Will banks be pulled into GameStop uproar?

WASHINGTON — Though banks have watched the turmoil unfold over GameStop’s stock price from the sidelines, some observers are urging the Financial Stability Oversight Council to get involved to ensure the market volatility tied to hedge funds does not spill over to other areas of the financial sector.

Trade groups and analysts say banks are far removed from the trading frenzy despite worries that the episode could lead to broader financial stability concerns.

“This episode is a helpful illustration of how much risk has moved outside the banking system,” Greg Baer, president and CEO of the Bank Policy Institute, said in a statement.

Treasury Secretary Janet Yellen held a meeting with regulators Thursday to discuss potential market effects, including Federal Reserve Chairman Jerome Powell. Industry critics say the big banks need to be scrutinized as well, citing their role as the prime brokers for hedge funds and their lending activities in the equity markets.

“Prime broker activities at banks provide a lot of services to hedge funds, including helping them employ leverage and providing financing to hedge funds,” said Gregg Gelzinis, associate director of economic policy at the Center for American Progress.

Market watchers were somewhat captivated as GameStop’s stock soared following a discovery by Reddit users that a big Wall Street investment firm, Melvin Capital, was betting against the stock.

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Treasury has not indicated whether the FSOC, a panel consisting of the heads of all the regulators that was created after the 2008 financial crisis to identify systemic risks, will look at the GameStop matter.

But Marcus Stanley, policy director at Americans for Financial Reform, said any examination of the trading event should weigh the ties between different types of financial institutions.

“We have to look at the interconnections and what is actually going on behind the scenes,” Stanley said. “The truth is as service providers and providers of leverage, the big banks are central to the Wall Street system, including financing hedge funds and probably supporting retail brokers as well.”

Market watchers were captivated as GameStop’s stock soared after Reddit users discovered that a big Wall Street investment firm, Melvin Capital, was betting against the stock.

A mad scramble to buy GameStop shares caused the company’s stock price to rise roughly 2,000%. In response to the market volatility, online trading platforms like Robinhood and TD Ameritrade quickly put restrictions on trading GameStop stock, inciting outrage from investors and lawmakers for curtailing individual investors. The stock has since tumbled after the initial trading frenzy.

While the events have led to some headline risk and standard criticism of Wall Street, the big banks aren’t sweating it. Citadel, which helped provide a financial lifeline to Melvin as it dealt with losses over shorting GameStop, is a large hedge fund. And Robinhood, which has been accused of intervening in the market, is an online trading platform, not a bank.

Baer said the activity surrounding GameStop was conducted outside of the banking space by hedge funds and online trading platforms.

“Citadel’s market share in equities trading must be quite a surprise to policymakers who think this is a bank market,” said Baer.

Some analysts agreed that any examination by regulators will focus on areas of the financial markets other than banks.

“I just don’t see how banks come into it right now,” said Ian Katz, a director at Capital Alpha Partners.

But others say the government should look more deeply at how systemic connections throughout the financial markets still make banks and other types of institutions vulnerable during periods of turmoil.

“It would be a huge mistake for regulators, legislators and prosecutors not to look at all of the financial market participants and activities,” said Dennis Kelleher, president and CEO of Better Markets, which has requested an FSOC review of the GameStop episode. “And at the top of that list should be the biggest ‘too big to fail’ Wall Street banks, because of their innumerable activities and interconnectedness with these market events.”

Gelzinis noted that Robinhood “drew on its line of credit provided by a bank.”

“Bank financing of broker dealers is certainly an important aspect to this,” he said. “So banks are absolutely going to get pulled in.”

Richard Hunt, CEO of the Consumer Bankers Association, said that traditional banks have been heavily regulated since the financial crisis, which has made the industry much safer.

“ ‘Wall Street’ will come under scrutiny as a result of the recent market turmoil and we will continue to remind policymakers that ‘Wall Street’ is not a catchall term for large banks,” Hunt said. “Congress passed fundamental banking reform legislation following 2008 and the industry has built a solid foundation since then. If reform is needed to create a level playing field for hedge funds and to protect retail investors, those reforms should be targeted to address specific concerns and not an excuse to relitigate battles from more than a decade ago.”

But Kelleher said banks’ role as securities lenders should be examined.

“Let’s not forget these major Wall Street banks are lenders, including securities lenders, so when the hedge funds and others are levering up their market activities, where do you think they’re getting the money from?” Kelleher said. “The banks are big securities lenders.”

Gelzinis said that a full FSOC examination is necessary to ensure all activities are reviewed.

“One of the reasons why the FSOC was created in Dodd-Frank was when risks developed outside of the regulated banking sector, they tended to fall through the cracks,” Gelzinis said. “This would naturally be an area for the FSOC to work with member agencies, because there’s obviously an important role here for the SEC and for the CFTC to play, but I think it would benefit from a careful FSOC-related inquiry here to work with the member agencies and fill any gaps here and vulnerabilities.”

Treasury said Yellen held a meeting Thursday with the heads of the Securities and Exchange Commission, the Federal Reserve Board, the Federal Reserve Bank of New York and the Commodity Futures Trading Commission.

“The regulators believe the core infrastructure was resilient during high volatility and heavy trading volume and agree on the importance of the SEC releasing a timely study of the events,” according to a Treasury Department press release. “Further, the SEC and CFTC are reviewing whether trading practices are consistent with investor protection and fair and efficient markets.”

Leaders of the House Financial Services Committee and Senate Banking Committee have indicated that they are planning to hold hearings about GameStop.

“We must deal with the hedge funds whose unethical conduct directly led to the recent market volatility and we must examine the market in general and how it has been manipulated by hedge funds and their financial partners to benefit themselves while others pay the price,” House Financial Services Committee Chairwoman Maxine Waters, D-Calif., said in a statement on Jan. 28.

But Katz said he doesn’t expect banks to be scrutinized. Policymakers will home in on the hedge funds and the online trading platforms that were directly involved in the market volatility, he said.

“I think the focus is going to be on brokers, on hedge funds, on short selling on SEC rules, a variety of SEC rules, like on capital rules and settlement times, and payment for order flow, and the broader issue of market structure,” Katz said.

Isaac Boltansky, director of policy research at Compass Point Research & Trading, said the trading events will likely result in stricter oversight of nonbanks.

“This is a brokerage issue, this is a market plumbing issue,” Boltansky said. “It is not a concern for big-bank capital levels or bank liquidity. … I think that we were going to see more scrutiny of the nonbank sphere over the next few years, already.”

He added: “I think we can agree that there was going to be more scrutiny of private equity, there’s going to be more scrutiny of hedge funds, more scrutiny of nonbank, mortgage lending. All of these things were already happening.”

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