves the same protection they get with other issues of securities," Gensler has said. "There's no reason to treat the crypto markets differently just because different technology is used."
There has been no shortage of pronouncements about the need for a coordinated approach to crypto regulation. For example, an Executive Order of Ensuring Responsible Development of Digital Assets issued by President Biden in March. Reports by the FSOC, the international Financial Stability Board and by the U.S. Treasury Department, which cites "the need for urgent action" to address "the extensive risks associated with engagement in crypto-asset markets." But so far there has been very little tangible, concrete action on the part of regulators. (Although, to its credit, the SEC did put an end to abusive initial coin offerings and threatened to sue digital exchange Coinbase for lending against digital assets.)
One of the challenges is that crypto refers to a broad range of products falling under the purview of multiple regulators in the U.S. – among them the SEC, Commodity Futures and Exchange Commission (CFTC) and banking regulators – which is setting the stage for a turf war over what types of products, all under whose jurisdiction.
Principal among these is a tug of war between the SEC and the CFTC, which turns on the question of whether, and if so which, digital assets are securities and which are not.
Congressional legislation providing role clarity and addressing gaps would be helpful, but probably isn't coming anytime soon. "Getting any piece of legislation through both houses of Congress is going to be a monumental task," opined one spokesperson for the Chamber of Digital Commerce trade group.
What we don't need from Congress are new regulations or a new crypto regulator. Coordination and cooperation among existing regulators who apply existing regulations will do the trick. But it needs to happen sooner rather than later, before more investors suffer irreversible harm.
For those interested in learning more about this topic, I recommend the comprehensive and surprisingly readable U.S. Treasury Department white paper, Crypto-Assets: Implications for Consumers, Investors and Businesses. Among the nuggets contained in the report:
"Financial markets, products and services that use native crypto-assets... are generally speculative in nature."
"To date, competing technologies, applications and paradigms... have produced a patchwork quilt of systems that have yet to deliver, separately or collectively, on many of the promised benefits for consumers, investors and businesses..."
Data from the Federal Reserve Board finds 29% of people who hold crypto-assets for investment purposes had an annual income of less than $50,000 and "available evidence suggests that... crypto-asset products may present increased risks to populations" vulnerable to disparate impacts, specifically, low income, BIPOC and elderly populations.
Baird does not currently recommend the purchase of or custody cryptocurrencies.