New Jersey attorney Akshat Tewary, a founder of the financial reform group Occupy the SEC (OSEC), says fighting on the side of the “99 percent” is an uphill battle, but he can cite successes and a continuing effort to influence industry regulation.
“There are so many topics that need to be addressed,” Tewary said as he discussed successes and future challenges of financial industry reform in a question-and-answer session with Thomson Reuters Regulatory Intelligence.
OSEC works within the Occupy Wall Street movement which arose to fight economic inequality. It was widely hailed for the intellectual firepower of its 325-page comment letter to U.S. federal regulators in 2012 that featured a line-by-line analysis of the then proposed “Volcker rule” banning proprietary trading by banks. Tewary was the only lawyer among the handful of activists who wrote the comment letter.
OSEC remains active as an advocate on a diverse range of issues from international trade and insider trading to criminal justice reform and regulatory capture. Although it sometimes employs the populist rhetoric of its political base, OSEC analyses are regarded as often rigorous and serve as an essential intellectual counterpoint to the voluminous commentary generated by the financial industry.
Most of the questions in the email exchange for this article revolve around the nature of proprietary trading in a post Volcker world, and the impact of the rule’s well-known carveouts, such as portfolio hedging, market making, and merchant banking. He also addresses Glass-Steagall, the repealed Depression-era law that is making a comeback as an issue in this year’s U.S. presidential campaign.
Tewary’s responses, edited for length, reflect his own views and not necessarily the views of OSEC:
Q: The U.S. Federal Reserve cited your comment letter 284 times when the regulators finalized the Volcker rule in late 2013. How many of your recommendations did the regulators incorporate in the final rule? What were your key victories and some of the things that you wish you could have done differently in your comment letter?
Tewary: Within a month or two of submitting our comment letter, we met with each of the five agencies in charge of writing the Volcker regulations. Most of the agencies were thankful for our submissions, and it was gratifying to hear that they were seriously considering our comments and criticisms.
It’s difficult to quantify our impact, but I believe that our letter provided an important counterbalance to the bank lobby. The Volcker rule’s writers were inundated with hundreds of detailed comment letters from bank-friendly companies, academics and institutions. Even the governments of Canada and Japan submitted comment letters asking for the relaxation of certain provisions in the proposed rule.
On the other side, there were only a dozen or so detailed comment letters supporting the Volcker rule or requesting the strengthening of its provisions. The number of times we were cited in the final rule – 284 – ended up being in the same ballpark as Securities Industry and Financial Markets Association (SIFMA) – the bank lobbying juggernaut that holds considerable sway over Washington. The fact that the suggestions of a handful of informed activists could be seriously considered as part of the same conversation as the comments of multimillion dollar lobbyists and law firms speaks volumes about the potential for direct, democratic engagement in American government.
The agencies seemed to adopt a few of our suggestions explicitly. For one, they added a requirement that any (trading) position taken for liquidity management purposes be “reasonably” directed towards that purpose. Also, the regulators seemed to accept our view that banks keep documentation justifying their reliance on the hedging exemption at the trading desk level, and not at a broader “organizational” level. This change puts a damper on banks’ ability to engage in portfolio hedging.
We were disappointed that the agencies ignored our suggestion to remove the blanket exemption for repurchase agreements and securities lending. Under the final Volcker rule, banks can continue to trade these instruments under the guise of “cash management.” As we detailed in our letter, repo positions can be crafted with hidden proprietary positions. We have already seen the pernicious effect that these short-term lending mechanisms had in exacerbating the 2008 credit crunch. Repos could once again be the locus of the next crisis.
In retrospect, I wish we had pushed harder for a blanket prohibition on the holding of uncleared derivatives for any purpose. The Lincoln Amendment to Dodd-Frank originally required banks to “push out” these risky instruments from their FDIC-insured subsidiaries, but that law was surreptitiously gutted as part of the 2015 Congressional budget. A blanket prohibition on bespoke derivatives under Volcker would have rendered the Lincoln Amendment superfluous.
Q: The final Volcker rule retains the “portfolio hedging” exception to the proprietary trading ban. Banks may continue to make trades using their own money to offset losses in not only specific, identifiable positions, but also multiple aggregate positions. The press anticipated that the final rule would unequivocally eliminate macro-level hedging in response to JP Morgan’s large “London Whale” losses related to a leviathan hedge involving credit default swap indices.
OSEC was on the front lines to eliminate the exception, but you pointed out postmortem that regulators never had discretion to alter the underlying statutory language (Section 619 of Dodd-Frank), which allows banks to trade for “risk mitigating hedging activities in connection with and related to individual or aggregated positions.”
Given that Dodd-Frank was drafted under intense pressure to respond to the crisis, do you think that Congress fully understood the meaning of Section 619 when it passed the law? As a general matter, should we require our lawmakers to employ prospective economic analysis of proposed legislation, just as the Administrative Procedure Act requires executive branch agencies to perform prospective economic analysis when they make their rules?
Tewary: Section 619 is not unique in the manner in which it was adopted. Many vital pieces of legislation are passed in response to some pressing societal need. The general public might find it shocking, but no senator or representative reads every bill that he/she has voted upon. The sheer length and number of bills is just too overwhelming.
But that doesn’t mean that bills are voted upon willy-nilly. Nonpartisan government agencies like the Congressional Research Service (CRS) and the Government Accountability Office (GAO) are already available to assist members of Congress with bill summaries and policy guides. And congressional staff, legislative aides and the Office of Legislative Counsel are all available to fine-tune the nitty gritty verbiage of bills.
That said, prior to 1995 Congress had more legislative support. But that support was gutted when the Republicans gained the majority in 1995 and argued that offices such as the CRS were superfluous and representative of government waste. As a consequence of this reduction in legislative support staff, Congressional members have become increasingly dependent upon think tanks for critical (though hardly impartial) thinking on important legislative matters.
In the aftermath of 2008 the economy was the foremost issue on everyone’s mind, and I think the majority of Congress paid due attention to the contents of Dodd-Frank. That said, I agree that members of Congress can be rash and reactionary in the way they vote on legislation.
You raise an interesting question: Is there some way to ensure that members of Congress vote on bills with the necessary circumspection and analysis?
It’s a tough issue to crack, but I think a prospective economic analysis requirement would not be the solution. First, as I mentioned, legislative support services like the CRS and GAO already exist and could to be expanded as a possible solution to the problem. Further, bills can have noneconomic benefits that a purely economic analysis would ignore. For instance, a particular regulation might well impose some quantifiable costs on industry.
But how do you measure the “benefit” of overall economic stability, general welfare, fairness, equality under the law, etc.?
Another drawback is that an economic analysis requirement could impede much-needed legislation. We have already seen this occur in the administrative arena, where industry groups have used cost-benefit requirements as a tool to oppose inconvenient regulation in court.
Browbeaten by these lawsuits, financial regulators now expend precious agency resources on in-depth cost-benefit analyses of questionable utility. At some level the entire exercise is superfluous; Congress already decided on the merits (i.e. benefits vs. cost) in passing the law. Agencies should be free to implement Congressional will without having to re-litigate the merits of legislation within the morass of the Federal Register.
The financial regulators are already woefully behind in promulgating rules under DoddFrank. Fear of cost-benefit related lawsuits is causing them to lag even further behind, even as we appear to be approaching the next financial crisis.
Q: Section 619 of Dodd-Frank is a great example of the lawmaker-regulator dynamic. Are there other examples of disconnect in the post-crisis financial regulatory environment?
Tewary: Absolutely, the path from statute to regulation is similar to the “telephone game” – the final outcome can often be unexpected and/or unwanted.
One example is the Dodd-Frank Act’s Title II, which allows the Federal Deposit Insurance Corporation (FDIC) to liquidate a complex financial company in danger of default. The statute failed to specify exactly how the resolution should be structured.
The FDIC decided to opt for a Single Point of Entry (SPOE) system, under which just the parent company is liquidated. This system unfairly imposes losses on the parent company’s shareholders, while privileging the creditors of the parent’s subsidiaries. This arrangement is flawed because it serves as a backdoor bailout to Wall Street creditors, while leaving retail investors to hold the bag.
For example, Mom & Pop investors were more likely to own the shares of Lehman Brothers, the parent company, than one of its many subsidiaries. But only sophisticated investors would serve as creditors to one of Lehman’s esoteric subsidiaries. Why should retail investors of the parent company serve as the first line of defense? I doubt Congress passed Title II with the intention of protecting institutional creditors over retail investors, but that’s where we are, due to the lawmaker-regulator disconnect.
Another concern is that in some contexts Congress has afforded regulators wide swathes of authority that regulators are all too reluctant to utilize.
For example, Dodd-Frank authorizes the Financial Stability Oversight Council (FSOC) to classify nonbank financial companies that pose too-big-to-fail risks as “systemically important financial institutions” (SIFIs). SIFIs fall under the jurisdiction of the Federal Reserve, and must meet various liquidity, leverage and counterparty correlation limits that significantly reduce TBTF risks. The SIFI regime is a potentially powerful tool to help prevent the next financial crisis.
The problem, however, is that FSOC has only designated four companies as SIFIs, even though many more pose systemic risk to the economy. In 1998 LTCM (LongTerm Capital Management) was not in the Top 4 list of largest or most interconnected nonbank financial companies. But it nevertheless came close to decimating the financial markets, but for timely intervention by the Fed.
We don’t know who the 2016 (or 2017?) version of LTCM is, but it most likely isn’t on the FSOC’s diminutive list of four SIFIs. So here we have a clear example of the regulators not using the authority given to them, to possible detriment of the overall economy.
Market making, funds and systemic risk
Q: The final Volcker rule allows banking entities to engage in “market-making”, where banks purchase short-term inventory of securities in their own name to provide liquidity for customers who might want to trade them. Banks profit on the spread and price movements. Everybody agrees that market-making is a beneficial and essential function. And everybody knows that it can be very profitable. The question is who should be allowed to do it.
The banks claim that they are well-positioned to provide liquidity. The reformers assert that banks have the incentive to cloak their risky proprietary trades as routine market-making. Therefore, reformers believe that market-making should be shifted to hedge funds and other asset managers who do not have the government backstop. Hedge funds, which traditionally have relied on dealer banks for liquidity, do not take deposits, but they do have large clients like pension funds.
While Dodd-Frank increased the level of regulation for hedge funds, they are still more loosely regulated on disclosure and investment strategies than the traditional pools like mutual funds. Could rogue hedge fund activity in market making, or pack mentality in proprietary trading in general, spark a contagion that impacts the entire financial system, especially if hedge funds might have an incrementally higher incentive than banks to express their interest on just one side of the trade? Or are hedge funds “small enough to fail” and therefore do not pose systemic risk?
Tewary: There is no doubt that funds can pose systemic risk, despite their minuscule size relative to TBTF (too-big-to-fail) banks. The example I gave above of LTCM suggests that a small, highly correlated fund can spread contagion like wildfire. Large fund managers like BlackRock and Fidelity have escaped “SIFI” designation thus far, but there can be no doubt that regulators should be increasingly worried about the fund space being the site of the next crisis.
As you suggested, many funds exhibits a herd mentality in their investment decisions. Those high correlations exist because many fund managers use similar (or identical) financial models and trading strategies. What percentage of fund managers watches CNBC during the day or uses Bloomberg terminals for news? Most fund managers hail from a small selection of business schools or investment banks. Even if the average fund only manages money in the millions, herding behavior in the industry raises legitimate concerns about systemic risk.
That said, I think the regulators were correct to focus on systemic risk posed by banks as a first order of priority. If a fund fails, the manager’s reputation and bottom line are at stake. The fund’s investing partners and/or valued clients will be furious about losses. It’s a different story with the banking industry, which suffers from a troubling moral hazard problem.
Aside from enjoying access to government-insured deposits, major banks have access to a never-ending spigot of capital thanks to the Federal Reserve. The GAO acknowledged that between December 2007 and June 2010 the Fed made $16 trillion in near-zero percent loan facilities available to large banks. Funds don’t get that kind of access to capital. Failed (or failing) banks enjoyed close to a billion dollars in taxpayer bailouts (TARP program) with virtually no strings attached. Various economists have estimated that large banks enjoy an implicit bailout guarantee that can be valued in the tens or hundreds of billions of dollars. Again, most funds don’t get that subsidy.
And bankers themselves were left mostly unscathed, even as the typical American household saw 40 percent of its wealth evaporate from 2007 to 2010.
Everyone has heard of Bernie Madoff, but not a single bank executive was prosecuted in 2008 despite the banking industry’s complicity in producing the financial crisis, which the FDIC and others have acknowledged.
Lavish bank bonuses continued unabated even as banks accepted free money from the Fed – money that was supposed to be spread across Main Street.
The Volcker rule and other DoddFrank measures are intended to reduce that moral hazard, and thereby reduce systemic risk. Fund regulation is definitely needed, but that need is probably secondary to effective bank regulation.
Q: Shareholder activists have been obsessed with splitting up conglomerates like AIG (which has decided for the time being to “streamline” its operations). Might there be a scenario where shareholder activists eventually turn their attention to “lower margin” banks that have incrementally streamlined their profitable proprietary trading activities?
Tewary: Sure that’s entirely possible. Shareholders are owners, and owners can do what they want. Presumably we can rely on the “invisible hand” to guide shareholders toward efficiency-maximizing outcomes.
Now, are conglomerates efficient? Of course that’s a tough question. On the one hand, conglomerates enjoy economies of scale because of their larger size. On the other, they extract rents from the marketplace, hinder effective competition, and mischaracterize real prices to the detriment of customers.
I tend to think that mega-banks today are in the latter, “inefficient oligopolist” category. They surely make a lot of money. But at what public cost? And what about market externalities?
Larger banks are harder for both markets and regulators to control. If a community bank were involved in money laundering for Mexican drug cartels, can we doubt that there would be serious criminal punishment? Yet mega-bank HSBC admitted to that very conduct and was let off with a fine, which can be written off as the mere cost of doing business. You can call that “an economy of scale” but I call that a perversion of justice.
Even despite Dodd-Frank and the financial crisis, banking conglomerates are bigger than ever. As Bernie Sanders has pointed out, the top six financial institutions have assets equal to 58 percent of the GDP of America. And that number is actually an underestimate because it fails to consider off-balance sheet exposures.
Almost every day the financial pages are full of stories about bank conglomerates paying millions or billions in fines and settlements to regulators, or damages to private litigants. Most of the time it’s the same familiar faces. Midsize, regional and community banks don’t suffer from these problems (or at least not at the same proportions). As a result, I think they have little to worry about when it comes to interference from activist shareholders.
Breaking up is hard to do
Q: The Volcker rule aims to protect depositors without breaking apart the holding companies that are allowed to engage in deposit-taking and other commercial banking activities, investment banking, and insurance, but through separate subsidiaries and subject to functional regulation and consumer cross-marketing restrictions. OSEC wants to go further and have Congress restore the part of Glass-Steagall (the Banking Act of 1933) that prohibited commercial banks from affiliating with underwriters and securities dealers in the first place.
Vermont Sen. Bernie Sanders has made restoring Glass-Steagall a central plank of his campaign for the Democratic presidential nomination, and is a cosponsor of the proposed 21st Century Glass-Steagall Act of 2015. The bill is sponsored by U.S. Senators Elizabeth Warren and John McCain. That measure appears to take away the Glass-Steagall exception that allowed banks to form or acquire subsidiaries that were not “engaged principally” in underwriting and dealing in securities even before the prohibition was repealed by GrammLeach-Bliley in 1999. Warren-McCain also tightens up the list of the types of “core banking services” that comprise “the business of banking.” But Warren-McCain defers to regulators in a number of areas.
Regulators can define the types of “investment securities” in which banks can invest. And banks can purchase investment securities for their own account, subject to regulatory limits. If something like Warren-McCain is enacted, is it possible that we might eventually end up after the lobbyists are through with a regulatory environment that is similar to, or more permissive than, what we have right now?
Tewary: The Volcker rule’s proprietary trading restriction applies to both bank holding companies and their subsidiaries. In its purest form, the Volcker rule would not have been much different from the Glass-Steagall standard. Paul Volcker himself proposed his eponymous rule as a simple, two-page document that placed strict prohibitions on proprietary trading. And he was dismayed by what the rule became by the time it passed by Congress, regulators and the lobbyist gauntlet.
There is no question that the 21st Century Glass-Steagall Act of 2015 could face a similar fate. But one advantage that this law has over the Volcker rule is that it is premised on strict corporate separation, whereas Volcker relied on functional separation that requires real-time assessments of what constitutes proprietary trading. So even if the new Glass-Steagall Act is gradually deregulated, as its predecessor was in the 1980’s and 1990’s, at least it will start from a more absolute position of strength. But there is no question that reformers’ battle against deregulation will continue.
Q: A return to any version of Glass-Steagall will require divestiture. Warren-McCain gives financial institutions up to five years to divest nonconforming business. What is the best way for regulators to ensure an orderly, but market-driven, divestiture process?
Tewary: Banks routinely complain that they require time to ease into regulatory compliance, and there’s no doubt that the regulators are generally willing to accommodate them. For example, even though the Volcker rule was passed as law in July 2010, banks can conceivably hold proprietary assets until July 2022 under certain circumstances – hardly a “fire sale” scenario. And many banks pared down their proprietary trading activities even before Volcker went into effect, which suggests that timely compliance is quite possible.
Ultimately, banks shoot themselves in the foot by arguing that divestiture is messy. If it’s messy, that indicates that the bank is enmeshed in complex positions involving heightened counterparty risk that may be difficult to manage privately or regulate publicly. A bank suffering from that condition is probably a prime target for divestiture, for its own good.
Moreover, the entire issue of divestiture is less likely to come up under Glass-Steagall than under Volcker. Under Glass-Stegall, entire business units can continue to operate. It’s just that they must operate as distinct legal entities with a different shareholder makeup. If esoteric derivatives and other structured finance products are truly valuable, I’m sure the capital markets would love to own a piece of that pie.
In contrast, Volcker does not require strict divestiture of entire business units – compliance is possible without any corporate change if (nonexempt) proprietary positions are unwound. So falling into compliance can sometimes mean taking losses. But divestiture under GlassSteagall should be relatively clean.
Lastly, complex banks are already required to have “living will” resolution plans in place in case they run into trouble. Those plans should be useful in allowing banks to fall into compliance with Glass-Steagall.
Divestitures may seem uncomfortable at the present, but they will help both regulators and financial companies overcome the brunt of the next banking crisis (which is scheduled to occur relatively soon, if we are to heed the lessons of history).
Insurance and reinsurance
Q: In the insurance sector, it’s often cheaper for companies to “insure” and insurers to “reinsure” through the capital markets via insurance-linked securities than by purchasing commercial insurance and reinsurance. The competition between the traditional and capital markets has driven insurance premiums down, which could drive insurance firms to consolidate into larger companies. If it’s true that financing through the capital markets is cheaper than financing through bank loans, would a reconstituted Glass-Steagall exacerbate, rather than alleviate, “too big to fail” by driving banks to merge so that they can compete with non-banks who will still be able to provide credit more efficiently in the capital markets?
Tewary: I don’t think we can assume that a reconstituted Glass-Steagall would drive financial companies to consolidate. Classic economics informs us that the most efficient economies exist when the number of competing firms is large and their size is small. GlassSteagall would help us achieve that result by breaking up oligopolistic banks into smaller units. Those smaller units, in turn, would have to compete based on efficiency-promoting advantages rather than mere size advantages.
A new Glass-Steagall would reorient banks towards traditional banking. It would not eliminate credit derivative or other speculative markets. Rather, it would simply eliminate the moral hazard that has permitted government-backstopped banks to underwrite those markets. If pseudo-insurance (like CDS) is actually more efficient, investment banks and funds will gladly step in to fill the lacuna left by exiting banks post Glass-Steagall.
My sense is that the economy would not only be more efficient but also safer under Glass-Steagall. Investment banks that don’t have access to Fed largess (or the security of bank deposits) have to put up real money – that owned by partners, shareholders and/or clients. This is likely to have a disciplining effect on esoteric markets, even if that means that liquidity drops and spreads increase.
Of course, Glass-Steagall is not a panacea, and we would still need to rely on other regulations like the living will, SIFI, TLAC (“total loss-absorbing capacity” requirements) and orderly resolution rules to counteract TBTF concerns for banks and non-banks.
Q: Another controversial area is the ability of banks to engage in “merchant banking,” or proprietary passive investments in commercial companies or other assets like real estate. The Volcker rule tightened up Gramm-Leach-Bliley by restricting a financial holding company’s authority to engage in merchant banking through a private equity fund. But neither GLB nor Volcker prohibits a holding company from making direct investments, subject to passivity and holding period requirements. Would you be in favor of legislation that closes the gap and outright bans direct passive investments, which would, for example, preclude a bank from owning, rather than leasing its office space? More generally, what do you think of the proposition that there is a difference between proprietary trading as opposed to proprietary investing? Or are both dangerous because it is easy for banks to cloak the former as the latter?
Tewary: The Bank Holding Company Act has historically permitted banks to make passive investments in commercial activities under the merchant banking provisions. I think there is no question that the Volcker rule further constrains banks’ merchant banking authority. While Section 619 of DoddFrank was technically silent about merchant banking, there is definite overlap between Volcker’s fund provisions and the longstanding limits on bank commercial activity.
Section 619 effectively adds a new layer of restraint on bank investments (including in the commercial space). As a matter of statutory interpretation, a statute passed later in time (i.e. DoddFrank) holds more sway with courts than an earlier-passed statute.
That said, it would certainly be overkill to ban all bank investments altogether. The fundamental question is, is a particular investment “passive”? Purely passive merchant banking investments, by virtue of their passivity, are probably not undertaken for short-term gain or speculative purposes and thereby would not violate the spirit of Volcker.
Unfortunately, the Federal Reserve seems to have been taking every opportunity to liberalize the passivity standard that is applicable to the merchant banking exception. OSEC has complained to the Fed about this trend, and as Volcker compliance kicks in the regulators need to be vigilant about rooting out “merchant banking” that is really just a proxy for proprietary trading.
To that end, internal bank examiners should be given access to granular, portfolio-specific data to assess compliance with the passivity requirement. And banks relying on merchant banking exemptions should be strictly held to holding period requirements. Regulators could also impose a marginal capital charge to reflect merchant banking activities.
Q: Congress in 2014 expanded exceptions in the “push-out rule”, which requires depository institutions to transfer their swaps dealing activities to separately capitalized affiliates that do not receive federal deposit insurance. What do you think of the proposition, asserted by academic writers, that pushing out the riskiest swaps such as “structured finance swaps” to an affiliate may not change incentives within a holding company structure because the conglomerates involved in this type of business have the implicit guarantee of a government bailout even though their non-depository affiliates do not have the explicit guarantee of federal deposit insurance? The clearinghouses, who are supposed to absorb counterparty risk in exchange-traded swap transactions, also have FDIC support – how does this impact the incentives on swaps dealing?
Tewary: There’s no question that the December 2014 removal of structured finance swaps from the ambit of the swaps push-out rule has increased the risk of a future bailout. Those are the very instruments that led to taxpayer and Federal Reserve bailouts and pushed the FDIC fund to its limits during the last crisis.
It’s true that Titles II and XI of Dodd Frank imposed restrictions on any future taxpayer or Federal Reserve bailout. But in the face of another crisis, Congress could cite exigent circumstances and overturn those laws just as easily as it passed them. This is why swaps need to be standardized and pushed onto clearinghouses.
True, clearinghouses (like any financial institution) can also suffer from the risk of catastrophic failure, but there are numerous reasons why centralized clearing is preferable to bilateral OTC swap trades. For one thing, widespread central clearing would permit regulators to have better visibility over the entire swaps market, which in turn would allow regulators to foresee a crisis (instead of dealing with the aftermath ex post-facto). Also a massive loss that might wipe out one swap dealer may not have the same effect on a central clearinghouse because of the advantages of netting.
Furthermore, many of the largest clearinghouses are already subject to heightened prudential regulation by the Federal Reserve because of their status as systemically important Financial Market Utilities (FMUs). (A modern day LTCM, by comparison, would not be considered a nonbank SIFI). Therefore, the likelihood of clearinghouse failure is relatively remote.
Q: How does OSEC pick the issues it works on given the volume of proposed regulation, legislation, and executive action and pending court cases generated every year?
Tewary: Our focus is generally on financial regulation, although we do venture into ancillary areas like campaign finance reform and the regulatory revolving door. Given our extremely limited resources it can be difficult to focus on a particular issue, especially since there are so many topics that need to be addressed.
Ultimately we focus on issues that we feel will help the 99 percent, combat inequality, improve markets for investors/pensioners, and reduce TBTF risks. These are uphill battles given the financial lobby’s inordinate power, but it is enjoyable to fight the good fight (in our view), and to have some influence in the process.
About Thomson Reuters Regulatory Intelligence
This article was produced by Thomson Reuters Regulatory Intelligence, and initially posted on February 26, 2016.
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