A tumultuous spring on Capitol Hill
This report is current as of May 16, 2023
As spring bloomed in Washington, Congress began one of its busiest stretches of the year. Between the Easter recess and the break in early July, the Senate will be in session 9 of 10 weeks and the House, 8 of 10. This period will be dominated by jockeying over the debt ceiling, the Washington issue that will have the most direct impact on the markets and investors.
On April 26, the House of Representatives narrowly approved a bill that would raise the debt ceiling by $1.5 trillion or until March 31, 2024, whichever comes first. It also includes an outline for roughly $4.8 trillion in spending cuts over the next decade. Several other Republican priorities were also part of the legislation, including repealing most of the $80 billion in funding the IRS received as part of last year's Inflation Reduction Act, repealing several green energy tax credits and toughening work requirements for recipients of food stamps and Medicaid. Those provisions make the bill a non-starter in the Democrat-controlled Senate, as Democrats, including the White House, have consistently said they will support only a "clean" debt ceiling increase that has no strings attached. That stalemate is likely to persist until the country gets very close to the deadline when the U.S. will default on its debts.
On May 1, we learned that the default date may be much sooner than expected. Treasury Secretary Janet Yellen announced that "our best estimate is that we will be unable to continue to satisfy all of the government's obligations by early June, and potentially as early as June 1." While she included caveats that the date could be later than that, the announcement sparked immediate outreach from the president to key leaders on Capitol Hill for the first face-to-face talks in months. Meetings were held at the White House on May 9 and May 16, and while no agreement has been reached yet, negotiations have become serious. The approaching default date is also ramping up the anxiety on Wall Street about the potential market impact. In 2011, when a similar political configuration existed in Washington, Congress came the closest it has ever come to a default, rattling the markets, sparking significant volatility, and resulting in a downgrade of the U.S. credit rating. Market watchers are already anxious that a repeat scenario may play out in the coming weeks.
Banking turmoil sparks policy debates
Another major topic in Washington is banking regulation. The failures in March of Silicon Valley Bank and Signature Bank sparked turmoil across the banking sector, but contagion was relatively contained. Top regulators from the Federal Reserve and the FDIC have endured hard questions from lawmakers during a series of hearings on the banking turmoil. In late April, a trio of reports were released by the Fed, the FDIC, and the General Accounting Office, all of which pointed to regulatory oversight failures that contributed to the bank collapses. Regulators and lawmakers are focused on three policy areas in the wake of the crisis.
First, regulators will almost certainly toughen rules for mid-size banks, those with $100–$250 billion in assets. Enhanced stress testing and tougher capital and liquidity standards are among the steps regulators are likely to take. Those changes will go through the banking regulators' usual rulemaking process, so formal implementation is unlikely before 2024. But banking regulators can use their supervisory role to move banks in that direction more quickly.
Second, there are bipartisan calls on Capitol Hill for changes to the deposit insurance system. A May 1 report from the FDIC outlined some possible changes, including raising the $250,000 cap or even eliminating the cap altogether, though the agency said that higher limits may only encourage risky behavior with limited benefits to the financial system. But the FDIC said it favored a tailored approach that raised the deposit coverage for business accounts that are used for payroll. Whether Congress can find consensus on a plan remains to be seen.
Finally, many on Capitol Hill are eager to toughen penalties for executives of failed banks. In the case of Silicon Valley Bank, executives sold stock in the weeks before the bank's collapse, while bonuses were paid out the same week as the failure. Legislation to claw back bonuses and other compensation and to take additional steps to ensure that executives don't profit after a bank failure may see action later this year.
SEC Chair faces House committee
SEC Chair Gary Gensler testified before the House Financial Services Committee in April, his first appearance before the panel since Republicans took over the majority in the January. Over nearly five hours of frequently contentious questioning, Gensler sparred with lawmakers over the agency's busy regulatory agenda. Republicans pointed out that the SEC has proposed 53 different rules since Gensler took office two years ago, a much faster pace than previous commissions. Shortened public comment periods were also a frequent target of criticism.
The bulk of the hearing focused on several controversial issues, including cryptocurrency regulation, equity market structure reform, climate risk disclosure, and mutual funds. While cryptocurrency continues to grab a lot of headlines, market structure and the proposed rule for mutual funds are more likely to concern RIAs directly.
The SEC's market structure proposal is a behemoth: four separate rule proposals comprising nearly 1,700 pages of text. They include a new SEC best execution standard that bumps up against existing standards at FINRA; transparency for investors about the execution quality of their trades; reducing tick sizes below a penny; and a controversial proposal to overhaul how stock trading works by forcing most retail trades to be executed via an auction system at the exchanges. Industry pushback has been strong. Schwab joined the chorus of criticism, arguing in a comment letter that "the calls for change…are obscuring—and, in some cases, even endangering—the benefits that the current ecosystem provides for retail investors, including vastly expanded product offerings, world-class trading platforms that rival those used by investment professionals, no/low-cost trading, and superior execution quality."
RIAs should also be concerned about the commission's proposal to overhaul liquidity risk management at mutual funds by requiring funds to use swing pricing whenever there are net redemptions and by imposing a "hard 4 p.m. close." The latter proposal would require that orders be received at the fund by market close, an idea that represents a major disruption to the way fund trading works today. Most intermediaries bundle the day's orders and send omnibus trades to funds after market close. The new proposal would likely require an earlier cutoff time for mutual fund trades well before market close—and an even earlier cutoff time for trades requested by retirement plan participants. Schwab is among many firms that argued in comment letters that the move would disadvantage mutual funds, making them a much less attractive investing option than exchange-traded funds or other vehicles that could trade right up until the market closes. The SEC is currently considering the comments received on the proposal.
Fight over ESG investing escalates
Environmental, social, and governance-focused (ESG) investing has become a hot-button, highly politicized issue on Capitol Hill and in numerous states around the country. In Washington, it became the subject of the first veto of Joe Biden's presidency. At issue is a new Department of Labor (DOL) rule that was finalized last fall and went into effect on January 30, which allows retirement plan sponsors to consider ESG factors when choosing investment options for the plan, as long as the primary focus remains the plan's fiduciary duty to its participants. The rule reversed a regulation finalized during Donald Trump's presidency that prohibited plans from considering ESG factors.
In March, both the House and Senate passed a "resolution of disapproval," a mechanism that allows Congress to reject or overturn a specific rule issued by a federal agency. President Biden vetoed that measure, saying that eliminating the rule "would prevent retirement plan fiduciaries from taking into account factors, such as the risks of climate and poor governance, that could affect investment returns." Days later, the House took a vote to override the veto but fell well short of the two-thirds majority needed. That effectively ended the debate on Capitol Hill over the ESG rule, but the rule has also been challenged in court by 25 states. That case is pending, so the fight will continue.
At the SEC, ESG issues are also deeply controversial. First, the SEC in 2022 proposed a set of rules that would require public companies to disclose more information to investors about their impact on climate change and the risks they face from climate change. More than 15,000 public comments were submitted—among the highest responses to a rule in the SEC's history. Many businesses object to the complexity of the data they would have to collect, while other commenters, including Republican officials at the state and federal level, are pushing back on whether the SEC should be engaged in the climate debate at all. The SEC is expected to finalize the rule in 2023, but a legal challenge is almost certain to follow.
The agency has also proposed amendments to the "Names Rule," which requires funds to invest at least 80 percent of their assets in accordance with the investment focus the fund's name suggests. The proposal seeks to put some standards around the use of terms such as "green" and "sustainable" in a fund's name. This proposal is also slated to be finalized in 2023, though timing remains uncertain.
And, of course, the SEC has proposed ESG disclosure requirements for investment advisors. Under the proposal, advisors would be required to add new disclosures to their brochures if they consider ESG factors as part of their investing strategy. That proposal is also in the queue for finalization in 2023. It's one of several RIA-focused regulatory proposals that are on the docket for 2023, including due diligence for third-party vendors, cybersecurity, and a new proposal around custody of client assets.