Deus Ex Macchiato

Keep warm: I get the feeling that February is going to be cold for many of us…

Posted in: Photography by admin /
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Radio 4 has rebroadcast Václav Havel’s Leaving. It’s a play nominally about the chancellor of an ex-soviet state, perhaps Havel’s own Czeck republic, who is leaving office. But about ten minutes in, Havel in uncomfortable self-parody has the Chancellor say something that could have been Tony Blair (or David Blunkett):

I have always placed great importance on human rights. In the name of freedom of expression, I imposed significant limits on censorship. And during my term fewer than half of all public demonstrations were broken up by the police.

There is a certain contemporary resonance too…

Posted in: Media and Popular Culture, Politics by David /
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As not the Treasury view points out, the UK recession has now lasted longer than the Great Depression of the 1930s. (HT Krugman)

Now do you believe me that Osbourne is the worst chancellor in living memory?

Posted in: Economic Theory by David /
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Businessweek reminds us that the MF global situation has still not been resolved, money is still missing, and an exchange of lawsuits seems likely between the administrators of the UK and US arms of the firm:

MF Global Holding Ltd.’s clients may be the losers no matter who wins a $700 million dispute between bankruptcy administrators in London and New York that threatens the return of money locked in customer accounts.

The trustee of MF Global Inc., the New York brokerage unit, is seeking the return of money used as margin for American customers trading in Europe. It wants U.K. administrators KPMG LLP to tap into $1.2 billion it had set aside for customers with segregated accounts, which are supposed to be protected.

One set of clients or other will lose out: if the US prevails, there will be less in the client money pot for UK customers; while if the UK wins, U.S. customers will be treated as unsecured creditors. They will get less, and have to wait longer for it.

(Yes, that’s your liquidity. No, you aren’t getting it back any time soon.)

None of this is going to be resolved for months due to a ruling expected from the UK supreme court. Reuters reports:

KPMG’s plan will have to take into account an imminent British Supreme Court ruling brought by British clients of Lehman Brothers, who have been arguing they had segregated accounts at the U.S. bank when it collapsed in September 2008.

The British Supreme Court is set to rule, perhaps as early as March, on the clients’ claims that they had agreed with the bank before its collapse that their funds would be segregated, though the assets were later found not to have been segregated when the bank failed.

Given all this, it is hardly surprising that some lawmakers are restive. We welcome a new publication to DEM, the Billings Gazette, for this one:

Sen. Max Baucus, D-Mont., called for an investigation Wednesday into the regulators of investment houses… [By which he presumbaly means broker/dealers.]

“The fact that over $1 billion of customer money is missing is inexcusable and raises serious questions about the regulatory system that was supposed to protect these folks,” Baucus said. “If laws were broken, the people responsible need to be held accountable. If not, we need to know where the laws failed so we can make them stronger and better protect folks in the future.”

Never fear though. A trade association is riding to the rescue. Dealbook tells us

The Futures Industry Association, which represents both small futures brokerage firms and big banks that run futures businesses, announced Tuesday that it had created a committee to explore new safeguards for customer money.

That will be just fine then. After all,

The new committee, whose roster includes representatives from Goldman, Morgan Stanley and the CME Group

So you can really take comfort in that. Oh yes.

Posted in: Clearing and Collateral, Legal Risk and Trade Documentation by David /
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FT alphaville has a nice riff on the whole systemic risk of margin calls thing, discussing in particular the risk of variation margin calls in the ECB’s LTRO. They quote some Nomura research which makes a number of good points, but one dodgy one. The major thrust first:

The cost of the haircuts and existing funding costs on leveraged banks balance sheets means that the cost of funding from the ECB is not 1%.

True. You fund only 71% of the asset (assuming the collateral is a >5y corporate loan, which gets a 29% haircut at the ECB) at the ECB rate. The rest has to be borrowed unsecured*.

The error comes when the discussion turns to capital:

In this case against a €100 asset there would be a €29 haircut and €5 capital charge giving €34 to fund through other sources.

Nope. The capital charge is funding too. If you have a €5 capital charge on a €100 asset, then 5% of it is equity funded and the rest is debt funded. Thus if the ECB haircut is 29%, you get 71% from the ECB and 5% from your equity investors leaving 24% to raise in the unsecured market.

Now, often people keep ROE separate from ‘cost of funds’, as this separate is typically convenient for reporting; but both equity and debt capital are funding. Thus in this separation the ‘cost of funds’ should be the cost of the debt needed to fund the asset, i.e. interest on €95, not on €100.

*The Alphaville article says ‘Unsecured funding is closed (to all but the bestest of the best), ergo the bank scrapes together assets to pledge for cash somewhere, running the gauntlet of the collateral crunch.’ That isn’t quite it as you don’t fund the haircut of a collateralized asset (the 29%) with more collaterized borrowing. You fund it unsecured, because you have to – you have used 100% of the asset you have to raise 79% of its value. All assets need funding, and there aren’t spare ones lying around to use as collateral as – roughly – anything you can use as collateral is being used to fund itself. This just follows from balance sheets, err, balancing.

Posted in: Capital Structure Arbitrage, Liquidity and liquidity risk by David /
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Papagianis and Swagel writing on Bloomberg view about Fannie Mae and Freddie Mac argue that the US government should

recognize budgetary reality and put the firms’ liabilities on the government balance sheet and include their spending in the federal budget.

They are probably right. I certainly think that if an entity enjoys a government guarantee on its debt, then it should be on the government’s balance sheet. Indeed, you could make an argument that Fannie and Freddie’s problems were at least partly due to having private shareholders (which in turn was a 1954 trick to keep them off balance sheet).

Anyway, let’s ignore whether Fannie and Freddie should exist, and assume that they do. What function can they perform?

You could argue as follows.

1. A credit spread contains (at least) a liquidity premium, compensation for default, and a return on the equity needed to support unexpected risk.
2. Non mark to market holders are only exposed to default risk, assuming they are well enough funded and capitalized to hold to term.
3. Therefore, a non-mark-to-market government guaranteed player in the mortgage market does not need to make as a high a return as private capital and thus can charge less for mortgages.
4. If you believe that home ownership is a societal good (something I do not intend to get in to here), then having such an entity would by extension be good too.
5. But, seen in this light, it is really clear that government has the risk that the aggregate credit spread paid on mortgages is not sufficient to support experienced credit losses, and the profit if indeed the credit spread charged is more than sufficient. It is in the position of an equity investor as well as a debt guarantor (and so should consolidate).

Posted in: Federal Agency, Mortgages by David /
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Gorton, Lewellen and Metrick have a new paper on safe assets (HT FT alphaville, see Timothy Taylor for more details). This is a topic I have blogged about several times before, so here are the highlights.

• The percentage of all U.S. assets that are “safe” has remained stable at about 33 percent since 1952 – the population of safe assets has been remarkably constant.
• However, demand comes from various souces. As Taylor, quoting Ricardo Caballero says “Emerging and commodity-producing economies have added an enormous demand for assets that is not being met by their limited ability to produce these assets.”
• Another source of demand is from collateralized funding transactions. Back to Gorton: “To the extent that debt is information-insensitive, it can be used efficiently as collateral in financial transactions, a role in finance that is analogous to the role of money in commerce. Thus, information-insensitive or “safe” debt is socially valuable.” It is, in fact, the thing that makes the repo market, and hence a lot of banking funding, work at all.
• Making pseudo-safe assets via securitization to meet this demand did not pan out so well.
• Hence it is encumbant on policymakers to ensure there is enough safe debt around to meet needs. Or, as Gorton puts it “regulators and policymakers must adroitly balance the need to improve financial stability with the simultaneous need to maintain enough liquid, safe debt in the economy to meet the demand for such debt.”

Posted in: Clearing and Collateral, Economic Theory, Liquidity and liquidity risk by David /
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From the Daily Mash:

Credit rating agency Standard & Poor’s has upgraded itself to Triple-A Plus Super Fantastic.

(I was going to go with Philip Stevens’ somewhat more sober post on a similar theme in the FT, but I can’t resist the Daily Mash’s nuanced, balanced stance.)

Now, before we go, let’s remind ourselves as to what the collateral looked like behind the mortgages in some AAA tranches…

Posted in: Fun, Ratings by David /
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A propos the on-going fracas in the Labour party over austerity (see for instance here, here or here), Edward Pearce has a nice piece on the LRB blog. His final paragraph says

Blairites can’t understand why they lost the leadership. Their trouble is an affinity with exiled royalty; Ed Miliband’s succesful candidacy has been treated as a sort of Orléanist family treason. The reason is different. David Miliband, starting as heir presumptive, was rejected as Blair-compliant, a sparrow on the wrist. He embodied everything Jim Murphy seems to want for his party: assent to what a Conservative government does and yearning to do it oneself. Without discernible point, it is careerism transformed into Clause Four, yet a cause for which people are whispering and arming. David Cameron looks on.

Indeed. The Blairites’ position is, as Len McCluskey in the Guardian puts it, last gasp of the neoliberalism, but it is no less dangerous for that. Labour risks not only alienating its natural supporters by supporting austerity; it is also (as if that mattered in the calculus of position) profoundly wrong-headed. A party that says ‘we’ll do what they would, only not quite so much’ hardly has a convincing message. Labour needs to have the confidence to purge its quasi-Tory wing and actually start acting like an opposition party.

Posted in: Politics by David /
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Jonathan Weil, as so often, has a good article on Bloomberg. He trashes the ‘Fannie and Freddie were the cause of the crisis’ thesis, pointing out that

there was no single cause. What we can say is this: But for the actions of a vast number of actors, including Fannie and Freddie, the crisis wouldn’t have happened the way that it did.

Quite right. As I suggested in my account of the Crisis, there is no single cause, nor a single bad guy who we can blame. The Crisis was caused by a complex interaction between the design of various element of the financial system and the incentives of various parties within it. Blaming Fannie for the crisis is like Woodrow Wilson for the second world war. Sure, he might have had something to do with it, but other things were happening too…

Posted in: Federal Agency by David /
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Dealbreaker picks up on some interesting comments from Goldman’s Viniar about allocating regulatory capital to businesses:

As far as how we’re charging the desks, that’s a little bit of a complicated question. And we’re working through that now, and it — there’s no one-size-fits-all yet. And we have to be careful. As you know, Basel III does not kick in for quite a while, and quite a bit of what we do is very short dated. And so we don’t want to charge desks on a Basel III basis, have them turn down profitable opportunities that would be long gone from our balance sheet long before Basel III ever kicks in. So we’re really taking into consideration the tenor of what we do and trying to figure out what capital regime we’re going to be under. And it’s still — I would say, we’re going through a transition process here.

This makes sense. If you do a one year trade now, Basel III won’t touch it, so charging for Basel III capital is crazy. But if you do a twenty year trade, it probably will be affected by whatever ends up being implemented. Goldman being a US firm has less certainty here than many, as the US is notoriously slow at implemented Basel Accords, and quite likely when it does get around to doing something to implement a subtly different set of rules. So somehow a US bank like Goldman has to design a regulatory capital allocation mechanism that doesn’t discourage short term trades that are profitable under the current rules, but also doesn’t load up the balance sheet with long term ones that have an unattractive ROE under whatever the US version of Basel III ends up being. Tricky.

Posted in: Basel, Cost Benefit Analysis by David /
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For my sins, perhaps in a past life, I used to manage a model verification group. We looked at derivatives pricing models and checked their accuracy. Many of the ones we looked at were somewhat wrong, and some of these we passed anyway. Why?

• A model is only designed to be used with a domain of applicability. Provided that their are controls in place to make sure it is not used outside that domain, it doesn’t matter that it is wrong there.
• Moreover all models are a simplifications. They will always break if you stress them enough.
• Time to market sometimes beats correctness. Being first, even with a slightly wrong model, is sometimes better than being seventh with a more correct one.

In other words, modelling is like crossing a river on lily pads. It isn’t a question of whether things are secure – you know that they are not – it is a question of having sufficiently good judgement that you avoid taking a bath.

It does not surprise me, then, to learn that many research results may be false. People doing complicated things make mistakes, even without bias. Having open data (so that others can build their own model) and open models (so that they can see where yours breaks) helps, but mistakes are still going to slip through. Science, like finance, isn’t ‘correct’; the best it can aim for is ‘not obviously false’, and it might not hit that bar some of the time.

Indeed, ‘correctness’ is a really unhelpful idea in most modelling. Few models are absolutely correct, and certainly very few interesting ones. ‘Close enough, enough of the time’ is much more apposite, and ‘open enough that you can figure that out’ is a good way of helping to get there.

Posted in: Mathematics and Science, Model risk by David /
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I will be travelling next week so posting will be light. Here’s a bleak midwinter scene for all of you who haven’t had any snow:

Posted in: Photography by David /
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Switzerland has a freedom of information law, as do some of the Cantons. Now, the national law probably doesn’t apply to a transnational entity like the BIS, and it is anyway little used, but if anyone feels like making a nuisance of themselves, how about writing to the secretary of the Basel committee and asking him to make the Basel Committee membership, meeting schedule and minutes public? Then, when that does not work (as I am pretty sure it won’t), try the Swiss information commissioner.

Posted in: Basel by David /
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Risk Management Australia has a nice history of the Basel Accord process from Pat McConnell here. As well as describing how the Accords have evolved, he makes some good points about Basel’s responsiveness. My favourite section of the post describes what Basel did and didn’t do in the years around the crisis:

By the time that Basel II was finally implemented, in 2008, it was already too late. It was overtaken by the Global Financial Crisis (GFC), which was exactly the type of credit related calamity that Basel was meant to prevent. The Basel capital regime failed as supposedly well-capitalised banks around the world had to have injections of capital from taxpayers, sovereign wealth funds and investors, such as Warren Buffett. All sorts of risks that had been excluded from Basel rules, such as liquidity risks, had torpedoed some of the largest banks in the world, costing taxpayers trillions.

Basel was not responsible for the GFC, but it was as useful as an umbrella in a hurricane. During the crisis, when it should have been in the forefront of efforts to tackle the mayhem, the Basel Committee was ‘missing in action’, meekly trying to grab attention from the sidelines while bodies such as the G20 and the IMF rolled up their sleeves to tackle the problems…

When the hubbub died down, the Basel Committee did what it did best, which is to issue new rules to ‘fight the last war’. In 2010, the Committee unveiled Basel III, which in itself is not an unreasonable set of rules to force banks to maintain capital to cover liquidity risks. However, Basel III does not address some of the key root causes of the GFC, such as the problem of what to do with ‘too big to fail’ (TBTF) banks nor, given its reliance on the ratings of the rating agencies disgraced in the GFC, how to estimate the probabilities of credit default?

McConnell suggests that some independent oversight of the Basel process would help, perhaps from the IMF. It would. So too, would a Basel arbitrage group that looked at the proposed rules and figured out how banks would react to them. (I suggested this to both Howard Davies and Nout Wellink on separate occasions in the early 2000s, and got nothing more than two dirty looks for my trouble.)

Fundamentally though, a multinational process with 30+ participants and governance that is about as transparent as FIFA’s* cannot be responsive. The Basel process is not fit for purpose and it is time to stop pretending that it is. We need to escape the Basel doom loop.

*If you think I am joking, consider this. There is no public list of Basel Committee members. (You can find out which countries are represented, but not who goes to the meetings.) There are no published agendas for the meetings, which are all secret. Most of the real discussion happens in working groups: membership of these is secret, as are their meeting dates and topics of discussion. The process for election of a new chairman of the Basel Committee is private, as are the actual votes. You can’t apply for any of the jobs, nor can you learn how these jobs are allocated. I bet Sepp Blatter wishes he ran the Basel Committee.

Posted in: Basel by David /
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A major cause of systemic risk in the financial system is things that are mostly one thing, but occasionally another. Unlike Gremlins – where you are safe provided you don’t get them wet* – these things change without your intervention. Euro-periphery government bonds are one example; AAA RMBS during the crisis are another.

These things are dangerous precisely because you are lulled into thinking that they are always safe, when in fact they mostly are. A shortage of things that are always safe, plus perhaps a touch of greed, causes folks to buy the almost-safes. And we all know how that ends: a flight to (genuine) quality and contagion as investors exit all assets that might even possibly be risky.

There are two reactions to this. FT alphaville nicely sets out the positions in relation to uninsured bank deposits. You can say folks should grow up, and understand the risk; or you can say the risk ought to be removed. For me, the ‘grow up’ position is naïve. Just saying people should not be mistaken solves nothing. At least the ‘do something’ school (represented by Amar Bhidé) recognises the risk that investors will fail to recognise the risk, then flee when bad things happen. If those same investors are forced to pay now for the protection they will need later, maybe stability is enhanced.

Now, of course, there are lots of issues with this, and lots of potential to get the design of the solution wrong. But just throwing your hands up in the air and saying people should be smarter – well, that’s as dumb as a fish trying to swim up Kingston Falls.

(For a further discussion of the importance of genuinely safe assets, see here.)

* Or feed them after midnight, or expose them to sunlight.

Posted in: ABS, Bank Run, Clearing and Collateral by David /
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A slightly updated version of the Systemic Risks of OTC derivatives central clearing paper can be found here.

Any new comments would be much appreciated; they might even persuade me to share the pie…

The paper should print better than the prior version too, now that I have discovered how to save ISO 19005-1 compliant PDFs.

Posted in: Clearing and Collateral, Publications by David /
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When I heard Kodak was probably going to file for bankruptcy, my first thought was to wonder what it might do to the price of medium format digital cameras. You see, Kodak makes one of the few sensors in this area, and MF digital is still really expensive. It turns out though that Kodak have already sold that business, so the answer is probably that it will have rather little effect.

That means I suppose that I might look at the Nikon D800 when it comes out. Meanwhile, I’ll leave you with a (cheap APS-C camera) shot and a link to Tim Parkin’s excellent large format film vs. high end digital shoot out.

Posted in: Photography by David /
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FT alphaville suggests that targeting the GC repo rate could be a more efficient goal for the FED than targeting FED funds. I think that’s right. GC is much closer to real banks’ cost of funds than FED funds, and it’s (it seems) a bigger market.

The FED says that tri-party repo alone funds $2 trillion or more a day, while FED funds hovers in the hundreds of billions range. GC is harder to move, but more effective at influencing bank funding when you move it.

(More background from the ECB here.)

Posted in: Economic Theory, Liquidity and liquidity risk by David /
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Kenneth Rogoff has an insightful post. It might be titled the limits to growth (as an idea) if that appellation had not already been taken.

Modern macroeconomics often seems to treat rapid and stable economic growth as the be-all and end-all of policy… as a long-term proposition, the case for focusing on trend growth is not as encompassing as many policymakers and economic theorists would have one believe.

There are at least three aspects to this.

• Technically, the focus on growth alone, and the assumption that it is always and everywhere desirable, is a limitation of much conventional economic thinking. It makes it much harder to explain, Italy, for instance; a country that seems rather content, in general, with comfortable stagnation. (Now of course not all Italians are content, but quite a few of them don’t see the point in increasing GDP if it threatens the dolce vita.)
• Practially, significant growth may well be a big stretch for the West at the moment. If you can’t get what you want, try wanting something different. You might even end up in a better place.
• Environmentally, the price of growth, or at least some growth, may be too high. Trying to price environmental damage is really hard, and highly subjective. The price of damage is too dependent on how desirable you view growth to be.

A lot of the work in new economic foundations is, to be polite, fanciful. But that is not to say that such foundations are not worth searching for, or that new perspectives are always unwelcome. Economics is too unsuccessful to reject any new directions, let alone all of them.

Posted in: Economic Theory by David /
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Ever since a helpful comment by Hans on my post about what financial risk managers can learn from flight safety, I have been meaning to write about OODA loops. OODA stands for observe, orient, decide, and act; the concept is quite a helpful way of thinking about managing risk.

According to it’s inventor, USAF Colonel John Boyd, the OODA loop is a useful concept because once you figure out that this is what you are doing, you can tighten the loop and so make decisions faster than the next guy. You need to work on all four parts of the loop, and it is this segmentation which I think is most useful:

• ‘Observe’ is obvious. Decide on your risk parameters and get the data*.
• ‘Orient’ is more interesting. The OODA model explicitly includes a cultural element. Wikipedia quotes a Boyd paper which says that ‘the repository of our genetic heritage, cultural tradition, and previous experiences’ are ‘the most important part of the O-O-D-A loop since it shapes the way we observe, the way we decide, the way we act’. In other words, since culture is an important implicit element in decision making, you had better build it into your model of how you make decisions.
• ‘Decide’ is also obvious. You have the data, you have analysed it based on your model of the world – figure out what to do next.
• ‘Act’ – then do it.

The usual picture is this one (click for a larger version):

What we get wrong in financial risk management so often is never getting to the DA. We measure a lot of stuff. We have committees and reports and limits and such like. But the really big risks are often not acted upon because we are oriented so that we cannot decide. Look what happened to those people who tried to act against the firm’s orientation at MF Global, or Enron or HBOS.

Once a year – and why not make it the committee’s first meeting? – the group risk committee should ask themselves what features of the firm’s culture stop them from making effective risk decisions, and how they can be changed.

*Interestingly, some critiques of the OODA loop paradigm in military decision making are based on the inevitable tendency for what you observe to be narrowed to just those things that seem to help with decision making:

The result of this type of thinking is to spend a lot of time narrowing the focus of what we choose to observe in order to better orient and decide. This drives one to try and reduce the noise associated with understanding the problem.

To me, this is a risk, but not one confined to this approach. You always need to ask the question ‘what am I missing?’ in any risk measurement situation.

Posted in: Authority and Leadership, Decision Making by David /
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Happy New Year to you all.

Let’s start with a nice statement of the difficulty of writing good rules from the Streetwise Professor:

The hard thing is to design regulations that balance between micro incentives (to control opportunism) and macrostability.

Let’s hope that balance is achieved a little better this year than it was last.

Now go and read the full article: it is worth it.

Posted in: Regulation, Rules by David /
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Brad DeLong puts it better than I could:

The economy must possess enough AAA-rated assets suitable to serve as collateral to keep the moral hazard associated with lending your wealth to somebody who knows more about the deal than you do from causing a Minsky meltdown. If not we see a downturn and what we see now: relatively low asset prices for risky assets and assets perceived as safe selling at values far above any reasonable estimate of long-run fundamentals that does not take account of their value as collateral for greasing financial-intermediation transactions.

This is exactly what I have called economic policy on the asset side. Governments should provide sufficient safe assets to meet investors needs. This is separate from the money supply problem, and needs to be coordinated with it. Thus while I am not sure that the chart showing the declining universe of AAA assets is the most important chart in the world, it is certainly pretty important…

Posted in: Economic Theory by David /
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Steve Randy Waldman has an interesting post at interfluidity about the role of banks as credit intermediaries and how their existence facilitates risk bearing. It is pretty insightful in places:

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky. Further, the probability of success of any one project depends upon the degree to which other projects are simultaneously underway… One purpose of a financial system is to ensure that we are, in general, in a high-investment dynamic rather than a low-investment stasis.

(That, by the way, is a purpose developed world banking is not fulfilling right now, but that is not the subject of this post.)

What interfluidity correctly identifies is the importance

• of banks as diversified pools of risk;
• of the tranching of bank fundings as a mechanism for ensuring investors can select an appropriate security [e.g. deposits, senior debt, sub debt, or bank equity]; and
• of deposit insurance

I would also add maturity transformation, as this is a key function of banks. (Maturity transformation plus deposit insurance is kinda magical: maturity transformation without insured deposits is just scary.)

Banks capital structure and backstops mean that it is quite likely that banks will perform based on the realised value of their lending, not their market value: they will stick around long enough to see how things play out. That is important, as the realised value of a highly diversified pool of risk across an economic cycle is very likely to positive. Markets are very good at setting prices so that this is true. Sure, sometimes markets screw up, but not in all asset classes all of the time. Moreover, when markets screw up, they eventually over correct, so the banks that survive make out like bandits the next year.

Given all of this, and assuming that we regulate banks properly, set sensible capital requirements and so on (OK, perhaps a big ‘if’); well, then the risk of bank failure is small, and it is worth bearing in exchange for the increased growth that efficient credit extension provides.

Now I am not arguing that this model is a good (or a bad) thing. But it has worked pretty well in the past, and I think it could work reasonably well again. Therefore I don’t agree with Interfluidity’s conclusions:

Financial systems are sugar pills by which we collectively embolden ourselves to bear economic risk. As with any good placebo, we must never understand that it is just a bit of sugar.

Diversification, tranching, maturity transformation, and capital allocation are not sugar pills. They are legitimate and valuable economic functions which can and do earn a positive return. (Probably they shouldn’t earn as big a return as they have done over the last few years, but again, that isn’t the point.) Just because some part of the current financial system are not serving society well does not mean that we can do without entities which take deposits and make loans.

Posted in: Economic Theory by David /
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Abstract:

The solvency/liquidity spiral was a major mode of large financial institution failure during the 2008 financial crisis. Many institutions began the crisis with significant funding liquidity risk. Initially unjustified investor doubts over an institution’s solvency caused a loss of confidence. This in turn caused the price and availability of funding to deteriorate, until in some cases this lead to failure. Thus a key factor in financial institution distress was loss of confidence caused by investor uncertainty over solvency.

As we show, the official accounts of the failures of Lehman Brothers and RBS provide substantial evidence for this failure mode. Our model has implications for confidence-enhancing regulatory and accounting policy, which we discuss. In particular, it suggests that minimum required capital is needed to keep investor confidence in a firm, and thus only capital above the minimum is available to absorb losses.

The full version is here.

Any comments would be much appreciated.

(Irritating geeky note: some folks have had some problems in the past with PDFs saved from Word 2010 not being readable on ipads. I think I have cured this problem here by saving an ISO 19005-1 compliant PDF, but please let me know if I haven’t.)

Posted in: Liquidity and liquidity risk, Publications, Regulation by admin /
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… a paper on confidence in banks, funding liquidity and solvency uncertainty. This will probably be up tomorrow.

For now: a festive picture.

Posted in: Photography by David /
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FT alphaville has a post on derivatives netting, which is mostly reasonable, although it links to a piece by (self-proclaimed?) expert Das, which isn’t.

To begin with, it is important to understand what a properly executed master agreement does. I think of it as glue: it binds up all the contracts between two parties, so that instead of many little contracts, there is one big complicated contract. As a result of this glueing, the parties owe each other whatever the net value of the big contract is. Thus we get two forms of netting: payment netting on everyday cash movements, reducing the number of cashflows between parties; and close out netting, which means that if one of the parties is in contractual default, then only a single net amount is payable.

In jurisdictions where this works (which is most of them – Russia and China being the most prominent examples where it may fail), this means that there is a single claim against the estate of a failed bank (or a single payment to it if the defaulter is in the money on the big contract).

Now, the really delicate thing is how this close out amount is determined. Unsurprisingly, a standard methodology is not imposed as part of the standard master agreement as this agreement has to deal with both bank-to-client relationships, where there are often a small number of derivatives which are easy to value, and bank-to-bank relationships, which may be much more complex. Of course, the vast majority of close-outs are of bank-to-client relationships – and you don’t hear anything about these proceeding without disputes (which they do, all the time).

A big bankruptcy like that of Lehman Brothers generates litigation on pretty much everything. The amounts of money at stake are large enough that it is worth sueing. So people do, on whatever can reasonably be disputed – and often on something things that can’t. Derivatives are part of this, but they are not especially problematic. Indeed, as Kimberly Summe points out, Lehman’s derivatives have received a lot of unnecessary and unwarranted stigma. The unpalateable truth is that it was real estate lending and bonds that broke Lehman, combined with liquidity risk, not swaps.

So far, we have noted that derivatives are not unusual in creating court cases, and that most close outs are simple and effective. But there is an issue that remains: how can it be that reasonable people differ on what the close out amount on a derivatives portfolio is? The answer is that while bankruptcy law usually has a simple idea of what you can claim, determining that amount is not straightforward. Thus for instance in UK law, broadly, if I suffer a loss of £10 because of your bankrupcty, I have a claim of £10 against the estate of the bankrupt. The obvious example is that I have lent the tenner to the bankrupt. But with a derivatives portfolio, what have I lost? Clearly it depends on how much it costs me to close out the risk. I can’t – especially if I want to look good in front of the judge – just use my own valuation: I have to actually go into the market and close out the risk, then add up the cost of doing that. And what I do has to be ‘commercially reasonable’. Thus for instance getting separate bids on the equity, credit and commodity derivatives sub-portfolios might well be commercially reasonable, but doing separate trades on every derivative rather than offering a portfolio of mostly offsetting instruments to the market probably isn’t. (This is a point which Das gets wrong and which lies at the heart of the Nomura vs. Lehman case.)

The problem at the heart of close out, then, is figuring out what value a bank has been deprived of when one of their derivatives counterparties fails. This is often simple, but for a large multi-asset portfolio, it can be both complicated and sufficiently uncertain that it is worth going to court about. The real story isn’t that there is a problem with netting: it is that the valuation of big portfolios of financial instruments is difficult, especially when you have to do it in a crisis.

Posted in: Derivatives, Hedging and Convexity, Fair Value, Legal Risk and Trade Documentation by David /
3 Comments

There may perhaps be a post or two more this year – or there might not. In any event, though, I wanted to wish my readers cordial greetings for the season. Thank you for your attention. I’ll leave you for now with a snowy scene:

Posted in: Photography by David /
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The consequences of Cameron’s ‘diplomacy’ are becoming clearer. Bloomberg reports:

European Union officials may abandon U.K.-backed safeguards on derivatives legislation, four people familiar with the situation said, a week after Prime Minister David Cameron’s demands to protect London’s financial industry almost wrecked an EU summit.

Ambassadors for the EU’s 27 nations, meeting yesterday in Brussels, discussed weakening an October agreement to grant national regulators powers over clearinghouses, according to the people, who couldn’t be identified because the talks are private. The British government has argued that the accord was essential to protect U.K.-based clearing firms from pressure to move part of their business to the euro area.

The possible unravelling of the derivatives deal follows Cameron’s decision to break ranks with French President Nicolas Sarkozy and German Chancellor Angela Merkel at an EU summit last week.

Ooops.

Posted in: Euro, Politics by David /
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Mark Carney is not a shill: he gives it to us straight. Sadly, what he says is pretty depressing:

The market cannot be solely relied upon to discipline leverage.

It is not just the stock of debt that matters, but rather, who holds it. Heavy reliance on cross-border flows, particularly when they fund consumption, usually proves unsustainable.

As a consequence of these errors, advanced economies are entering a prolonged period of deleveraging.

Central bank policy should be guided by a symmetric commitment to the inflation target. Central banks can only bridge real adjustments; they can’t make the adjustments themselves.

Rebalancing global growth is the best option to smooth deleveraging, but its prospects seem distant.

Like Carney (and the IMF), I am pretty negative about the prospects for advanced economies in 2012. Still, at least we have Christmas before we have to worry about that, and you can always go long vol at a relatively attractive level.

Best wishes all.

Posted in: Economic Theory by David /
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A pot pourri today:

• IFR has an interesting article on the Seat Pagine credit event. My guess, having no particular private knowledge of the situation, is that the release of the hitherto private loan agreement between SEAT and the SPV may have been intended to satisfy the ‘public information’ requirement of the credit event definitions.
• FT alphaville has a nice summary from Lewis Alexander, Nomura’s chief US economist, on how Dodd Frank has reduced the powers US regulators have to intervene in financial institutions. The bottom line is that while the reforms (combined with Basel III and the SIFI requirements) do in some ways make US banks more robust, the FED/FDIC/OCC complex now has less ability to help individual firms.
• A provocative but perhaps amusing quote from Philip Pilkington: “Austrian economics provided a metaphysical-theological basis for what is today called ‘libertarianism’ – a popular, dogmatic political cult in the vein of Marxism-Leninism.”
• Bloomberg has a story about some damning testimony from CME chairman Terrence Duffy to the U.S. Senate about Corzine’s knowledge of (presumably illegal) transfers of funds from customer accounts. That’s not what interests me, though, juicy though it is. Rather I want to highlight how the story describes the CME chairman’s role:
  

  Duffy, whose company is MF Global’s regulator and principal exchange

  That’s right. The CME is both a shareholder owned for profit firm which makes money if its members trade more, and the regulator of those members. Gosh, isn’t it amazing something went wrong?

Update. In an exclusive (well, only shared with 594,861 youtube viewers), we have Duffy’s actual statement. Probably.

(I particularly like the line ‘my morals got me on my knees I’m begging please stop that rehypothecation’…)

Posted in: CDS and Negative Basis, Clearing and Collateral, Legal Risk and Trade Documentation, Regulation by David /
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Today I want to look at another aspect of the RBS failure: regulatory change since the crisis, and how it measures up given what we know about RBS. As before, the FSA report into the failure of RBS will provide our material.

The causes of losses at RBS

What caused big losses at RBS? At the grossest possible level, 3 things, in order of significance:

1. Bad Loans
2. Buying ABN
3. Bad Trading Book assets

As FSA says:

“Between 2007 and 2010, RBS made net accounting losses of £30.7bn. This reflected £50.0bn of income net of tax and other expenses, offset by three main categories of loss.

• Losses of £32.5bn on loans and advances in RBS’s banking book, across a wide range of sectors and geographies…
• Goodwill write-offs of £30.5bn, of which £22.0bn resulted from the acquisition of ABN AMRO…
• £17.7bn on credit trading, arising from assets acquired both as a result of organic growth and as part of the ABN AMRO acquisition.”

(Page 120)

Just to ram the point home, here is a summary of RBS’s losses due to impairment charges in its banking book:

Regulatory change

FSA acknowledges that it has to do more about big strategic acquisitions like RBS buying ABN:

“Supervision has since modified its current approach to acquisitions to ensure that it is considerably more intrusive and challenging in its handling of major takeovers… The Review Team recommends that the FSA formalise its more intensive approach to major corporate transactions involving high impact regulated firms, by producing guidelines.” (Page 187)

Big changes have already happened in the capital regime for the trading book, and more are planned:

“A fundamental review of the market risk capital regime (including reliance on VaR measures) was required. This was recommended by the Turner Review, and is being undertaken by the Basel Committee. In the meantime, the Basel Committee has agreed a package of measures, including stressed VaR and enhancements to the capture of credit risk within the trading book, which is being implemented in the European Union.” (Page 93)

(If you are connoisseur of this kind of thing, you will recognise that ‘in the European Union’ as a dig at the FED.)

So, to summarise, FSA thinks that the pre-crisis regime for the causes of the second and third largest category of losses at RBS should be improved. What about the top cause? What about loans in the banking book? After all, both corporate property lending and corporate other (primarily ordinary corporate loans and loan committments) both caused bigger losses than all the trading book put together. Where’s the acknowledgement that the Basel II regime for the banking book was inadequate?

The closest we get is this:

“But it is now clear that the Basel II capital regime, introduced on the eve of the financial crisis, failed entirely to identify and address the issue of inadequate overall capital resources. As a result, the devotion of significant FSA resources to Basel II implementation failed to make any significant contribution to making RBS or any other major bank more robust in the face of the financial crisis.” (Page 270)

Now of course Basel III and the associated G-SIFI reforms have increased the total capital requirement for a bank like RBS from a 2% common equity tier 1 ratio to 9.5% or more. There are the liquidity reforms too: these represent potentially the most significant and most overdue changes in bank regulation in three decades. But still, I think a much more explicit acknowledgement that the Basel II regime for the banking book was inadequate is required. The trading book gets a lot of regulatory attention, yet it actually wasn’t the cause of the biggest issues at many banks including RBS. At least the FSA report gives us some data here. Doing something about the Basel II banking book capital regime, though, is another matter.

Update. Lest you think that RBS had an unusually poor loan book, here is how it compares to its peers:

The easy fix would be to increase the default correlations in the Basel II IRB formula, then recalibrate the common equity tier 1 ratio so that the changes are broadly neutral across the financial system. That would advantage large diversified banks less versus smaller, less systemic rivals, something that is surely systemically advantageous.

Posted in: Basel, Credit, Regulation by David /
2 Comments

I’m reading the FSA report into the RBS failure (so you don’t have to, and because I griped about it not yet being out last week, so I can’t really ignore it). I’ll post in coming days on various aspects of this long and juicy document, but for now let me concentrate on what I think is clearly the mechanism by which RBS failed: a solvency/liquidity spiral.

First, some quotes from the report.

RBS did not have a solvency problem.

“Many accounts of the events refer to RBS’s record £40.7bn operating loss for the calendar year 2008. But that loss is not in itself an adequate explanation of failure. Most of it indeed had no impact on standard regulatory measures of solvency:

• Of the £40.7bn loss, £32.6bn was a write-down of intangible assets, with impairment of goodwill contributing £30.1bn. Such a write-down signals to shareholders that past acquisitions will not deliver future anticipated value. But in itself, it had no impact on total or tier 1 capital resources, from which goodwill had already been deducted.
• In fact ‘only’ £8.1bn of the £40.7bn (pre-tax) operating loss resulted in a reduction in standard regulatory capital measures.

Given that RBS’s stated total regulatory capital resources had been £68bn at end-2007, and that it raised £12bn in new equity capital in June 2008 (when the rights issue announced in April 2008 was completed), an £8bn loss should have been absorbable.” (Page 38)

RBS had a liquidity problem…

“The immediate driver of RBS’s failure was … a liquidity run (affecting both RBS and many other banks)… it was the unwillingness of wholesale money market providers (e.g. other banks, other financial institutions and major corporates) to meet RBS’s funding needs, as well as to a lesser extent retail depositors, that left it reliant on Bank of England ELA after 7 October 2008.” (Page 43)

“The vulnerabilities created by RBS’s reliance on short-term wholesale funding and by the system-wide deficiencies were moreover exacerbated by the ABN AMRO acquisition” (Page 46)

… which was driven by concerns about its potential insolvency

“Potential insolvency concerns (relating both to RBS and other banks) drove that run.” (Page 43)

In other words, people were not sure RBS was solvent (even though it was)

“In the febrile conditions of autumn 2008, however, uncertainties about the asset quality of major banks and the potential for future losses played an important role in undermining confidence.” (Page 126)

“The inherent complexity of RBS’s financial reporting from end-2007, following the acquisition of ABN AMRO via a complicated consortium structure, also affected market participants’ view of RBS’s exposures.”

“It is clear that RBS’s involvement in certain asset classes (such as structured credit and commercial real estate) left it vulnerable to a loss of market confidence as concerns about the potential for losses on those assets spread.” (Page 135)

A significant factor in this was that RBS was seen to be too optimistic about what its assets were worth

“Deloitte, as RBS’s statutory auditor, included in its Audit Summary report to the Group Audit Committee a range of some £686m to £941m of additional mark-to-market losses that could be required on the CDO positions as at end-2007, depending on the valuation approach adopted… a revision of £188m was made to the valuation of these positions and was treated as a pre-acquisition [i.e. pre-ABN acquisition] adjustment. No other adjustment was made.

Deloitte advised the Group Audit Committee in February 2008 that an additional minimum write-down of £200m was required to bring the valuations of super senior CDOs to within the acceptable range calculated by Deloitte… The Board agreed that additional disclosures should be made in the annual report and accounts, but supported the view of RBS’s management that no adjustment should be made to the valuation.” (Page 150)

“those exposures [i.e. CDO positions] became a focus of concerns by market participants and thus played a significant role in undermining confidence in institutions active in these areas… RBS’s relatively high valuations of super senior CDOs were scrutinised by market comment in early 2008, and there was concern among market participants that further write-downs would be needed, at a time when RBS’s low core capital ratio was already a source of market comment.” (Page 151)

To conclude then

Liquidity risk and opaque/inadequate disclosures, which give rise to concerns about possible insolvency, are enough to doom a bank even if it actually remains solvent.

There will (I know, I know) be more on this tomorrow.

Posted in: Accounting, Liquidity and liquidity risk, Mother of all Bailouts, Reputational Risk by David /
9 Comments

#Higgsmas. (The seminar starts in half an hour: see here for a liveblog, or here for even more tweets.)

Update. And the answer is… Santa may have brought us a Higgs at around 125GeV, but we won’t know for sure for a year or more.

Posted in: Mathematics and Science by David /
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First, is the agreement the 26 have reached a good one? I tend to agree with Foreign Policy on this one:

Merkel’s short-sighted, audaciously Germany-first reaction to staunch the eurocrisis is the Germanization of European monetary and fiscal policy, foremost the codification of its obsession with tight money, fiscal purity, and budgetary orthodoxy. In spite of all evidence to the contrary, she insists that what’s good for Germany is good for everybody else, too. It’s clearly not. And with the world’s leaders begging her to do “whatever it takes” to stave off global calamity, she’s doing it with Sarkozy at her side and over the heads of the now completely irrelevant European “voters” (“subjects” is the more fitting word). This is a catastrophic mistake, which, politically, vastly expands the EU’s centralized authority while robbing it of even the fig leaf of democratic legitimacy it had sported. Moreover, the economics of Berlin’s Germanocentric prescriptions for the eurozone compound the very problems that landed Europe’s weaker economies in the mess they’re in right now.

In other words, it is politically dangerous – because it has no democratic legitimacy – and it probably won’t work in the long run (and maybe even the short run).

Second, what really caused Cameron to use his veto? The Economist has a lot more evidence here than we had on Friday morning.

By a certain point on Thursday night, I am told, a majority of countries were growing interested in a quick and dirty legal fix, suggested by the president of the European Council, Herman Van Rompuy. The fix was dreamed up by lawyers working for Mr Van Rompuy. They said that a legal device, known as “Protocol 12″, would allow the 27 leaders of the EU to agree most of the new rules and mechanisms for fiscal union in the euro zone by a simple, unanimous decision among themselves.

Suddenly, Germany looked isolated. Mr Van Rompuy, a former Belgian prime minister elected by EU leaders to chair their summits, decided to see if he could sweeten the deal for the wavering EU leaders, and asked Mr Cameron if he would consider dropping some of his requests. This made sense to some leaders in the room. Mr Cameron’s demands were already more than many of his colleagues would tolerate, and Britain had already said publicly it would tailor its demands to the scale of the treaty change on the table. Mr Cameron said he would not lower his ambitions, and that his demands would be the same in the event of Protocol 12 being used, or a full-blown EU treaty.

A hostile view of this is that Mr Cameron overplayed his hand. In this version of events, the British prime minister thought the mood of the room was running towards Protocol 12, and because Protocol 12 is decided by unanimity, he thought he had the whip hand.

Instead, my source tells me, the room turned on Mr Cameron. This, I am told, “was the point at which the Protocol 12 route, which requires unanimity, was effectively closed down and one country after another accepted a new treaty at 17+.”

Did Mr Cameron miscalculate? Did he want to end up with a treaty being crafted at almost 26, with Britain on the outside? My source is certain that was not Mr Cameron’s goal, and my source is not alone in this thinking.

It is now almost inevitable that separate structures be set up, with Britain on the outside, it seems. Talk in London of preventing the “Eurozone-plus” from using the Court of Justice is also a mistake, I am told. Article 273 of the treaty allows just this.

You can choose to believe this account or not. It comes from a single source, who is well-placed but clearly viewing this from a particular perspective.

Time will tell. But what a mess.

What Britain wanted was a return to inanimity for votes on certain issues in financial regulation; that was Cameron’s price for agreeing to Protocol 12. Clearly he overplayed his hand. The more you read about it, though, the more extraordinary it seems that a compromise could not be reached. Perhaps Cameron didn’t want an agreement in order to appease his backbenchers. (I typed ‘bankbenchers’ the first time I wrote that sentence, a telling error.) Perhaps the French waited for Cameron to go too far then shot down his balloon. In any case, the outcome – both in terms of what has been agreed and where it leaves Britain – is depressing and unsatisfactory.

One key point – a point I didn’t get on Friday – is that Cameron wasn’t trying to stop Sarkozy from doing something: he was trying to get agreement to change the voting system for financial regulation. He didn’t succeed. In other words, he annoyed the 17 (or more) and got precisely no gain for Britain. This, I suspect, is why Clegg changed his tune over the weekend. In any event, Cameron looks more incompetant now that the facts are clearer.

(Further, insightful comment on how well the pact will work can be found here, while this post has an interesting discussion of Cameron’s behaviour and its consequences.)

Posted in: Euro, Politics by David /
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Two of the greatest painters of the last few decades have shows within a mile of each other in London. Gerhard Richter is at Tate Modern until 8th January, while Anselm Kiefer has just opened at White Cube Bermondsey. If you have a few hours free in London and you care at all about painting, you could do a lot worse than see these two fantastic shows.

Posted in: Art by David /
2 Comments

If I had to pick an unconventional member for the financial stability board, I would seriously consider an aircraft safety expert. Let me explain.

Civil engineers know about one kind of safety; the safety of bridges and such like. The crucial thing about a bridge for our purposes is that the elements of it don’t change their nature when you change the design. They might change their role – whether then are in compression or tension say – but their physical properties are constant.

Aircraft safety adds an element that civil engineers don’t have to worry about (much) – people. People react to the situation they find themselves in. They learn. Importantly, they form theories about how the world works and act upon them. Thus aircraft accidents are often as much about aircrew misunderstanding what the plane is telling them as about mechanical failure. The system being studied reacts to ‘safety’ enhancements because the system includes people, and hence those enhancements may introduce new, hard to spot error modes.

The report into the Air France 447 crash is an interesting example of this. See the (terrifying) account in Popular Mechanics here. As they say in their introduction to the AF447 Black Box recordings:

AF447 passed into clouds associated with a large system of thunderstorms, its speed sensors became iced over, and the autopilot disengaged. In the ensuing confusion, the pilots lost control of the airplane because they reacted incorrectly to the loss of instrumentation and then seemed unable to comprehend the nature of the problems they had caused. Neither weather nor malfunction doomed AF447, nor a complex chain of error, but a simple but persistent mistake on the part of one of the pilots

AF447 was, by the way, an Airbus 330, a plane packed to the ailerons with sophisticated safety systems. Not only didn’t they work, the plane crashed partly because of the way to pilots reacted to their presence.

Aircraft risk experts understand this kind of reflexive failure whereby what went wrong wasn’t the plane or the pilot but rather a damaging series of behaviors caused by the pilot’s incomplete understanding of what the plane was and wasn’t doing. This is often exactly the type of behaviour that leads to financial disasters. Think for instance of Corzine’s incomplete understanding of the risk of the MF Global repo position.

Another thing aircraft safety can teach us is the importance of an open, honest post mortem. Despite the embarrassment caused, black box recordings are widely available, at least for civil air disasters. (The military is less forthcoming, although things often leak out eventually – see for instance here for a fascinating account of the Vincennes disaster.) In contrast, we still don’t have FSA’s report on RBS, let alone a good account of what happened at, to pick a distressed bank more or less at random, Dexia. UBS is a beacon of clarity in an otherwise murky world.

It is hard to learn from mistakes if you don’t know many of the bad things that happened and what the people who did them believed at the time. Finance, like air safety, is epistemic: to understand it, you have to know something about what people believe to be true, as that will give some insight into how they will behave in a crisis.

The more I think about this, the more I think risk managers in other disciplines have to teach us financial risk folks.

Posted in: Complexity, Engineering, Operational Risk and Rogue Trader, Rules, Worst case scenarios by David /
7 Comments

Oh dear me. This is very hard. I dislike David Cameron and most things he stands for. I think Britain’s future is in Europe, and I was (wrongly) in favour of the UK joining the Eurozone – so I’m not exactly a Europhobe. But much to my distaste, I have to admit that Cameron might – might – have done the right thing in Brussels last night. Now clearly it wasn’t diplomatic, and the veto might have been better wielded later in the process. But if this list of Cameron’s demands (from the Guardian) is correct, then they are pretty reasonable:

• Any transfer of power from a national regulator to an EU regulator on financial services would be subject to a veto.
• Banks should face a higher capital requirement.
• The European Banking Authority should remain in London. There were suggestions that it might be consolidated in the European Security and Markets Authority in Paris.
• The European Central Bank be rebuffed in its attempts to rule that euro-denominated transactions take place within the eurozone.

It seems to me that Sarkozy tried to impose policies which would have moved a lot of financial activity from London to Paris or Frankfurt, and Cameron wouldn’t let him. So yes, this veto represents a tragedy in terms of Britain’s influence in Europe and it is to be hugely regretted on those grounds, but David might actually have had reason for what he did.

Update. So why were these issues so important?

Well, financial services are (rightly or wrongly) hugely important to the UK economy. So Cameron wants to make sure that UK bank regulation, and indeed regulation of foreign bank subsidiaries operating in the UK, remains under UK control. In particular I would guess he doesn’t want a Paris-based EBA to set capital ratios for UK Banks. This cuts both ways; EBA requirements might be either too high or too low from a UK perspective. Also of course it is important for the UK to be able to impose the Vickers Commission requirements without having to ask for permission from Brussels.

The final point is in many ways the most interesting. It is very much against the UK national interest for there to be a requirement to clear Euro denominated derivatives in the Eurozone – as London is a (in fact, currently the only) credible alternative. So Cameron wanted to make sure that this was not forced upon him.

If Sarkozy thought that he could impose these changes on Cameron by force of will, he sorely mis-read his man (and his man’s backbenchers, it must be said). It would have been an enormous miscalculation to use something as important as this summit to try to grab financial services business away from London.

Posted in: Euro, Politics, Regulation by David /
6 Comments

I am tempted to go after the MF Global rehypo story, but FT Alphaville and Reuters have done it well between them (albeit that the Reuters story is a little histrionic), so let me turn to the ECB, as promised, instead.

Specifically I want to look at some choices in central bank repo operations, and what their consequences are. This will be quick and dirty.

Difficult, isn’t it?

Posted in: Clearing and Collateral, Liquidity and liquidity risk by David /
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The highlights, from the ECB:

• To conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months. [3 years. Jeepers, 3 years!] and the option of early repayment after one year.
• To discontinue for the time being, as of the maintenance period starting on 14 December 2011, the fine-tuning operations carried out on the last day of each maintenance period.
• To reduce the reserve ratio, which is currently 2%, to 1% as of the reserve maintenance period starting on 18 January 2012. As a consequence of the full allotment policy applied in the ECB’s main refinancing operations and the way banks are using this option, the system of reserve requirements is not needed to the same extent as under normal circumstances to steer money market conditions.
• To increase collateral availability by (i) reducing the rating threshold for certain asset-backed securities (ABS) [so that basically any obligation up to and including dry cleaning receipts will be eligible collateral at the ECB] and (ii) allowing national central banks (NCBs), as a temporary solution, to accept as collateral additional performing credit claims (i.e. bank loans) that satisfy specific eligibility criteria. These two measures will take effect as soon as the relevant legal acts have been published.

I’ll give some comment tomorrow. Meanwhile though Reuters sets the tone: European shares fall on Draghi comments.

Posted in: Euro, Liquidity and liquidity risk by David /
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I don’t know, but I think it is an interesting question. These musing follow from a conversation I had with a man who knows a lot more than I do earlier in the week.

Consider:

• “The rich getting richer while the poor keep getting poorer. This effect in America saw people produce more for less wages. Since 1973 in the US, median family income rose by just 0.6% a year, falling far behind their output per hour, which jumped 2.6% annually. In the quarter of the century before that, ordinary households saw pay packets rise 2.8% a year, “rising lockstep” with their productivity.” (From the Guardian, in a piece about Jared Bernstein.)
• “The gap between rich and poor in OECD countries has reached its highest level for over over 30 years, and governments must act quickly to tackle inequality,” according to a new OECD report.

  Divided We Stand: Why Inequality Keeps Rising “finds that the average income of the richest 10% is now about nine times that of the poorest 10 % across the OECD.”

• Social mobility is falling as inequality is rising. As Obama said yesterday: “over the last few decades, the rungs on the ladder of opportunity have grown farther and farther apart, and the middle class has shrunk. You know, a few years after World War II, a child who was born into poverty had a slightly better than 50-50 chance of becoming middle class as an adult. By 1980, that chance had fallen to around 40%. And if the trend of rising inequality over the last few decades continues, it’s estimated that a child born today will only have a one-in-three chance of making it to the middle class – 33%.”

Now, regardless of what you think the answer to this is – even regardless of whether you think it needs an answer – this set of facts has political consequences. The Occupy movement and its slowly forming demands are one early result, but I suggest that it is possible that this is the tip of the iceberg. A state of affairs that cannot continue, won’t. Enough people – enough people with votes – are unhappy enough with the fact that their real income is falling while the 1% are making out like bandits that they will do something about it. And if voting doesn’t work, then maybe rioting will. It certainly might feel like a chance to get even.

I’m not saying this is justifiable. I’m not saying it would be a good thing. But I am saying that these economic facts have political consequences and if they are not managed, there is the possibility that things might get really ugly.

We are approaching the Europroblem in a dangerous way. Disenfranchisement is the flipside of technocracy: sure, if all those wise men really do fix the problems, then the rich can go back to crashing their Ferraris in peace. But if it doesn’t, then either we are going to need solutions with democractic legitimacy, or it will be a really good time to invest in companies that make riot shields.

Posted in: Politics by David /
2 Comments

Here’s the simpleton version: FT alphaville has the upmarket version.

Q. What happens when Eurozone banks can’t borrow easily in dollars?

A. You can make a lot of money from lending them dollars.

Q. How do you protect yourself against the credit risk?

A. Take collateral.

Q. What’s the safest collateral in Euros?

A. Bunds, probably.

Q. What happens to the markets if lots of people do this trade?

A. Bund repo spreads go to zero, the EUR/USD basis goes down to (or even below) Euribor rates.

Q. What happens when central banks pour lots of dollars into the Eurosystem?

A. The implied USD/EUR rate (i.e. the rate for borrowing USD against EUR collateral) kicks back up above zero. The Bund GC rate goes up too.

Posted in: Markets by David /
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Breaking news from Bloomberg:

Regulators may diminish the central role of government bonds in planned banking rules designed to make the financial system safer.

The Basel Committee on Banking Supervision, which coordinates regulations for 27 countries, may let banks use equities and more corporate debt, in addition to cash and sovereign bonds, to satisfy new short-term liquidity standards, said two people with direct knowledge of the plans who requested anonymity because the talks are private.

Posted in: Basel, Liquidity and liquidity risk by David /
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FT alphaville, in another great post, point out this interesting chart from the Credit Suisse 2012 Global Outlook:

We have riffed on collateral shortages and the macroprudential importance of managing them before: see here, here, here and here. This not just a future (post Basel 3, post mandatory clearing issue): it is also causing serious funding problems right now. As the FT says:

…the decline in safe assets has come at a time when investor demand for these assets has only climbed for them and as the deep freeze in European unsecured lending has meant a big shift towards collateralised lending. Hence the widening discrepancy in repo prices for different types of collateral (also noted by Draghi) and, in particular, the negative spread between Libor and the secured repo rate, on which Izzy superbly elaborates. For all but the strongest banks, i.e. those with surplus cash reserves, the ECB is increasingly the only shop still open.

One thing worth pointing out in this context is the huge price benefit it gives to those sovereigns that are still in the ‘safe’ club. Large demand and declining supply means higher prices, so we can expect a further disconnect between ‘the price of sovereign credit risk’ and ‘the price of government bonds’ for the US, UK and Germany. (I wouldn’t put any of those in the ‘completely safe’ category, but that is by-the-bye.) JGBs are likely beneficiaries too. At least that means that financing the deficit, for now, isn’t a problem for these countries. That’s good, right? One couldn’t imagine this advantage being used to defer difficult decisions could one?

Posted in: Clearing and Collateral, Liquidity and liquidity risk by David /
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From Nick Hanauer writing in Bloomberg view:

When businesspeople take credit for creating jobs, it is like squirrels taking credit for creating evolution…

So let’s give a break to the true job creators. Let’s tax the rich like we once did and use that money to spur growth by putting purchasing power back in the hands of the middle class. And let’s remember that capitalists without customers are out of business.

Posted in: Taxation by David /
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The most recent Bank of England financial stability review has an interesting discussion of the declining confidence in regulatory capital. (FT alphaville comments on the same section are here.)

The Bank’s take is quite measured:

The regulatory capital framework is complex and implementation of internationally agreed rules varies across jurisdictions. The move to Basel II added to this complexity. It aimed to increase the risk-sensitivity of the capital framework through the use of internal models. In doing so, it also introduced a new source of variation in regulatory capital ratios: differences in banks’ own estimates of RWAs.

Some degree of variation in banks’ models can contribute to financial stability. Banks with different beliefs may react differently to new information and the banking system as a whole will be less susceptible to the failure of a single risk model. Observed variation in RWAs also does not necessarily relate to the use of internal models. For example, it could also reflect differences in business models, accounting standards or the implementation of international regulatory requirements.

But market participants have increasingly raised concerns over the degree of variation in average risk weights both across banks (Chart 3.16) and through time (Chart 3.17).

Investors are often unable to compare reported capital adequacy ratios across banks meaningfully and have expressed doubts over the extent to which RWAs accurately reflect the risk of different banks’ portfolios… effectiveness of market discipline in good times. And, in times of stress, it could increase uncertainty over counterparty solvency, contributing to funding strains.

This is an interesing problem for regulators. On the one hand, they want regulatory capital requirements to reflect risk. Necessarily that requires models. But models are complicated and hard to verify – especially when you have to verify all the inputs. So they can be questionable. And the last thing you need in a crisis is questions about whether capital is adequate.

For me, the leverage ratio backstop in Basel III should help here. At least it means that there is something stopping arbitrary amounts of RWA mitigation. But beyond that, some level of inter-bank benchmarking to stop the most egregious excesses of PD understatement would be a good ideas. This should be coordinated at the Basel level, and the results published. If there is a problem with some banks understating capital, then Basel should name and shame. If there isn’t, crowing about it will help to restore confidence.

Posted in: Basel by David /
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Let me explain. First, some news from Mayan archaeology:

The end is not quite nigh. At least that is the conclusion of a German expert who says his decoding of a Mayan tablet with a reference to a 2012 date denotes a transition to a new era and not a possible end of the world as others have read it.

The interpretation of the hieroglyphs by Sven Gronemeyer of La Trobe University in Australia was presented for the first time on Wednesday at the archaeological site of Palenque in southern Mexico.

Gronemeyer has been studying the stone tablet, which was found years ago at the archaeological site of Tortuguero in Mexico’s Gulf coast state of Tabasco.

He said the inscription described the return of the mysterious Mayan god Bolon Yokte.

Now, turning to the Eurozone, we have Angela Merkel’s comments yesterday:

Angela Merkel has vowed to create a “fiscal union” across the eurozone with wide-ranging powers to avert catastrophe, saying the process was already under way as part of the “marathon” effort to solve the European debt crisis.

The German chancellor said she was determined to push for treaty changes at next week’s EU summit.

It’s all pretty clear. The new Eurozone will begin in 2012 and, as per the prophecy, it will be a God amongst currency zones, with one bank to rule them all. Now I admit that ‘Bolon Yokte’ is not quite as catchy as the ‘Neues Eurozone’, but it could catch on…

Posted in: Euro, Fun by David /
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It nows seems that there is some clarity on exactly how much customer money MF Global pillaged. The FT reported a few days ago:

The estimated hole in MF Global’s customer accounts has doubled in size to $1.2bn, astonishing traders as the investigation into the broker’s failure enters its fourth week.

The new figure, from the bankruptcy trustee for MF Global’s US brokerage, is equivalent to almost a quarter of the $5.45bn in client funds that the company was required to hold separately from its own funds.

The Gary and Mary show isn’t exactly reassuring here. The FT again:

… the law does allow futures brokers to conduct internal “repurchase” operations, swapping out customer cash for collateral. Gary Gensler, chairman of the Commodity Futures Trading Commission, told a congressional hearing that such transactions should be banned. “I think we need to tighten that up,” he told the Senate agriculture committee on Thursday.

Mary Schapiro, chairman of the Securities and Exchange Commission, said her agency was reviewing whether there needed to be “more disclosure” of the “repurchase to maturity” agreements that MF Global used to place a $6.3bn bet on eurozone debt.

More disclosure? Oh well that will fix it. How about not letting them do it in the first place Mary? Between you and Gary, someone should be checking that the funds that are meant to be segregated, are. Reuters has an interesting paragraph here:

MF Global had nearly a half dozen regulators, including the CFTC, the SEC, the Chicago Mercantile Exchange (CME.O), the Chicago Board Options Exchange, and the Financial Industry Regulatory Authority, policing various parts of the firm. However, there was no one clear watchdog responsible for the whole company.

In other words, there were far too many regulators and, it seems, given the missing 1.2 yards, not nearly enough actual regulation. One pertinent question congress might ask Gary and Mary is ‘When did you last do a review of client segregation at MF Global, what were its results, and what actions were taken to address the issues raised?’

Posted in: Clearing and Collateral by David /
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From Mario Draghi’s speech today:

Dysfunctional government bond markets in several euro area countries hamper the single monetary policy because the way this policy is transmitted to the real economy depends also on the conditions of the bond markets in the various countries. An impaired transmission mechanism for monetary policy has a damaging impact on the availability and price of credit to firms and households.

It is worth spending a moment on why this is true. First and most obviously, falling bond prices causes losses at banks which threaten their solvency – or at least the perception of their solvency. This in turn makes it difficult for them to lend, not least because it is difficult for them to borrow.

There are more subtle and possibly just as significant other mechanisms at work too though. As bond prices decline, repo haircuts increase, and that creates funding stress too. Banks are pushed to fund more at the central bank as less collateral becomes acceptable in the private markets.

Confidence bites too as banks delever so that they can claim to be relatively well capitalized. An arms race of competitive deleveraging can even set in. This is particularly toxic as it further impairs the monetary transmission mechanism: central bank money doesn’t go into increased lending, but rather into reducing private funding.

Liquidity alone is not enough in these circumstances: capital is needed too. That, I fear, will be one of the next steps in the unfolding saga of central bank intervention.

Update. In that context, Bloomberg’s account of the new EU rules on state support for banks is worth reading.

Separately, Bloomberg also reports remarks made by Mervin King today about yesterday’s intervention:

“This is not a solution,” King said at a press conference in London to present the Financial Stability Report. “All this can be is to help with temporary relief for liquidity problems, but those problems are a result of solvency issues.”

Posted in: Liquidity and liquidity risk, Mother of all Bailouts by David /
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Q. Why is the British economy like Kate Middleton?

A. They have both been royally screwed by posh idiots.

(See the Guardian story here, or Krugman here.)

Posted in: Economic Theory, Politics by David /
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Forgive me, as this isn’t well thought out yet.

Here are the pieces. First, from FT alphaville, an account of flattening and lowering of European sovereign repo curves caused by the demand for the bonds as eligible collateral at the ECB. In other words, central bank repo is so important a source of funds for Eurobanks that it is driving repo rates negative.

Second, an oldie but a goodie, Gorton and Metrick’s paper on Regulating the Shadow Banking System. This makes a lot of good points, but for our purposes two will suffice:

• The importance of repo as the primary funding mechanism for the shadow banking system; and
• The lack of data on it.

Third, CGFS 45, and its echo of the importance of finding effective measures of liquidity, notably including conditions in the repo market.

Fourth, Singh’s recent paper on the velocity of collateral. Again there is a lot in here, of which three points are pertinent here:

• Many of the recent regulations have focused on building equity and reducing leverage at large banks.
• The decline in the overall availability of collateral is sizable and roughly $4-5 trillion since pre-Lehman days (i.e., reduced ‘source’ collateral times velocity of collateral). Increase in M2 due to quantitative easing (QE) may not substitute for loss in financial collateral.
• The size (including the length of chains) of the nonbank funding relative to the size of securities lending, repo, and related markets provides a gauge to the potential dislocation that may result from the unwinding of such funding.

Fifth, via Singh, Borio and Disyatat’s paper on the explanatory power of the excess savings hypothesis in explaining the crisis. I don’t fully agree with this paper’s conclusions, but it does observe interestingly ‘current accounts and the corresponding net capital flows say very little about financing activity and intermediation patterns’. So what does? The authors make a reasonable (if not entirely convincing case) that the high but variable elasticity of the financial system caused by :

A useful concept to approach the question is that of “elasticity”. This is defined to be the degree to which the monetary and financial regimes constrain the credit creation process, and the availability of external funding more generally. Weak constraints imply a high elasticity. A high elasticity can facilitate expenditures and production, much like a rubber band that stretches easily. But by the same token it can also accommodate the build-up of financial imbalances, whenever economic agents are not perfectly informed and their incentives are not aligned with the public good (“externalities”). The band stretches too far, and at some point inevitably snaps. As argued in detail elsewhere, the recurrence of major financial crises with serious macroeconomic costs across countries of all types is a reflection of these deep-seated forces. That these crises have affected countries at various degrees of economic and financial development and have increased in frequency is a telling sign that the elasticity of the current international monetary and financial system may be too high.

So what we have is a market that is enormous, hard to measure, changing fast, and which plays a key role in facilitating bubbles – and crashes. It is going to take more than a blog post to pull this together…

Posted in: Clearing and Collateral, Liquidity and liquidity risk by David /
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Due to the planned strikes on the 30th November, my talk at LSE has been postponed. Up the workers!

While the strike is about public sector pensions, it is perhaps worth examining while we are talking about political unrest the related topic of the Occupy London demands. It is striking how reasonable they are:

• We must abolish tax havens and complex tax avoidance schemes, and ensure corporations pay tax that accurately reflects their real profits.
• Legislation to ensure full and public transparency of all corporate lobbying activities must be put in place. This should be overseen by a credible and independent body, directly accountable to the people.
• Those directly involved in the decision-making process must be held personally liable for their role in the misdeeds of their corporations and duly charged for all criminal behaviour.

Posted in: Politics by David /
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The problem with collateral is that it often creates exposure. Let me explain.

Say you owe me $100 via some kind of contract, perhaps a derivative. You pledge $100 of cash against that exposure. We’re flat, right? Well yes, but if you gave me the money – collateral movement by title transfer – then I own it. If I default and it turns out that the close out amount on our contract is only $80 (perhaps because the market moved when I defaulted), then you have an unsecured claim of $20 even if netting works. Moreover, if you let me rehypothecate the collateral, I might have sent it on to someone else against some other exposure of mine. The money has left the building.

The only way around this is to let a third party we both trust to hold the collateral. Then I know I can get it if you fail, and you know you will get any excess collateral back if I default. Even better, there is no incentive for either of us to argue about a collateral call because we are worried about how the other party’s credit has deteriorated.

So who do we pick? The traditional answer is a tri-party repo bank, but there are not many of those, and they are all systemic. So that is a bad answer.

(Quiz question of the day: what are the custody assets of BNY Mellon? You get a prize for getting within the nearest $5 trillion. Yep, Bony has $23 trillion of other people’s assets, or 150% of US GDP. That is what we in the money trade call ‘quite big’.)

How about making the central bank the custodian? That might be a rather better answer. First, it is safer than using a tri-party repo bank. Second, having this central role would increase transparency for regulators about liquidity movements. Third, it would give them an important policy tool, by allowing them to control the rate paid on this collateral. This would be useful as a shadow banking system analogue to the custodian role central banks play for commercial bank reserves.

Posted in: Clearing and Collateral by David /
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This is still standing after seven hundred years; what of our constructions will be able to boast the same?

Posted in: Photography by David /
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FT alphaville recently talked to Richard Comotto, author of the International Capital Market Association’s repo survey. Comotto points out, quite properly:

• Investors are increasingly trying to protect themselves by demanding higher haircuts from counterparties, with the focus on the party receiving the collateral and offering the cash.
• This fails to account for the fact that there is still an exposure on the other side of the trade.
• What if the financier (sitting on the collateral) goes bankrupt? The over-collateralisation leaves the counterparty exposed on what is effectively an unsecured basis. They have volunteered collateral which is worth more than the loan, but may now never receive the assets back.
• The trend towards overcollateralisation will put more pressure on the collateral market which is already short of quality collateral.

All true and all interesting. The point about overcollateralization being an unsecured exposure is particularly noteworthy; this is often also true of initial margin at a CCP of course.

The last point leads me nicely to Australia, specifically to the problems they are having as there isn’t enough government debt to act as collateral. In response, the RBA is creating a committed liquidity facility or CLF. The basic idea is to meet banks’ need by allowing them to pledge non-qualifying collateral and get in exchange assets which will work for Basel III liquidity purposes. Eligible instruments include

..domestic issues by supranationals and other foreign governments, ADI [Authorized Deposit-taking Institution] issued debt securities and asset-backed securities, including residential mortgage-backed securities (RMBS).

However for the purposes of the CLF, the RBA will also allow banks to present certain related-party assets such as self-securitised RMBS.

The RBA, then, is meeting banks’ needs for quality collateral, albeit for a fee. Perhaps a more interesting question though is why there is this collateral squeeze. Basel III and clearing together, as we have said several times, are creating a huge demand for high quality collateral, and the systemic implications of this have not yet played out.

Postscript. Are you impressed that I resisted the urge to post a picture of a haircut?

Posted in: Clearing and Collateral, Derivatives, Hedging and Convexity by David /
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When is a sale not a sale? When the purchase price is financed by the seller. Bloomberg has a gotcha story on European bank deleveraging:

European banks, vowing to sell distressed assets as regulators tighten capital requirements, are lending money to buyers to get deals done.

Royal Bank of Scotland Group Plc may provide as much as 600 million pounds ($939 million) in debt to help Blackstone Group LP acquire part of a 1.4 billion-pound portfolio of commercial mortgages from the bank after the private-equity firm struggled to get outside funding, three people with knowledge of the transaction said. The deal, scheduled to close within weeks, follows Credit Suisse’s agreement to finance the sale of $2.8 billion of property loans…

I don’t think it is quite a bad as Bloomberg suggests, but certainly it reeks of desperation. One remembers Merrill’s close-to-forced sale to Loan Star in 2008 – although that was worse as the loan was non-recourse. Of course, this – like lending money to clients to post back as margin on derivatives – is a pure capital arbitrage. But when the capital rules for old fashioned lending are so generous, why not take advantage of them?

Posted in: Regulation by David /
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The usual (and so far as it goes correct) account of why procyclicality is bad goes like this: when times are bad, risk and capital requirements go up, causing banks to deleverage, and hence sell into falling markets exascerbating the falls. What this account fails to emphasise is why banks need to sell, i.e. why they bought too much in the good times.

In an interesting paper, Hyun Song Shin (HT Paul Krugman) studies that question. Using BIS data, he suggests

Banks and other financial intermediaries’ lending depends on their “balance sheet capacity”. Balance sheet capacity, in turn, depends on two things — the amount of bank capital and the degree of “permitted leverage” as implied by the credit risk of the bank’s portfolio and the amount of capital that the bank keeps to meet that credit risk. Bank lending expands to fill up any spare balance sheet capacity when measured risks are low. Since the balance sheet constraint binds all the time, lending expands in tranquil times in order that the risk constraint binds in spite of the low measured risks.

At one level this is obvious, but the paper is interesting first because it shows the mechanism in action using real cross border flows data, and second because it focuses on the importance of preventing excess leverage before it has built up, rather than on trying to address the deleverage mechanism.

(Thanks, by the way, to those commenters on my earlier post on global liquidity. I am still digesting CGFS 45, and will post something on it in due course.)

Posted in: Liquidity and liquidity risk, Regulation by David /
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Dear Reader

You have a hard decision to make regarding next Wednesday evening, the 30th November. You could go to a jovial gathering, perhaps one with free food and drink. You could return home to the bosom of your family. Or you could come and hear me talk about bank capital at the LSE. I know, I know, it is a tough one, but ultimately you know what the right call is.

Here are the details:

Time and date: POSTPONED
Location: TBA
Title: Post crisis Bank Regulation and the Rôle of Capital

I’ll post the presentation here after the talk.

Update. Due to the strikes scheduled for this day, the talk has been postponed.

Posted in: Regulation by David /
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An article on Bloomberg this morning is interesting more for the fact that it has been written – and that it appears on the Bloomberg front page – than for what it says. It is about Taunus, which is the holding company for Deutsche Bank’s US activities. Simon Johnson points out

it’s the U.S.’s eighth-largest bank holding company… with assets of just over $380 billion…

The latest figures … show Taunus with total equity capital of just $4.876 billion. This implies an eye-popping leverage ratio of around 78.

Now let’s just pause for a second. A Bloomberg commentator has bothered to look at the leverage, not of a bank, but of the US subsidiary of a large foreign bank. The fact that it isn’t particularly well capitalised has made the Bloomberg front page, and under ‘Top News’ rather than ‘View’ too. This would have been inconceivable a few years ago. Few people worried about the leverage of banks, let alone that of obscure subsidiaries. Deutsche was even viewed as basically German government credit by some.

I’m not saying Johnson is wrong to look at this. He may even have a point that Deutsche could be a vehicle for contagion; although I think he’d have a better point if he focussed on the French banks. But the outright nationalism of his position is worrying:

Why would the Federal Reserve and the new council of regulators known as the Financial Stability Oversight Council allow Deutsche Bank to operate in the U.S. with sky-high leverage — with its huge implied risk to the rest of the financial system? Presumably, in the past, U.S. authorities have taken the view that Deutsche Bank had a strong enough balance sheet worldwide that more capital could be provided to its American subsidiary, if needed…

Such a presumption now seems questionable, at best.

What Johnson is saying implictly is that governments should not trust each other’s bank inspections and capital regimes, as they have in the past, and instead should require foreign subsidiaries to be separately capitalised. If other countries adopt that approach, by the way, Citi, JPMorgan and BofA would be amongst the biggest losers. Moreover this approach would pretty quickly lead the way to the breakdown of the Basel consensus, and it would force banks to raise more capital simply to support foreign subsidiaries. As they can’t do this easily, they would instead contract off-shore activities, reducing lending.

Now all of this may be a desirable outcome eventually. But right now, it would be catastrophic. The last thing we need is the US banks holding a strike on lending to the Eurozone, or the big Eurobanks withdrawing from the US. Neither economy is strong enough to handle a shock like that.

This kind of regulatory nationalism, in other words, would be a modern day version of the Smoot Hawley act.

Posted in: Politics, Regulation by David /
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It wasn’t so long ago, you know, that the global financial system was not plunging towards ruin…

Posted in: Photography by David /
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We all know that VAR performed terribly in the crisis, and as a result lost credibility as a risk measure. But how badly?

BaFin’s annual report gives us a clue. It reports both the number of German banks with permission to use VAR models and the total number of backtest exceptions (see page 138).

In 2008 there were 15 German banks with VAR permission; in 2009, 14. Banks calculate 99% VAR so we would expect a trading loss bigger than VAR one day in a hundred or roughly 2.5 per year. With 14 institutions, then, we would expect to see a total of 14 x 2.5 = 35 exceptions. How many were actually reported to BaFin?

• In 2008, 120.
• In 2009, 14.

This is startlingly bad. It is also exactly what we would expect knowing the deficiencies of VAR. Models calibrated to the good times of 2005 and 2006 dramatically under-stated risk in 2008, leading to lots of exceptions. Similarly, those same models calibrated to the very volatile markets of 2008 over-state risk in 2009 when things were not (quite) as bad.

Given this powerful evidence, why does Basel 2.5 still require banks to use VAR (plus stressed VAR plus all the other stuff)? max(VAR, stressed VAR) would be a more robust and less procyclical risk measure.

Posted in: VAR by David /
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Jonathan Weil has an excellent Bloomberg post on Unicredit’s $10B goodwill writedown and the light it shines on bank accounting. First Weil points out

On average the shares of the 32 companies in the Euro Stoxx Banks Index trade for about 44 percent of book value

Unicredit was worse than average, trading at 28% of book. Why is that, Weil asks? Why does the market think that the banks are worth so much less than the accountants do?

About 12 billion euros, or 23 percent, of UniCredit’s equity consisted of deferred-tax assets. Basically, this number represents the money UniCredit believes it will save on taxes in the future, assuming it will be profitable. Trouble is, in a crisis, those assets are pretty much useless.

On top of that, UniCredit’s balance sheet still showed 11.5 billion euros of the intangible asset known as goodwill, even after the bank wrote this down by 8.7 billion euros [$10B] last quarter. Goodwill isn’t a salable asset. It’s the ledger entry a company records when it pays a premium price to buy another. The asset exists only on paper…

Add up the goodwill and deferred taxes, and that’s 23.5 billion euros of junk assets right there, which is more than the company’s market capitalization.

In other words, book value has little value to investors as it includes things that they don’t think, well, have any value. Goodwill, like loan loss provisions, is a large and easily manipulated accounting entry that can have a huge impact on a bank’s book value, particularly a bank that has been on an acquisition spree like Unicredit (or Credit Agricole or Santander or JPMorgan or…) Because it is impossible to know what the right number for goodwill is, prudent investors assume that it is zero.

This disconnect between official accounts and what investors believe about banks is to the discredit of accounting standards setters. As with the fair value option on own liabilities, as with netting, they have created their own world which is far from the needs of the readers of financial statements.

Posted in: Accounting by David /
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The conceptual consultative paper on the fundamental review of the trading book has been delayed. It is now expected ‘after the TBG’s March 2012 meeting’.

Posted in: Basel by David /
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I am out of town so this will be brief, but there are a lot of good things around today:

• Zoltan Pozsar has a nice paper on VoxEU, ‘Can shadow banking be addressed without the balance sheet of the sovereign?’. One of his main points, which we have made before, is that the demand for safe assets was an important contributor towards the crisis. As he says, Seeing the shadow banking system from the perspective of the safe asset demands of institutional cash investors is crucial for drafting the right policies for shadow banking.
• A lovely piece from FT alphaville on the interaction between CVA hedging and sovereign CDS. Amusingly, they use data from the EBA stress tests to show how big this problem is for European banks.
• Another good piece from Alphaville (these guys are on fire this week) about the impact of the IRC on European sovereign bond prices. They kindly refer back to an old point of mine about the IRC creating pressure to move bonds to the banking book, as ask
  

  All the other factors now driving the crisis speak against holding sovereign debt in banking books as well, increasingly. No?

  They are of course right about that. But if the TB/BB boundary is flexible, in other words you can just move sovereign bonds that you had in the TB into the BB with no impact on strategy and a big saving on capital, why wouldn’t you. A great question in this context is where is sovereign bond repo booked: TB or BB.

• Finally, a Dealbook piece by Jesse Eisinger that quotes me as saying that ‘I’m pretty certain that clearing is being imposed without anyone actually knowing whether it actually reduces counterparty risk or not.’ Just to be clear, what I mean by that specifically is that the problem of whether the multilateral netting benefits of clearing (clearable OTC trades with A and B are now both with the CCP, resulting in risk reduction) outweigh the disadvantage of splitting netting sets (trades with A are split into clearable ones, now with the CCP, and unclearable ones, now still with A) is still open. So far as I know, there is no study of this that makes remotely plausible assumptions about the multiplicity of CCPs for multi-currency, multi-asset portfolios.

Posted in: Basel, Credit, Derivatives, Hedging and Convexity, Liquidity and liquidity risk, Markets, Sovereign Default by David /
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Two Bloomberg stories show how a CFTC rule change made it easier for MF Global to repo customer assets, and what it is doing about it. The history first, from William Cohan:

Before 2000, the [CFTC] rule[s] permitted futures brokers to take money from their customers’ accounts and invest it in a number of approved securities limited to “obligations of the United States and obligations fully guaranteed as to principal and interest by the United States (U.S. government securities), and general obligations of any State or of any political subdivision thereof (municipal securities.)” That is, relatively safe securities with high liquidity.

The banks, however, pushed the CFTC to expand the investment options that would allow firms to practice “internal repo.” In this scheme, money is taken from customer accounts and invested short-term in a variety of securities, with the futures brokers reaping the not- insignificant financial rewards from their customers’ money…

In the end, the door was opened for firms such as MF Global to do internal repos of customers’ deposits and invest the funds in the “general obligations of a sovereign nation.”

For me, this is a classic example of regulatory capture. The upside of allowing the rule change was more profit for the clearing members; the downside was greater risk for customers. But the clearing members had a voice at the supervisor and the customers didn’t, so rules were relaxed.

Now of course the CFTC is trying to bolt the barn door. A separate Bloomberg piece reports:

The U.S. Commodity Futures Trading Commission may vote Dec. 5 on rules governing how derivatives brokers invest client funds, a measure that gained urgency after $600 million went missing in MF Global Holdings Ltd. (MF)’s collapse.

CFTC Chairman Gary Gensler plans to set a vote on the rule, first proposed in October 2010, that would restrict how client assets may be invested in money-market funds and limit investments in foreign sovereign debt and internal repurchasing agreements, Gensler said today during a speech in Chicago.

If you were a client of MF’s, I would imagine that that October 2010 proposal, and the failure to act on it, would hurt.

Posted in: Clearing and Collateral by David /
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This picture is from Pictet (via the ever helpful FT alphaville):

Alphaville’s question is, given this, was Union sensible? I think it clearly was; on a weighted average spread basis, the EZ countries are still doing better than they were prior to the Euro, and even if they weren’t, those eight or nine years of low spreads were worth having (or at least they would have been if the money had been spent sensibly). In any event, what interests me more is why spreads were so low for so long. It seems to me that there are three (not necessarily mutually exclusive) possibilities:

• Despite having thousands of smart people looking at these things, the markets were wrong about what the bond spreads of Eurozone countries should be. They have now woken up.
• The markets have over-reacted to current events, and spreads are now well above where ‘fundamentals’ would suggest they ‘should be’ (whatever that means).
• The markets are right, and the spread changes have been in response to new information, specifically the discovery that leading EZ politicans are unwilling or unable to backstop the periphery.

I’m not sure where I come out on this yet…

Posted in: Credit, Euro, Markets, Sovereign Default by David /
2 Comments

The Tate yesterday said:

Personally I think January 2012 is a little late for the ECB to be brought into the game, but Nicholas Serota moves in mysterious ways.

Posted in: Photography by David /
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The president of the Bundesbank has ‘firmly rebuffed international demands for decisive intervention in the bond markets by the European Central Bank to combat the eurozone debt crisis, warning that such steps would add to instability by violating European law’.

Jens Weidmann told the Financial Times that ‘only politicians could resolve the crisis, and he rejected the idea of using the ECB as “lender of last resort” to governments’.

All he needs now is a white cat to stroke.

Posted in: Economic Theory, Euro by David /
3 Comments

Mark Carney’s Drapers’ Hall speech has rightly been getting a lot of attention. It is about global liquidity. Carney starts with the context:

global liquidity has swung wildly from the exuberant surge that fed a cavalier “search for yield” during the Great Moderation to the severe retreat that prompted the desperate “rush for shelter” in the aftermath of Lehman

We all know broadly what he means by that – but what does he mean specifically? What is global liquidity?

Carney acknowledges that there is no agreed definition, and profers a sense of it:

liquidity represents the ease with which financial institutions, households and businesses can obtain financing…

To capture all the dimensions of global liquidity requires a combination of price and quantity measures. Price indicators, such as the general level of interest rates or credit spreads, provide information about the conditions under which liquidity is provided, while quantity measures, such as credit aggregates, show the degree to which such conditions translate into the build-up of risks.

While I don’t disagree with any of that, it doesn’t really give me much of a hint about how to monitor global liquidity. What matters in what proportions: repo/securities financing spreads, credit spreads, rates, flows measures and/or something else?

It seems to me that the first task is to construct a reliable set of measures of the various aspects of global liquidity that take into account both the marginal cost of financing and the size of flows. This will be differentiated by financed asset class and currency. After all, you can’t arrest Keyser Söze until you have figured out who he is.

Posted in: Liquidity and liquidity risk by David /
6 Comments

There is a long and interesting article by Paul Volcker in the current New York Review of Books on financial regulatory reform. Whatever you think of Volcker and his rule, he is smart and he has been thinking about these issues for a long time, so he is worth reading. For me, the final paragraph is the easiest of the lot to agree with:

One thing is sure: we have passed beyond the stage in which we can expect the officials of central banks, regulatory authorities, and treasuries to rely on ad hoc responses in dealing with what have become increasingly frequent, complex, and dangerous financial breakdowns. Structural change is necessary. As it stands, the reform effort is incomplete. It needs fresh impetus. I challenge governments and central banks to take up the unfinished agenda.

Posted in: Regulation by David /
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The Guardian says:

Reports that Germany and France have begun talks to break up the eurozone amid fears that Italy will be too big to rescue

If this happens, it will make the aftermath of Lehman look like a day in the park. An utterly preventable disaster is now looking entirely possible. Truly our leaders have let us down.

Update. I strive not to be drawn into hysteria. As the economist says:

I hate to get this pessimistic about the situation. It feels panicky and overwrought. I can’t believe that Europe would allow so damaging an outcome as a financial collapse and break-up to occur… the window within which something could be done to prevent it is closing, and fast. I hope to be proven astoundingly wrong in my assessment, but I’m struggling to see alternative outcomes.

These folks are not known for proclaiming the end of the world on a regular basis. Neither is Brad DeLong, and he says:

I have been complaining for some time now that Reinhart and Rogoff think that the time is always 1931 and that we are always Austria–that the great fiscal crisis is about to erupt and send us [i.e. the US] lurching down toward Great Depression II.

Well, right now guess what? The time is 1931, and we are Austria.

The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip.

The Federal Reserve Needs to do so now.

A little historical perspective may be helpful. One of the first events in the Great Depression, and a major contributor to the loss of confidence, was the failure of Creditanstalt. This was a proto-investment bank, one of the largest in Austria; its collapse was unexpected – just like Lehman. So, um, yes Brad; it does look altogether too much like 1931 for comfort.

Posted in: Euro, Markets, Politics, Sovereign Default by David /
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Aditya Chakrabortty tells a lovely story about how Antanas Mockus solved Bogota’s traffic problems:

Put yourself in the position of one of Colombia’s would-be tough guys. Dawdling obediently at a red signal is hardly going to enhance your credibility, while traffic policemen are figures of authority whom it is your right, nay, duty to menace.

What to do about the ensuing rush-hour chaos? Soon after taking office, Mockus decided to hire 420 mime artists, to stand at key junctions across the city centre. Now jay-walkers found themselves followed by clowns, imitating their movements. Similar mockery was dished out to reckless drivers.

This was ingenious: any Colombian machito trying to clock a face-painted mime artist would look ridiculous. So what happened? Within months, the proportion of pedestrians obeying traffic signals leapt from 26% to 75%.

As Chakrabortty says, Mockus spotted that the problem he was up against was cultural, and hence it required a cultural solution. This is a nice example of re-engineering behaviours.

Posted in: Organisational Culture by David /
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I am puzzled. The WSJ has a useful, sortable list of earnings and employment percentages by undergraduate major based on 2010 US census data. Mostly, the data makes sense: reading science, engineering or a classic professional subject like medicine makes it less likely that you are unemployed and more likely to have a high salary. What’s bizarre, though, at least to my eyes, is the poor performance of those who read psychology. The three majors which generate the lowest median earnings are school student counseling, counseling psychology and educational psychology, all coming in below $35K. (OK, student counseling makes sense, but the other two?) Even clinical psychology and straight psychology only give median earnings of $40K or so.

The employment picture is even worse. Clinical psychology majors have the worst employment prospects of all, with nearly 20% unemployed at survey date, while social psychology, miscellaneous psychology, and educational psychology are all in the bottom 15 (out of 173).

Can anyone explain what is going on here?

Posted in: Mathematics and Science by David /
8 Comments

From the Daily Mash:

G20 leaders revealed as covert anti-capitalism activists

THE leaders of the G20 nations are undercover anarchists who have deliberately destroyed the West’s capitalist economy, it has emerged.

Suspicions were aroused after key participants of last week’s acutely dysfunctional summit left with dejected facial expressions that looked suspiciously like ham acting.

French customs officials subsequently searched President Obama’s suitcase to discover a Guy Fawkes’ mask, luminous juggling clubs and dog-eared back issues of Class War magazine with notes pencilled in the margins.

Entirely plausible isn’t it?

Posted in: Fun by David /
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One difficult criticism for those of us who believe that strong financial regulation is necessary – even if we don’t believe that the current structure is heading in the right direction – is that of rent seeking. The issue is that the stronger regulatory power is, the more it can be exploited. For me, the clearing provisions in Dodd Frank are a great example of this. The clearinghouses have been handed juicy profits by regulatory fiat.

The issue, though, isn’t that particular example. It is how negative externalities can be corrected without excessive rent seeking. This is one of the basic problems of regulation. If we ignore it in our (justified) anger at the behaviour of some in the financial system, then we risk designing a highly inefficient financial system which will then be vulnerable to deregulatory pressure in coming decades. That deregulation will then lead to the risk of instability and we are back to square one, with a lot of growth lost and pockets lined in the meanwhile.

I wish I could say I had a good answer: I don’t. But I do think that alertness to the problem is important. A degree of humility about the likelihood of unintended consequences in general and rent seeking in particular has been noticeable by its absence in regulatory policy design since the crisis. I’m not hopeful that this will change, but that does not mean it should be ignored.

Posted in: Economic Theory, Regulation by David /
4 Comments

I am sure you could make a case for pronouncing that ‘fvail’…

Dealbreaker points out a nice trick here. Note that:

• Basel III is demanding banks increase the amount of equity they have (as opposed to total capital);
• Some banks, like BofA, have seen large increases in their credit spread;
• If you buy back your own debt at the market price, you can monetise that fair value gain.

So what has BofA done? Buy back subordinated debt and preferreds, and issue both equity and senior debt. It’s cute:

Note first of all that you profit by “volatility in credit spread movements” by buying back the things with the longest duration: perpetual preferred and trust preferreds, which are trading at double-digit percentage discounts to where they were issued. You replace them with a thing that in some loose theoretical way looks similar from a duration and capital structure perspective: a mix of about half common stock (400mm shares = about $3bn on a good day) and half senior notes. It’s a regulatory capital improvement. And you’ll be paying out less cash going forward, since the senior debt should be cheaper than the preferred and, um, about those common dividends. Sure your common shareholders will be diluted, but not so much on an EPS basis, and they’ll be so thrilled with the juiced earnings this quarter that they won’t be too worried about the dilution.

Update. I fixed a typo; thanks to Dennis for pointing that out.

Posted in: Basel, Capital Structure Arbitrage by David /
7 Comments

It is really worth playing with the channel mixer menu in photoshop; you can sometimes find interesting black and white shots based on a colour picture if you play around a bit.

Posted in: Photography by David /
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I am reluctant to use the phrase ‘What Went Down at MF Global‘ as I think events at the broker have a somewhat different tenor to a drug bust. Let’s ignore the title, then, and look at what Brad DeLong has written about the risk that brought MF Global down:

• In stage zero MF Global sets up the financing with its counterparty and buys southern Europe’s bonds.
• In stage one we learn whether the market is tolerant or intolerant of southern Europe risk: if the market is tolerant the bond prices stay high; if the market is intolerant the bond prices collapse.
• In stage two southern Europe either pays off its bonds or defaults.

In other words, DeLong (correctly) says that MF Global faced two risks in its repo-to-maturity trade: risk that repo haircuts increased during the trade (risk in what DeLong calls stage one); and default risk (stage two risk).

DeLong gives approximately* this diagram:

The key point, I think, is that while MF focusses on the default risk – witness the fact that they hedged against a Europe wide crisis by shorting France – they didn’t focus on the possibility of large increases in repo haircuts. This failure to understand the liquidity impact of collateral calls is exactly the risk that caused AIG to fail.

Thus I think DeLong is not precisely right about this:

MF Global’s bet is (i) highly leveraged…

MF Global’s bet is attractive to… (a) rogue traders (and rogue CEOs) speculating with other people’s money, (b) those who are highly confident in their ability to switch from highly-leveraged speculators to patient well-capitalized investors in fundamentals if necessary, and (c) those who don’t believe that there are shocks to risk tolerance that are orthogonal to shocks to fundamentals.

The bet is only highly leveraged in the tail. For most states of the world, it produces low, stable returns; this makes it look much more benign than many leveraged positions. If you didn’t know about the collateral support risk, then you would not have to have fallen into DeLong’s (a)-(c) to do the trade. You would just have had to have thought that default was unlikely and the impact of it, even if it happened, was within your risk tolerance; a perfectly reasonable conjecture.

It seems much more likely to me that Corzine et al. didn’t understand the repo haircut risk – a modern phenomenon – than that they were rogues. Or, to use my own slang, this is a cockup not a conspiracy.

*Specifically, I fixed a typo in DeLong’s diagram.

Update. My thanks are due to the Streetwise Professor for a very kind commentary on this post.

Unkind update. Normally I don’t go in for selective quotation, but this, from Matt Levine, is too good to miss:

It is normally a good and noble endeavor to make fun of Gretchen Morgenson, because she really really doesn’t care at all if what she writes about Big Evil Banks is true or not, so it’s mostly not.

Oh, OK then.

Posted in: Clearing and Collateral, Liquidity and liquidity risk, Markets by David /
4 Comments

FT alphaville gets it:

right now, CVA desks are driving something like a quarter of the demand for sovereign CDS.

My guess is more like a third, but yeah, CVA desks are major players in the sovereign CDS market.

Doing this is in part a regulatory arbitrage for them such that more hedging means a lower capital requirement.

Not quite. It will, once Basel III is implemented, mean a lower capital requirement. And it isn’t regulatory arbitrage in the sense that this CDS does indeed somewhat hedge the position: it just doesn’t completely hedge it (because for instance the CDS might not trigger when you want it to).

To the extent that other market participants think that such CDS are now worth less because of politicians’ attempts at financially engineering around a credit event for Greece, that will cause spreads to move tighter, making the arb cheaper. Go Team Basel III!!

Yeah, the less the market believes that CDS hedge, the cheaper they are, and so the cheaper the CVA hedge is to put on.

We haven’t even mentioned the death spiral whereby sovereign CDS widen out and CVA desks are obliged to buy more, driving spreads higher… That’s one crowded trade all pointing in the same direction. Keep this in mind the next time spreads are widening out and politicians howl about the evil speculators that are exacerbating moves in the market (psst they may just be CVA desks following Basel regulations).

Exactly. CVA convexity is a big deal.

It’s also worth reiterating that nearly all sovereigns do not post collateral, but do demand it themselves — the dreaded one-way CSA. Banks have been trying to encourage sovereigns to start posting collateral so that they wouldn’t have to hedge against with CDS quite so much.

With the exception of a few minor countries (Portugal, for instance) they have not had much success. If sovereigns would agree to full two ways CSAs (zero threshold, daily collateral, cash only), then the CVA problem goes away. But, for now at least, they won’t, which is a shame as that is the only sensible way out of this mess.

Posted in: Basel, CDS and Negative Basis, Clearing and Collateral, Derivatives, Hedging and Convexity by David /
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From the FT:

CME Group, the biggest US futures exchange operator and key regulator of MF Global, the broker-dealer that filed for bankruptcy protection on Monday, said the company had failed to comply with rules on collateral in segregated customer accounts…

A widespread concern among futures traders in Chicago is over how much of customers’ funds held in MF Global’s segregated clearing account at the CME they will be able to reclaim.

Mr Donohue [CME chief executive] suggested on Tuesday that customers would ultimately be responsible for losses and suggested they may have to bear any shortfalls. “Customers have the risk of other customer losses in the customer segregated pool and there’s always the risk as well that customer funds are not properly protected,” he said…

Asked if CME was now reviewing all other clearing member accounts, a CME spokeswoman told the FT: “As a designated self-regulatory organisation, we regularly monitor for compliance of all rules.”

Segregation is operationally difficult and some firms’ management of it has been less than strict, so it is not surprising that deficiencies are discovered when a broker files for bankruptcy; foul play is not necessary. Still it is worth noting that segregation is the only mechanism by which customers of a clearing member are protected, so CME’s oversight failures are not impressive.

Posted in: Clearing and Collateral by David /
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It is with a heavy heart that I tackle this – but given recent events, the question of what risks purchased CDS protection on a bond hedges against cannot be ignored.

Here’s the issue. Suppose I buy a bond, and I buy CDS to maturity of the bond. Then if the bond defaults, the CDS pays out right?

Well, kinda. First clearly I have counterparty risk on my CDS provider. That can be managed with collateral, so assume I have enough of that too.

Second when do I get a payout on the CDS? The answer is ‘When the ISDA determinations committee votes that a credit event has happened’. Sadly we know from the example of Greece that some things that look a lot like default to the naive observer aren’t in fact credit events. Now certainly caveat emptor applies here: before buying a CDS I should have understood exactly what kind of thing it is. (See here for a nice discussion from FT alphaville on the evolution of CDS documentation.)

But now flip things around and suppose I am a regulator looking at this situation. Clearly the bank I am supervising can take a loss on a sovereign bond and does not get a corresponding CDS payment. I might reasonably argue that this means that the bank should not get full capital relief for the CDS. (Indeed, this principal has been established for the similar situation of corporate bond restructuring, which is why European regulators require CDS to have restructuring as a credit event before granting capital relief.)

Unfortunately, Basel is finding it difficult to do the right thing here. If it takes away the benefit of CDS hedges, especially sovereign CDS hedges, it will be the beleaguered large European banks who will suffer. And the Basel Committee will look like idiots; Basel III recently entrenched the role of CDS by making single name default swaps the main way of reducing capital charges on CVA risk. An about face on that issue would be embarrassing, so I think it is more likely than not that the Committee won’t be prudent. Which, frankly, is not a big surprise.

Posted in: Basel, CDS and Negative Basis by David /
3 Comments

It isn’t looking like we will get something that works.

Posted in: Photography by David /
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In a helpful post on project syndicate, Mark Roe gives an interesting example of the effect of central clearing in bankruptcy. I am going to tidy it up a little, to make it [I hope] particularly clear. Suppose we have three firms, BofA, AIG and Citi, with just the following assets and liabilities:

• BofA owes AIG 100.
• BofA owes Citi 100.
• Deutsche owes BofA 100.

BofA has more liabilities than assets so it fails. In bankruptcy (ignoring costs), AIG and Citi divide the assets, 100, and so get 50 each.

Thus the outcome is:

• BofA fails.
• AIG loses 50 (i.e. it is paid 50 out of 100 owed).
• Citi loses 50 (i.e. it is paid 50 out of 100 owed).
• Deutsche pays the 100 it owes.

Now suppose that there is some clearing but the same contracts:

• BofA owes AIG 100 on a cleared contract.
• BofA owes Citi 100 on an uncleared contract.
• Deutsche owes BofA 100 on a cleared contract (with the same clearing house).

Bof A still fails. The position is:

• The clearing house is flat vs. BofA (as BofA’s cleared contract with AIG nets with its cleared Deutsche one).
• BofA owes Citi 100.

Therefore Citi loses 100, and the new outcome is:

• BofA fails.
• AIG is flat (i.e. it is paid the 100 it is owed).
• Citi loses 100 (it loses all 100 it is owed).
• Deutsche pays the 100 it owes.

So all clearing has done is reallocate losses to those outside the clearing house.

As Roe says:

Whether the clearinghouse reduces systemic risk depends on the relative systemic importance of those inside and those outside the clearinghouse – AIG versus Citibank in this basic example – not on the clearinghouse’s capacity to reduce risk among its members. In this example, if Citibank is precarious and is as systemically vital as AIG, the clearinghouse has obscured that it has saved AIG only by transferring risk from the clearinghouse to Citibank, which then fails.

Posted in: Clearing and Collateral by David /
3 Comments

I have commented before on a number of LCH Repoclear’s margin changes on Irish government bonds, but I hadn’t noticed quite how many there have been until I looked in detail. Here is [I think] the picture:

Posted in: Clearing and Collateral, Euro by David /
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From a recent speech by Paul Tucker:

There is a big gap in the regimes for CCPs – what happens if they go bust? I can tell you the simple answer: mayhem. As bad as, conceivably worse than, the failure of large and complex banks.

Errr, yes.

Posted in: Clearing and Collateral by David /
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Sorry, I am suffering from post backlog. Here’s something I have been meaning to get to for a little while.

An analysis of the relationships between 43,000 transnational corporations has identified a relatively small group of companies, mainly banks, with disproportionate power over the global economy.

Now I don’t entirely agree with the methodology but that does not matter too much: the important part is that the authors have tried to ‘empirically identify such a network of power’. Chapeau.

Posted in: Economic Theory, Mathematics and Science, Software and Virtual Worlds by David /
2 Comments

No, no sarcastic comment this time. Things in the Eurozone are too serious for that.

Posted in: Photography by David /
2 Comments

I have blogged quite a bit recently talking about the uncertainty in the value of banks, so much of Martin Sandhu’s recent column in the FT makes sense to me. He says:

Can we ever meaningfully know how profitable a bank is? We can, of course, measure how much cash is taken out of it to benefit its employees and shareholders. But that need not bear much relation to how much value the bank has created – so fleeting a quantity as to be almost unknowable… So it is only for a bank that is being wound down that one can decisively ascertain what contribution it has made to economic value.

I think that’s true, although to be fair it isn’t exactly easy for any large corporation, particularly one whose main business is not making and selling things. Matters are especially complex for banks, though, even once you have stripped out idiocies like fair value gains on own debt and DVA.

What we need is not to abandon hope that financial statements can ever be useful, but rather to reform them so that, for instance, readers get useful information about valuation uncertainty, provision levels under different models, and so on. In short, we need accounting standards that acknowledge that they are prepared by unreliable narrators…

I am less supportive of Sandhu in the next part:

What we can know is this. First, the enormous growth in financial claims of uncertain value during the boom led to huge losses in the bust. The frightening realisation that we do not know what we thought we knew (about how much our claims are worth) is the cause of the current crisis of confidence and the real economic hardship it has produced.

There is an element of truth in that, and certainly the emphasis on the importance of confidence in the (ongoing) crisis is important. This analysis however ignores why there was such a growth in claims, or why people were mislead about their value. That, of course, is a different story.

Next, some (partially justified) finger pointing:

Second, the malleable nature of the values they manage has not stopped bankers from securing a safe stream of wealth to themselves… That, more than anything, is what has angered people around the world: that one segment of society should inure itself against the pain it has helped inflict on everyone else.

And that surely, is pertinent. If I buy widgestuff for $2, make a widget from it, and sell my newly minted widget for $5, then I really have made $3. But if the expected present value of my future earnings is $3, then matters are rather different. There is many a slip between cup and lip after all. So spiriting away that $3 despite the fact that that profit might well turn into a $10 loss before the year is over: that isn’t fair. Nor is it how capitalism is meant to work.

Posted in: Accounting by David /
3 Comments

I feel for Croatia. And Romania, Bulgaria and the rest. As FT alphaville shows, (using data from this FSB report), many smaller countries, especially emerging ones, have banking systems that are primarily overseas-owned. More than 90% of Croatia’s is, for instance.

The primary culprits are the Spanish (BBVA and Santander are big in Latin America), the Nordics (Nordea and Swedbank are big in the Baltic), and the global megas (Citi and HSBC are big in a lot of places). They are not the only ones of course: ING, Credit Agricole and Unicredit’s presence across Europe are also worth mentioning. So what’s the problem?

The problem is that some of these banks have no natural lender of last resort. They have lead supervisors, of course, but those supervisors may be less than completely focussed on, say, the Croatian subsidiary, despite the fact that that sub is important to Croatia. That’s because it isn’t important to the parent group. Moreover if one of these pan-national banks gets into trouble outside its home country, the home central bank might well resist what could be seen locally as bailing out foreigners. Will the Bank of England really help HSBC if it has a problem in Asia? For that matter, does the the Bank of Spain have enough firepower to save Santander in all plausible crises even if it wanted to?

The problems of supervising these cross border banking groups are bad, and those of providing them with emergency liquidity if required are arguably worse. Ring-fencing and local supervision & liquidity provision are part of the answer, but I wonder if they will be enough, especially given the pressure in good times to centralise treasury functions. If I was governor of the central bank of Croatia, I’d be trying to find a legal way of persuading my foreign friends to divest themselves of their local banks. Perhaps a 100% capital requirement on intragroup exposures (with no credit for collateral), and a requirement to fund all of the balance sheet locally would do the trick…

Posted in: Regulation by David /
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Goodness me there are some fishy things being written about BofA moving their derivatives to the retail bank (which of course has FDIC insured deposits). Some of the things that are not true include ‘If a retail bank is a derivatives counterparty, then it doesn’t need to post nearly as much collateral’ and ‘The derivatives aren’t themselves insured by the FDIC, but they have extremely senior status, which means that the bank can use its deposit base to pay off derivatives counter parties.’ (These actually consecutive sentences too – clearly Reuters does not bother to fact check blogs.)

What is true is that a retail bank often has rather better liquidity than a broker/dealer. This alone makes it safer, and hence (assuming that liquidity does not get spread around the rest of the group – something that should not happen too much) the retail bank is more attractive as a derivatives counterparty. Note though that these days everyone uses the same interdealer CSA (zero threshold, daily margin, cash only), so there is no collateral advantage to being in the retail bank; moreover being in a retail bank doesn’t suddenly make derivatives super senior; they are just good only fashioned pari passu with senior debt, the way they always were – and not FDIC-protected.

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation by David /
5 Comments

An updated draft of my note can be found here. There are two health warnings: First, I had a hard 5,000 word limit, so it’s a little terse in places, especially if you aren’t sad enough to have spent time on OTC derivatives clearing in the past. And second, this is a draft, so I make no promises about what the final version will say… That said, any comments would be much appreciated.

Posted in: Clearing and Collateral, Publications by David /
6 Comments

The forgive student debt movement seems to be gaining some traction. What I think is interesting about this – other than the fact that ex-students seem rather more deserving of forgiveness to me than sovereigns who have spent beyond their means – is the change in tone of the debate. Suddenly, partly thanks to the visibility of OWS, a lot seems possible. Now certainly history is littered with popular protest movements that came to nothing, but equally progressive change is unlikely without this kind of clamour. The autumn has signs of spring.

Update. I love the use of the term temporary autonomous zone for what is happening in Zuccotti Park. For more on that, including a lovely analogy from Slavoj Žižek (and a measure of utter nonsense), see here.

Posted in: Politics, Sovereign Default by David /
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The paper will be posted tomorrow. Meanwhile…

• Bloomberg reports ‘Interest-rate derivative users may have to set aside at least $1.4 trillion in margin payments under new rules mandated by the U.S. Dodd-Frank Act, according to research firm Tabb’. That is a lot of extra margin.
• Also from Bloomberg, unsurprisingly given the prior item: ‘Demand to transform non-standard collateral for use at swaps clearinghouses is set to grow as new rules take effect for the $601 trillion over-the-counter derivatives market, according to CME Group Inc. (CME)’s Craig Donohue’.
• In similar vein, it is hardly surprising that ‘Banks and insurers have hit back at the UK regulator’s moves to block a new form of funding transaction [i.e. collateral swaps] between banks and insurers… Phoenix Group and Lloyds Banking Group have each had transactions blocked [by FSA]‘, the Financial Times reports.
• Next a fascinating post from the Physics of Finance on what really moves markets when HFT is possible. The key result:
  

  As the efficient markets hypothesis (the “weak” version, at least) claims, market prices fully reflect all publicly available information. When new information becomes available, prices respond. In the absence of new information, prices should remain more or less fixed.

  Striking evidence against this view comes from studies (now almost ten or twenty years old) showing that markets often make quite dramatic movements even in the absence of any news… stronger evidence comes from studies using electronic news feeds and high-frequency stock data. Are sudden jumps in prices in high frequency markets linked to the arrival of new information, as the EMH says? In a word — no!

• Finally, my favourite, also from Bloomberg, a story about Morgan Stanley’s foray into Ukrainian farming. Yes, when times are good, investment banks really do think that they can do anything.

Posted in: Clearing and Collateral, Economic Theory, Markets, Reputational Risk by David /
3 Comments

I am working on a longer paper on the systemic risks of OTC derivatives clearing and will be busy on that for a few days. I’ll post a draft once it is in reasonable shape.

Posted in: Clearing and Collateral, Photography by David /
3 Comments

Timmy did it wrong. (That is hardly a surprise.) So European finance ministers, looking to recapitalize their banks, should not take his example. First the background from the FT:

European Union finance ministers are examining ways of co-ordinating recapitalisations of financial institutions after they agreed that additional measures were urgently needed to shore up the region’s banks.

Although the details of the plan are still under discussion, officials said EU ministers meeting in Luxembourg had concluded that they had not done enough to convince financial markets that Europe’s banks could withstand the current debt crisis.

What he should have done, and what the European finance ministers should do, is buy equity. They should buy it at market – unlike the UK recapitalisation of RBS – and they should vote the stock. It is time to get some control in exchange for the cash European taxpayers will be stumping up.

Update. Carter has some good points, and some I disagree with, in the comments. To begin, where he is right:

I wholeheartedly disagree. First, let’s assume right off that you don’t mean buying equity IN the market, as this would just be a bailout of existing shareholders.

Yes, indeed. I did not mean that.

Buying “equity at market” absolutely ignores the dilution of the existing shareholders. Buying equity “at the market” price even if they are newly issued shares is a subsidy to the existing shareholders. It is paying an above-market price.

Yes again. What I was really thinking was ‘not above the market price’, as in the UK’s case. But you are right, the fair price given dilution is well below the current market price for normal market size.

You criticize the US TARP, but essentially the USG backstopped a public issuance by the banks. Banks that could effectively raise funds at a lower cost than the USG proposed did so, and the market provided the funds. Those that could not were going to be funded by the USG, the equity would have been massively diluted, and the USG would have obtained the requisite voting rights.

Um, but the US Government promised not to vote their equity where they had some, and often they took prefs or warrants where they could have taken equity. It seemed to me – and I would be eager to hear counterexamples – that they bent over backwards to be in a position where they did not have to vote stock.

But the government should not arbitrarily take control of an institution that the market is willing to fund and believes is viable.

Hmmm, I disagree. It should not do it often, that is for sure. But in the European case, where the implicit subsidy of ‘we will step in if we have to’ is worth a great deal (Haldane estimated $50B for the UK banking system, so at least $100B for the EU), taxpayers deserve something for that backstop. I would prefer a system where banks explicitly paid for this insurance all the time – similar to the FDIC model – but they should pay a market rate.

Posted in: Mother of all Bailouts by David /
7 Comments

There is another way of understanding yesterday’s anomalous result that banks with a Basel III ratio greater than 7% did not fail, yet it seemed from some rather rough maths as though some of them should have done. It is simply that more capital protects a bank for longer, and thus you don’t need enough capital to survive a big shock, just enough to survive long enough for the authorities to intervene. In other words, some of those highly capitalized banks would have failed absent intervention…

Posted in: Basel, Probability Theory by David /
2 Comments

Well, a little bit.

Quite a few posts recently have argued against higher capital requirements. That doesn’t mean I don’t believe banks don’t need higher capital, just that it should not be a minimum requirement (because only capital above the minimum can be used to absorb losses). I do think, though, that those capital increases should be delayed.

Given this, you might think I would be pleased when The Clearing House produced a document suggesting that a capital ratio above 7% was not necessary. Unfortunately, part of this document made me suspicious. They

Analyzed the relationship between Basel III capital ratios of large global banks at the onset of the financial crisis (defined as December 2007), and subsequent Bank distress during the crisis.

123 banks were in the sample, representing 65% of global banking. The document reports the following results:

It was that zero that worried me. It was too convenient, and it didn’t seem to fit with the other data points. So I did some modelling.

Warning: what comes next is very, very crude.

For rather general (i.e. not very good) reasons, we would expect this distribution to be fat tailed. Given the three data points – not very many – we can’t fit anything sophisticated, so you will have to make do with this:

Note that the fit to the data points isn’t terrible. Now, obviously we are extrapolating a long way beyond what we know, but still, using the fit we get

99% safety comes at a capital ratio of 18% and 99.9% at 25%.

Now, I would be the first to say that this ‘analysis’ is far more than the data will support. But still, it is interesting that this work suggests that you would have needed a very high capital ratio to get a low probability of failure during the 2008 crash. (Of course it tells us nothing about what might be needed in other, as yet unforeseen market events.)

Just as a final riff, what is the liklihood that the clearing house observed zero failures in the >7% bucket if our fit was correct? They say that there are roughly the same number of banks in each bucket, so the >7% bucket should contain roughly 31 banks. We will assume all these banks have a Basel III ratio of 8%. Then we would expect to see 13% x 31 = 4 distress events. Assuming a binomial distribution, the chances of seeing zero events when you would expect 4 from 31 is 1.5%. This is not low enough to conclude that our fit is wrong. Moreover if even one out of the those 31 is questionable and should really be counted as distress, then the probability jumps to 6.5%. So, to be charitable, the Clearing House might be unlucky rather than mendacious if the analysis above is broadly correct.

Posted in: Basel, Probability Theory by David /
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From a terse but excellent post by Jonathan Hopkin on what Ed Miliband, Labour party leader, should have said in his speech to conference:

Ed could do with saying:

“We used to think that you could cut your way out of a recession, and increase employ­ment by reducing Government spending. I tell you in all candour that that option no longer exists”

It’s a tough sell, but to refuse the challenge condemns Labour, should it win, to the kind of centrist no man’s land Obama finds himself in. The electorate have to be told what is going on, however counter-intuitive it is. There is nothing to gain by offering a softer version of Cameron’s Hooverism.

Hopkin is riffing on Jim Callaghan for the first part, but what I really like is that phrase ‘Cameron’s Hooverism’. It is all too accurate I am afraid.

Posted in: Politics by David /
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This post is an attempt to figure out what ROEs, returns on capital, and capital structure really tells us about the risk of banks. It is partly a response to Martin Wolf’s FT blog post What do the banks’ target returns on equity tell us? but also more generally a comment on the whole banks can have more equity and it won’t cost much meme.

First, we should define some terms. By ROE or return on equity, I mean the return on equity based on the current market price. So if I buy a share for a dollar, and my total return (price appreciation plus dividend yield) in a year is seven cents, I have a 7% ROE.

Return on regulatory capital is slightly different. This is because capital is not the market price of a firm’s equity; rather it is* shareholders funds. This includes money raised from issuing equity, retained earnings, and a few other (typically smaller) items. Thus the return on capital is based on the price of equity at issue, plus whatever earnings have been retained, and a few other bits and bobs. Firms typically cannot issue meaningful amounts of new equity at the current price, as new equity dilutes existing shareholders. It also usually irritates them. Therefore it is usually easier to increase capital by retaining earnings rather than by issueing new stock.

The naive ‘banks can easily have more capital’ crowd typically argue thus:

• The Miller Modigliani theorem says that capital structure does not matter; if you have more equity, you are safer, hence your debt trades tighter, hence the extra cost of the equity is made up for in having cheaper funding;
• Remember that more equity makes banks safer?
• Get more of it.

The problem with this is that the Miller Modigliani theorem is false. Amongst other things, it assumes no taxes; it assumes that investors are risk neutral; and it assumes that risk is perfectly known by all investors. None of these things are true, and thus those who trade capital structure based on MM alone are known as ‘bankrupts’. For me, the biggest issues in MM are the linked ones of no risk premiums and perfectly known risk. Of course if I know the distribution of a firm’s earnings precisely then I can price the stock. It is the very fact that I don’t that makes equity investment difficult: it means that investors demand a variable but high premium for taking equity risk. Because an equity issuer has to pay this extra premium whereas a debt issuer doesn’t (or at least doesn’t have to pay as much of a one, assuming we are not in high yield territory), equity cannot be substituted for debt without cost.

Note that the existence of risk premiums means that you cannot assert that just because a bank’s target ROE is 15%, it is highly risky. Wolf makes this mistake, saying that mid teens ROEs demonstrate that ‘these desired returns must represent the result of extreme risk-taking’. Of course, he may be right, but one cannot conclude that from the evidence available.

What happens if you raise capital requirements above current levels? Clearly a bank has two choices:

1. Raise more capital; or
2. Reduce risk (as measured by capital requirements).

The first of these is typically done by retaining earnings, unless the new capital required is large, due to the aforementioned pissing-off-the-stockholders feature of issueing new equity.

It is the second I want to focus on, though. What would we do to reduce risk? Well, clearly, we need to cut those businesses with a low return on regulatory capital. And that, sadly, means commercial lending. Both retail banking (because it has relatively low regulatory capital requirements for the risk) and investment banking (because it, historically at least, has high returns) look better under return on reg cap than commercial banking. So that’s where you cut. And you cut savagely as your whole portfolio generates regulatory capital, so to meaningfully affect it, you have to make a dramatic change to the speed of origination of new business.

This is why I think that meaningful changes to banking regulation are best done in good times, not bad ones. In a boom, a decrease in the supply of credit is probably a good thing. It is certainly less bad than it is in a recession.

Note, by the way, that both increasing capital and reducing risk have the effect of reducing ROE. The first because either there will be more shares for the same earnings or because increasing retained earnings will be reflected in a higher stock price; the second because reducing risk will typically reduce earnings. The effect is not linear and not easily modelled though, especially capital tends to be sticky. For a large bank, raising another hundred million dollars of capital will often not budge the stock price at all, but a couple of billion will move it substantially.

At the end of the day, economics should be about what works. Yes, we want a more stable financial system. But we also want economic growth. Whether increasing bank capital requirements should or should not lead to decreased lending in your model or mine does not ultimately matter. What matters is whether it in fact does, and what the macroeconomic consequences of that are. It would be truly irresponsible to attempt banking reform in the depths of a recession without at least being alert to the possibility of adverse consequences, and moving quickly to address them if they occur.

*For simplicity here I have ignored deductions and a few other wrinkles which mean that common equity tier 1 is not quite the same as shareholder’s funds.

Posted in: Capital and Contingent Instruments, Capital Structure Arbitrage by David /
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Praise be. The EU has actually acquired some balls and is proposing a financial transaction tax. Yes, it will be widely evaded. Yes, it will make the EU less competitive. But the only way that these things get globally implemented is if someone tries it and it works well enough that the naysayers can be safely ignored. In this case at least, necessity is the mother of invention.

Posted in: Taxation by David /
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