Deus Ex Macchiato

Let’s imagine a conversation between banker Bob and a regulator Reg.

Reg: OK Bob. You screwed up big in 08. This time, I’m gonna make sure that your bank is safe. Damn safe.

Bob: Very well, Reg, I see your point. But what exactly do you mean by safe?

Reg: I mean that you have enough capital so that you can withstand losses. Any losses your stupidity might lead you to make.

Bob: Any losses?

Reg: Yep.

Bob: What is Godzilla climbs out of the Hudson, walks down 42nd street, and eats our headquarters. At the same time all our assets, including US treasuries, fall to zero, while all of instruments we are short go up. Do we need enough capital for that?

Reg: Well, no, obviously not, that’s stupid.

Bob: Of course – no one uses 42nd street if they can avoid it. 44th would be much faster.

Reg: You’re gonna have to have enough capital to withstand a real crisis.

Bob: What kind of crisis?

Reg: A bad one.

Bob: You will forgive me if I suggest that that is less than specific.

Reg: I know your game. If I say ‘once in a hundred years’, you buy billions of once in a thousand year risk. If I say ‘once in a thousand years’, you take a leveraged position in once in ten thousand year risk. I’m not gonna get caught out like that.

Bob: So I can’t take any risk?

Reg: Well obviously you can take some. Just not too much. And we want you to keep lending to the real economy, of course.

Bob: So ordinary banking – the kind of banking that has been responsible for banks failing for hundreds of years – is fine. But anything else is to be done in moderation. How much of that is too much pray tell?

Reg: Nothing that might make me have to rescue you.

Bob: This conversation is getting a little circular…

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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The Streetwise Professor points out something that I had not realised about regulatory capital arbitrage: not only do regulatory capital arbitrage opportunities blunt the impact of regulation, but they also produce crowded trades. By definition all the banks who engage in these trades are one way round, while all their counterparties are the other. This kind of situation often ends badly, so it does encourage me to renew my call for supervisors to set up Regulatory Capital Arbitrage groups to look at these opportunities. The only difficulty would be to stop the good ones turning themselves into hedge funds…

Posted in: Regulation, Rules by David /
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(My apologies for the dearth of posts recently: I acquired a horrible cold and it took me some days to kick it.)

A long time ago I became interested in economics when someone – to my shame I can’t even remember who – pointed out that it wasn’t just dull money stuff, but rather that it was the study of incentive structures. That still strikes me as true today: a good piece of economics explains how and why we react to changes in incentives.

It is therefore somewhat surprising to find that some commenters on bank regulation – and even some regulators – can be so bad at understanding incentive structures. If you make an activity really difficult or expensive for banks to do, but it is profitable, then non-banks will figure out a way to do it (usually in a badly capitalised, unregulated vehicle). Moreover, if you make one way of taking a risk really difficult and expensive but another way of taking the same risk much cheaper, then banks will take it in the second way not the first. That is why I have always advocated regulators having a specialist regulatory arbitrage group to spot these features and plug them. But of course the problem with this is that the existence of the group would be tacit admission that the rules are not fair between different risks and not risk sensitive either. That would never do.

Basel III, as one might expect for something written in an awful hurry and without the luxury of much impact analysis, will make this situation worse. It adopts the same approach to regulatory capital as I apply to wrapping parcels: keep on adding things piecemeal until it looks bulky enough to survive. I can go through half a roll of tape for a big parcel, and the result is always ugly. Sadly the consequences of adding extra lumps of capital here and there are equally ugly but less likely to result in safety: they could well result in risk leaving the banking system, and/or banks optimising the channels of their risk taking. The fact that these consequences are not obvious to the Basel Committee is deeply dispiriting. It isn’t quite too late to fix these problems, but with the full Accord due in October, the clock is ticking…

Posted in: Basel, Regulation by David /
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From the Committee, edited down for brevity:

The Committee retained most of the definition of capital proposals set out in the December 2009 consultative package. However, it concluded that certain deductions could have potentially adverse consequences and may not appropriately take into account evidence of realisable valuations during periods of extreme stress. Therefore, the following amendments to the December 2009 proposal have been agreed.

Definition of capital

The Committee will allow some prudent recognition of the minority interest supporting the risks of a subsidiary that is a bank. The excess capital above the minimum of a subsidiary that is a bank will be deducted in proportion to the minority interest share.

The December 2009 reform package required that unconsolidated investments in financial institutions be deducted when the holdings exceed certain thresholds. These thresholds continue to apply. The December paper also stated that gross long positions may be deducted net of short positions only if the short positions involve no counterparty risk. The Committee agreed to eliminate this counterparty credit restriction on hedging of financial institution investments and to include an underwriting exemption.

Instead of a full deduction, the following items may each receive limited recognition when calculating the common equity component of Tier 1, with recognition capped at 10% of the bank’s common equity component:

• Significant investments in the common shares of unconsolidated financial institutions. “Significant” means more than 10% of the issued share capital;

• Mortgage servicing rights (MSRs); and
• Deferred tax assets (DTAs) that arise from timing differences.

A bank must deduct the amount by which the aggregate of the three items above exceeds 15% of its common equity component of Tier 1.

Counterparty credit risk

The Committee is making the following modification to the treatment of counterparty credit risk, including the bond equivalent approach to calculating the credit valuation adjustment (CVA):

• Modify the bond equivalent approach to address hedging, risk capture, effective maturity and double counting;

• To address the excessive calibration of the CVA, eliminate the 5x multiplier that was proposed in December 2009;
• Keep the asset value correlation adjustment at 25% to reflect the inherent higher risk of exposures to other financial entities and to help address the interconnectedness issue, but raise the threshold from $25 billion to $100 billion; and
• Banks’ mark-to-market and collateral exposures to a central counterparty (CCP) should be subject to a modest risk weight, for example in the 1-3% range, so that banks remain cognisant that CCP exposures are not risk free.

Leverage Ratio
The Committee agreed on the following design and calibration for the leverage ratio, which would serve as the basis for testing during the parallel run period:

• For off-balance-sheet (OBS) items, use uniform credit conversion factors (CCFs), with a 10% CCF for unconditionally cancellable OBS commitments (subject to further review).

• For all derivatives (including credit derivatives), apply Basel II netting plus a simple measure of potential future exposure based on the standardised factors of the current exposure method.
• The leverage ratio will be calculated as an average over the quarter.

When it comes to the calibration, the Committee is proposing to test a minimum Tier 1 leverage ratio of 3% during the parallel run period.

The parallel run period commences 1 January 2013 and runs until 1 January 2017. During this period, the leverage ratio and its components will be tracked, including its behaviour relative to the risk based requirement. Bank level disclosure of the leverage ratio and its components will start 1 January 2015.

Procyclicality, systemically important financial institutions, and the net stable funding ratio have all been kicked into the long grass, with further proposals at the end of the year (i.e. past the G20 Basel 3 deadline of November).

The Liquidity coverage ratio stays, but with some recalibration:

• Retail and SME deposits: Lower the run-off rate floors to 5% (stable) and 10% (less stable), respectively (from 7.5% and 15%). These numbers are floors and jurisdictions are expected to develop additional buckets with higher run-off rates as necessary.

• Operational activities with financial institution counterparties: Introduce a 25% outflow bucket for custody and clearing and settlement activities, as well as selected cash management activities.
• Deposits from domestic sovereigns, central banks, and public sector entities (PSEs):
  • For unsecured funding, treat all (both domestic and foreign) sovereigns, central banks and PSEs as corporates (ie with a 75% roll-off rate), rather than as financial institutions with a 100% roll-off rate.

  • For secured funding backed by assets that would not be included in the stock of liquid assets, assume a 25% roll-off of funding.
• Undrawn commitments: Lower retail and SME credit lines from 10% to 5%. Treat sovereigns, central banks, and PSEs similar to non-financial corporates, with a 10% run-off for credit lines and a 100% run-off for liquidity lines.
• Inflows: Rather than leave it to bank discretion to determine the percentage of “planned” net inflows, establish a concrete harmonised treatment in the standard that reflects supervisory assumptions.
• Definition of liquid assets: All assets in the liquidity pool must be managed as part of that pool and are subject to operational requirements. The December 2009 proposal outlined that the assets must be available for the treasurer of the bank, unencumbered, and freely available to group entities. The Committee will finalise these operational requirements by the end of this year.

  As part of the narrow definition of liquid assets, allow the inclusion of domestic sovereign debt for non-0% risk weighted sovereigns, issued in foreign currency, to the extent that this currency matches the currency needs of the bank’s operations in that jurisdiction.

• Introduce a “Level 2” of liquid assets with a cap that allows up to 40% of the stock to be made up of these assets.
  • Include (with a 15% haircut) government and PSE assets qualifying for the 20% risk weighting under Basel II’s standardised approach for credit risk, as well as high quality non-financial corporate and covered bonds not issued by the bank itself (eg rated AA- and above), also with a 15% haircut.

  • Utilise both ratings and additional criteria as outlined in the December proposal (bid-ask spreads, price volatility, etc) to determine eligibility.
• Develop standards for review at the September 2010 BCBS meeting for jurisdictions which do not have sufficient Level 1 assets to meet the standard.

Posted in: Basel, Regulation by David /
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As Reuters correspondents go, Chrystia Freeland is sensible, certainly more so than some of her fishy colleagues. She recently pointed out the importance of systemic weakness rather than people in the Crunch, a point I have been making since it began:

Blaming the crisis on human error is a lot easier than trying to work out the systemic problems it laid bare… But just because something is easy doesn’t make it accurate.

In particular she points out that Chuck Prince actually had a point in his much-derided “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” remark:

What’s really unsettling about Prince’s observation is not that he was wrong, but that he was right… Peter Weinberg [said] “It’s very, very hard to lean against the wind in a bubble. … If one of the heads of the large Wall Street firms stood up and said, ‘You know what, we’re going to cut down our leverage from 30 to one to 15 to one, and we’re not going to participate in a lot of the opportunities in the market’ — I’m not sure that chief executive would have kept his job.”

This is entirely on point. In the main, investment bankers did their job. OK, there were some clear errors of judgment, perhaps some fraud, perhaps some inadequacies of disclosure. But the big question, the question that must be addressed if we want a safer financial system, is ‘why did the system make it their job to do these things?’ Ms Freeland points out

Not only is betting against an asset bubble dangerous — buying into it can be smart.

She then references a 2003 Brunnermeier and Abreu Econometrica article which you can find here. This of course leads to the vexed and complicated question of macroprudential regulation, aka anti-cyclical regulation: how can we stop it being so attractive for firms to inflate bubbles. We are still taking baby steps in this area. But it is this, rather than throwing stones at individuals, that will make the next crisis less likely.

Posted in: Regulation, Rules by David /
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I attended a meeting last week at which a doctrinaire free markets economist was praising the benefits of a market in markets. The theory was that lots of different markets in the same asset would somehow give better liquidity, cheaper trading and hence better price transparency. What tosh.

No, what we see instead is that a diversity of markets produces poor liquidity, gappy markets, and just occasionally, near disaster. That seems to have happened on the 6th of May, when a market fall erased a trillion dollars in value in what Bloomberg dubs a ‘flash crash’. The WSJ account is here. It seems that a ‘fat finger’ trade, i.e. a mistaken transaction where perhaps a trader executed billions rather than the intended millions set off the wave. What happened then, it seems, is that waves of automated trading intensified the problem. Some of the smaller dark pools – alternative markets – were overwhelmed by the orders placed and became disorderly.

As Rajiv Sethi says, this is a recipe for disaster: computer-driven trading executed in milliseconds, poor liquidity, and no automatic trading stops make for instability.

The Bloomberg article above then says

One SEC memo, according to people who saw it, discusses a theory raised yesterday by NYSE Euronext spokesman Ray Pellecchia, who said sudden price moves in multiple stocks reached so-called liquidity replenishment points. That prompted the exchange to slow trading in those shares as it tried to ensure an orderly market. Such incidences allow other exchanges to ignore NYSE price quotes.

Trades sent to electronic networks then fueled the drop, said Larry Leibowitz, chief operating officer of NYSE Euronext. While the first half of the Dow Jones Industrial Average’s 998.5-point plunge probably reflected normal trading, the decline snowballed as orders went to venues lacking liquidity to match them, he said in an interview yesterday…

NYSE competitors such as Nasdaq OMX Group Inc. don’t use liquidity replenishment points. The SEC and CFTC in their joint statement raised concerns that the plunge may have been caused by exchanges not adhering to uniform practices.

“We are scrutinizing the extent to which disparate trading conventions and rules across markets may have contributed to the spike in volatility,” the regulators said.

No wonder. It is time to end this market in markets, and to throw some sand in the cogs of the algos. If every trade executed in the same, say, five second interval got the same price, instability would be greatly reduced, yet ordinary investors would not notice the effect. And if every trade were executed on the NYSE, or at least using the same market conventions, then officials could actually stop everything when things get out of hand.

Update. Here’s the letter from Senators Ted Kaufman and Mark Warner asking the SEC and CFTC to investigate the events of the 6th. The joint SEC/CFTC ‘we are looking at it’ letter is here.

A very readable and plausible account from a sell side analyst is here. I’m going to quote it at length as it deserves the widest possible dissemination:

I’ve got 28 pages in front of me of P&G prints [individual trades in Procter and Gamble] that occurred between $39 and $50 per share and between 2:46 p.m. and 2:51 p.m. At 36 prints per page, that means P&G traded over one thousand times at those “crazy” and “surely erroneous” levels. I’m sorry, but that isn’t an error, THAT IS WHAT WE LIKE TO CALL TRADING. So what happened here? Three things:

1. Sellers probably had orders in algorithms – percentage-of-volume strategies most likely, maybe VWAP – and could not cancel, could not “get an out.” These sellers could be really “quanty” types, or high freqs, or they could be vanilla buy side accounts. It really doesn’t matter. The issue here is that the trader did not anticipate such a sharp price move and did not put a limit on the order. The fact that the technology may have failed does not mean the trader deserves a do-over, it means that the trader and the broker who provided the algorithm need to decide whether any losses should be split.
2. Sell stop orders were triggered which forced market sell orders into an already well offered market.
3. While the market was well offered, it was not well bid. Liquidity disappeared. For example, in P&G, 200 shares traded at $44.10 at 2:51:04 in the afternoon and one second later, at 2:51:05, three hundred shares traded at $47.08. That’s a three dollar jump in one second. Bids disappeared, spreads blew out, and no one was trading except a handful of orphaned algo orders, stop sell orders, and maybe a few opportunists who had loaded up the order book with low ball bids (“just in case”). High frequency accounts and electronic market makers were, by all accounts, nowhere to be found.

It boils down to this: this episode exposed structural flaws in how a trade is implemented (think orphaned algo orders) and it exposed the danger of leaving market making up to a network of entities with no mandate to ensure the smooth and orderly functioning of the market (think of the electronic market makers and high freqs who can pull bids instantaneously as opposed to a specialist on the floor who has a clearly defined mandate to provide liquidity).

Posted in: Markets, Regulation, Software and Virtual Worlds by David /
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In the past I have made the argument that there is a trade off between financial stability and growth. You can have low growth and financial stability; you can have high growth and instability; if you get it really wrong, you can have low growth and instability. But what you can’t have is high growth and stability. The new Basel reforms in bank capital will have an impact on the growth rates of the economies in which they are applied.

There have been various hints at the quantification of this recently, including a ’secret’ estimate prepared by PWC for the British Banks. But now Nout Wellink, chairman of the Basel Committee, has revealed according to the FT that

Economists at the Dutch central bank had calculated that the proposed reforms would knock a cumulative 0.5 to 1 percentage points off global growth

Wellink apparently thinks that ‘that price is not too high’. I wonder if finance minsters of the G20 will agree with him. After all 1% is little enough if you are China with 12% growth: but it is a lot for the Eurozone with GDP growth less than 1% already…

Posted in: Regulation by David /
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There is a noticeable piece of terminological gymnastics that commentators engage in when discussing regulatory measures. If they are in favour of something, they call it risk sensitive. If they are against, they call it procyclical. Now, not all risk sensitive measures are procyclical and vice versa, but the connection between them is strong, and the tension is unavoidable.

This is particularly so as there is a paucity of satisfactory solutions to modifying current regulatory arrangement to make them less procyclical. The ‘Spanish’ dynamic provisioning scheme is one suggestion, but this only addresses expected loss provisions not capital, and it is anyway fraught with difficulties, many accounting-related. (Some firm’s accounting is focussed only on provisions for loans which are already uncollectable, in some sense; others provision for expected future losses which have not yet occurred: many mix the two. The Spanish proposal essentially allows for a flow from the EL provision into the incurred provision in bad times, and forces higher EL provisions in good ones, but it only works if you have both types of buffer.) Clearly if one could identify the place in the cycle then one could set an anticyclical capital buffer, for
instance requiring a 10% Basel ratio at the top of the cycle vs. a 6% one at the bottom. But the difficulty is knowing where one is. It seems (and this is anecdotal – I will try to find a reference) that the ratio of credit growth to GDP growth is a reasonable way of identifying the upswing in the economic cycle, but that it is less helpful for spotting a crisis. One could perhaps devise a methodology involving various stress indicators such as the price of credit (i.e. bond and CDS indices), the price of liquidity (i.e. the spread between interbank and government rates), market volatility indicators (such as the VIX) and country risk. But the model risk is considerable.

Subjective judgements are also problematic. Imagine the impact on confidence if the financial stability board officially announces that we are in a crisis and so bank capital ratios have been cut by 2%. A clearer signal to stop lending in the interbank and repo markets is difficult to imagine.

Another problem with risk sensitivity is that, like any measure which discriminates, well, it discriminates. Specifically it makes credit more expensive for borrowers which are perceived as riskier. If you want to ensure that access to credit is broad, and that the price of credit does not vary too much over time, then that is problematic. Certainly some governments do want to achieve this end, claiming that it is a societal good. In that case, having ever more risk sensitive capital requirements gets them further from their goal, not closer.

Of course, the argument in the other direction is forceful. If capital requirements are not risk sensitive, then some trade or other will be incentivised: in the case we suggest, it will be better to lend to low credit quality companies and worse to lend to AAA corporates. If one has a bias at all, that one makes sense, as high quality companies have access to the bond markets, whereas low quality ones often do not. However the subprime crisis demonstrates the dangers of making credit too cheap for bad borrowers, so more generosity is not necessarily better.

Posted in: Regulation, Rules by David /
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Deus Ex has tried, and mostly succeeded, to post daily since the start of the financial crisis. Now, though, the posting rate has slowed, and that will probably not change, at least for a while. The reasons are multiple: there is a new stridency about much financial blogging, which I do not want to emulate, and which is clearly a risk; there is a new hostility, too, with both readers and writers willing to blame before seeking to understand. I heard a new definition yesterday of a financial derivative: it is of course that instrument which takes the blame in any problematic situation, regardless of its role.

Clearly regulatory changes are needed. We have argued that all along. But much of what is being proposed at the moment is disproportionate, ill-designed, and badly targeted. Some of it will even make matters worse. (A good example is central clearing: if you can only clear 75% of trades – and that is likely to be the case for some years, regardless of regulatory pressure – then for most counterparties, central clearing will actually increase credit risk, as some of the clearable trades will be offsets for the non-clearable ones.)

The Goldman vs. SEC case also worries me greatly. This is not because I don’t think Goldman did anything wrong: I have no idea if they did anything wrong. But the disconnect between what the case is about and what it is portrayed as being about is deeply unhelpful. The complaint accuses them of failure to disclose relevant information. This has been reported as designing a security which they knew would fail. One can easily be guilty of the former without having contemplated the latter. So, while the headline ‘Goldman accuses of fraud’ might be helpful for certain political agendas, it is actually somewhat distant from the truth.

In an effort to retain a degree of equilibrium, therefore, and to try not to fall into the trap of writing knee jerk posts, Deus Ex is going to slow down. Expect slightly longer posts, rather less frequently.

Posted in: Legal Risk and Trade Documentation, Mother of all Bailouts, Regulation by David /
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Felix Salmon appears to have spotted something which casts a whole new light on the pro exchange slant of the Dodd bill:

Dodd’s wife, Jackie Clegg, is a director of the CME, which paid her $153,219 in 2009; she also owns shares in the company worth about $235,000.

If this is true the industry should scream conflict of interest rather loudly.

Posted in: CDS and Negative Basis, Regulation by David /
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From a short but frank Reuters interview:

There is a war that is about to happen over not just who regulates Wall Street but what the rules are.”

“To put it in the crudest possible way, these firms have to be smaller and less profitable,” Lewis told Reuters. “If they were regulated properly and the rules of their game were sane, it would be less profitable to be a trader at a big Wall Street firm … It is really a war over money.”

Certainly I agree that the big guns will soon be brought out. How the conflict will be resolved, though: that is the interesting question.

Posted in: Regulation by David /
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I very much hope not, but this ill-advised clause is in the draft Dodd Financial Reform bill:

It shall be unlawful for any person, other than an eligible contract participant, to enter into a swap unless the swap is entered into on or subject to the rules of a board of trade designated as a contract market…

Update. Bloomberg’s view is that this may well be not a problem. The quote Cornelius Hurley, an academic, who says that there are ‘loopholes galore’ so this ‘not going to have Wall Street upset’. I worry that this might be overly optimistic and that the give-and-take of the lawmaking process may leave us with a decidedly sub-optimal situation in the US.

Posted in: Regulation by David /
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Senator Ted Kaufman writes: I start by asking a simple question: Given that deregulation caused the crisis, why don’t we go back to the statutory and regulatory frameworks of the past that were proven successes in ensuring financial stability? It is a reasonable question. There are three components to the answer: First, the finanical system is different. We have securitisation, the big arbitrage tool for Basel 1; we have more internationalised banking and a different profile of lending; and we have different policies from central banks. That in turn is because the economy is different. It has different needs. Large corporates in particular demand a wider range of services. Moreover we are unwilling to accept a large fraction of society being denied credit as they were in the past. We are less tolerant of boom and bust: we want both high growth and stability. There is a real danger of looking back with rose tinted spectacles (if not without our heads). The regulatory system was not perfect in the days before OTC derivatives when Glass Steagall still ruled. (See here for a short list of financial crises in the last forty years.) As Dave said in the comments to a previous post, we need to design a regulatory system for the future, not for the past.

Posted in: Economic Theory, Photography, Regulation by David /
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Two contradictory signals. First from the FT:

Regulators have ordered UK banks to run a new round of tougher stress tests that assume the economy will endure a double-dip recession that would force unemployment up to 13.3 per cent.

The banks will be required to prove that their tier core one capital ratio – a key measure of banking safety – would stay above 4 per cent even if the economy contracted an additional 2.3 per cent for a total fall of 8.1 per cent from the boom, the Financial Services Authority said in its annual Financial Risk Outlook.

(The full document is here.)

Next from the FSA themselves:

the FSA said that it would not tighten quantitative standards before economic recovery is assured given that all firms were experiencing a market-wide stress. The FSA committed to giving a further update in the first quarter of 2010.

The FSA believes that it would be premature to increase liquidity requirements across the industry at the current time. This position will be reviewed later on in the year with a further announcement in Q4, 2010.

At first blush, this is odd. Stronger stress tests but no liquidity requirement (yet). But perhaps it is not so strange: the FSA is concerned about the possibility of a doble dip recession, and knows that banks have enough to worry about without meeting the liquidity requirements too. They have to balance making the banking system sounder with discouraging lending and hence making that double dip more likely. The news, then, is broadly positive: the stress tests probably won’t have much of a capital impact on most people, and the delay in the liquidity requirements will be very welcome for many banks.

Posted in: Economic Theory, Liquidity and liquidity risk, Regulation by David /
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What do regulators need to be successful? That the regulated are successful. Therefore it is no surprise that a regulator should defend their turf. Gary Gensler however goes further: here is his slick bait and switch in aid of the exchanges.

We’ll start with a classic example of ‘wouldn’t it be nice’:

A comprehensive regulatory framework governing over-the-counter derivatives should apply to all dealers and all derivatives, no matter where traded or marketed. It should include interest rate swaps, currency swaps, foreign exchange swaps, commodity swaps, equity swaps, credit default swaps and any new product that might be developed in the future…

First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

The only minor difficulty is that there is already such a framework. It is called the Basel capital accord. It might be inconvenient for Gensler, but we don’t need a new regulatory framework. What we need is for the Americans to apply the framework the rest of the world already uses, and they themselves use for the largest banks, to everybody else. Even if they don’t do that it hardly matters: the vast majority of derivatives are traded by dealers who are subject to Basel capital adequacy rules and to robust conduct of business requirements.

(Now of course Basel is not perfect, as I have argued elsewhere. But to pretend that there isn’t a regulatory framework when there patently is is at best sharp practice and at worst rank dishonesty.)

Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction.

How on earth will putting OTCs on exchanges improve transparency? The swaps market is already highly transparent and highly liquid. Moving that would not change anything, except the profitability of exchanges. Some credit derivatives are illiquid: how would putting them on exchange make them more liquid? One needs only look at the stale, unrepresentative prices that exchanges distribute on their existing illiquid contracts to see that simply having a contract on the exchange is no guarantee of liquidity nor of accurate prices.

Trade reporting is important for credit derivatives, and a central counterparty or other counterparty risk reduction technology are also needed. But none of this needs an exchange. In fact the only people who need OTCs to put on exchange are the exchanges themselves and, it seems, their regulator.

Posted in: Clearing and Collateral, Regulation by David /
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This is a dissection of one of the most ill-informed NYT editorials it has ever been my displeasure to read. The column tackles OTC derivatives with a blend of ignorance, paranoia, and prejudice that is deeply disturbing in a paper that aspires to a high standard of journalism.

Let’s pick a few doozies.

These particular — and particularly complicated — instruments are traded privately among banks, their clients and other investors with virtually no regulation or oversight.

No, no, no. Bank derivatives trading is regulated: there are capital requirements, conduct of business requirements, and so on. There have been for many years. What wasn’t well regulated was certain US derivatives activities of broker/dealers. Given that there aren’t any broker/dealers left – they all became banks – this is not a problem.

A big part of the problem is that derivatives are traded as private one-on-one contracts. That means big profits for banks since clients can’t compare offerings.

No. Many OTCs, including swaps, CDS on hundreds of names, and OTC FX options, are liquidly quoted, and prices are more reliable on many of them than on most exchange contracts.

That is why it is so essential to move derivative trades onto fully transparent exchanges.

How would that help? An illiquid market on an exchange is more confusing than an OTC one. At least with the OTC market, you can see that there are no prices. With the exchange, you get stale prices reported as facts, confusing the unwary. Liquid markets don’t need to be moved to exchanges, and illiquid ones are not much improved by the move.

Effective trade reporting is a separate matter: this is being achieved via mechanisms such as the DTCC reporting of credit derivatives. It does not require an exchange.

It is worth noting here that the exchange have been extremely effective at using the crisis as a tool to get more business. If they can persuade legislators that all the world’s financial problem can be solved by putting OTC derivatives on exchange, then their shareholders will be very happy. But they are simply a lobby group: we don’t have to uncritically believe all their PR.

Derivatives investors who stand to make huge profits if a company or country defaults, for example, might try to provoke default — a situation that regulators should be able to prevent.

The problem isn’t going to be solved by banning CDS. What we need is proper contract design which ensure that the voting rights of creditors go with the risk. This is a matter of derivatives documentation – and it should be relatively easily solvable.

No one could argue that derivatives markets are perfect, nor that the regulatory framework for them could not be better. But pedalling lies, half truths, and remedies that won’t work or aren’t necessary is not the answer. Can we please have some informed debate about derivatives reform?

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation, Regulation by David /
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There is a famous cartoon of a man sitting in his pyjamas at a laptop and calling out to his wife – who is in bed – ‘I can’t come to bed right now honey, there’s someone on the internet who is wrong’. I feel like that when reading Felix Salmon these days. He’s wrong, but pointing this out has limited effect. Still, this column of his is so mistaken that I can’t help deprive myself of a few minutes sleep to highlight some of its more obvious idiocies. I’ve reordered the points to make them quicker to shoot down, and reclaim a minute or so of slumber.

There’s a lot of blame to go around when it comes to this crisis, of course. But let’s see who deserves huge chunks of it:

• Traders at investment banks, who levered up and started making so much money that they ended up ousting the investment bankers who had historically run them.
• Arbitrageurs who made enormous sums of money by making leveraged bets that something with a 95% chance of happening was, indeed, going to happen.
• Senior US politicians who urged the deregulation of the derivatives industry over the objections of, among others, Brooksley Born.

No. Traders had nothing to do with it. It was mortgages, remember, that caused the crisis. Mortgages, not derivatives. So you should blame the people who made the loans – primarily mortgage banks – and the people who bought the risk, often insurance companies. But blaming derivatives or hedge funds for the subprime crisis is like blaming llamas for the Chilean earthquake: they might have been around, but they weren’t responsible.

• Senior management at investment banks, who urged their traders to take on ever more risk and leverage.
• Senior executives at big commercial banks who had no idea what risks they were running.
• Senior executives at big commercial banks who urged their fixed-income departments to take on ever-increasing amounts of risk.
• Board members at big commercial banks who failed to implement any kind of succession strategy should their CEO suddenly have to leave.

Oh come on. Either they knew about the risk and wanted more of it, or they didn’t know. In most banks of any size the risk decisions are taken far below the level of senior management – it is really no surprise if they don’t know the details of the bank’s risk position, just as it is no surprise if Warren Buffett has no idea how train signalling works. Moreover senior management work for the shareholders and hence rationally should use all the leverage that is safe. The blame rather lies in regulation that permitted that degree of leverage. But then Felix has proudly advertised his ignorance of regulation. And succession planning? You what?

• Senior US politicians who were responsible for dismantling Glass-Steagal.
• Bankers-turned-politicians-turned-banker s who institutionalized the revolving door between Wall Street and Washington, making it clear that if you did the banking industry’s bidding during your tenure in DC, you’d be rewarded on the other side with a highly remunerative job.
• Grandees who bullied lesser mortals into doing what they wanted just because everybody assumed they knew what they were talking about and because they were paid eight-figure salaries to just sit around and be grand.

Now we are in the realm of things it is reasonable to loathe, but had nothing to do with the Crisis. Many countries which did not suffer much had nothing like Glass-Steagal, from which we conclude that Glass-Steagal is a red herring. Similarly, find me a financial institution, and likely some of the senior people in it will be forceful characters. They might well make a lot of money. That does not make them responsible for the crunch, however dislikeable they are.

• Senior US politicians who ran US fiscal policy for the benefit of Wall Street, while asking for nothing but cheap debt in return.
• People so blind to their own weaknesses that even after the crisis happened, they refused to admit any responsibility for it at all.

Well, maybe. But you only score one out of ten, Felix. It’s easy to demonise people; to say that Rubin (or Greenspan or Mozilo or whoever) was responsible. And certainly there are people who do bear some of the blame. Nothing will improve, though, if we fine them, jail them, cover them in opprobium or indeed publically tar and feather them. Rather we need to fix the systemic weaknesses that led to the crisis. If incentive structures are wrong, there will always be people to exploit them. Who does it is almost irrelevant. Whereas if we rebuild the rules of the system properly – the accounting rules, regulation, and so on – then it is much harder for the actions of any group to lead us into another crisis. Hysterical blame slinging won’t fix the system however much it bolsters the righteous anger of some of Felix’s readers.

Posted in: Photography, Regulation by David /
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I mean that as in the ‘nature red in tooth and claw sense’. One of the many reasons that Basel 2, 3, pick a number, is bollocks, is that it permits little diversity, at least if taken seriously. (Some countries don’t take it seriously, of course.) We’d be better off letting countries innovate, and then seeing what works.

Joseph Stiglitz agrees. Writing in the FT, he says

…each country is responsible for ensuring the safety and stability of its financial system and economy, and for protecting its citizens. It is dawning on leaders – in some cases egged on by rightly impatient voters – that we cannot wait for co-ordination. It is far better to have strong action now and then harmonise the regulatory structures later. It may be “second best” – but far better than the third-best alternative of delayed and ineffective regulation.

We’ll see. The forces of Basel bollockery are strong, and the siren cry of the level playing field is still effective. But I honestly think the financial system would be stronger if each country went its own way. At least then global systemic crises would be less likely.

Posted in: Basel, Regulation, Rules by David /
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That’s Norwalk, Connecticut.

In Risk, we find:

faced with accounting changes that would result in more financial instruments being reported at fair value through the income statement – meaning changes in value would appear as profits or losses – regulators have been quietly discussing radical new rules that would separate profits into buckets depending on the liquidity of the underlying assets.

The new reporting regime would then allow regulators to restrict how gains on less-liquid instruments are used. As a result, derivatives and structured product businesses could find a huge chunk of their profits fenced away.

This is a variant on an idea I suggested earlier, and a bad variant to boot. The good thing about separating realised from unrealised gains is that only the latter are a good form of capital. If you have rigourous valuation risk management, then the P/L on the illiquid books is just as good as the P/L on the liquid ones, since both have sufficient valuation adjustments to cope with the uncertainties involved. Supervisors would be better off doing the boring (but hard) job of ensuring that firm’s are valueing their books properly, and then treating all unrealised profits as potentially suspect, not just level 2 and level 3 ones.

Posted in: Accounting, Capital and Contingent Instruments, Regulation by David /
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Governments borrow by issueing bonds of various maturities. They liquify the banking system by lending banks money, often for very short maturities. If the yield curve points up, as it often does, then banks can make money simply by borrowing for one week from the central bank and investing the proceeds in longer term bonds. Providing this is done in the banking book, it attracts no capital charge.

Usually banks don’t do this as the returns offered by lending the money out to corporates or individuals are attractive given the risks: the safety of government bonds is not needed. But in the current environment, with elevated credit risk and concerns over capitalisation, some banks are engaging in this rather attractive carry trade.

Is that OK? Well, no. It is a direct subsidy from taxpayers to the banks. It is also damaging for the economy as it reduces the amount of bank credit available.

There are a few obvious fixes.

• There should be a capital charge for interest rate risk in the banking book.
• Access to the central bank window should be conditional on new lending. That is, banks should only be able to borrow from the central bank if they pledge a certain amount of recently originated loans, commerical or retail, as additional collateral.
• Tax interest on government bonds held by banks more punitively. (This is however problematic if we want to force banks to hold some govvies to improve their liquidity risk.)
• Manage the shape of the yield curve to make the trade more attractrive, e.g. through quantitative easing.

Posted in: Liquidity and liquidity risk, Regulation by David /
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One thing that is interesting about the Obama proposal for banking reform is the fact that some things – owning private equity groups, sponsoring hedge funds – are going to be banned for banks. Not fully supported by equity: banned. Obama is effectively saying that no amount of capital, not even 100% of notional, is sufficient to remove the risk of these activities. I am supportive of the desire to ensure that Never Again Will the American Taxpayer be Held Hostage by a Bank that is ‘Too Big to Fail, but an outright ban seems a crude instrument. It might work, if Obama can get this through Congress, but now I think about it, it feels neither proportional nor optimal.

Update. From the FT:

The best that can be said for Barack Obama’s latest plan for financial regulation – banning deposit-taking banks from proprietary trading and capping financial groups’ market share of funding – is that it shows he now sees only radical policies can crisis-proof the financial system. But the claim that these ones will increase stability is misguided, if not misleading.

Being cut off from trading securities for their own book will not stop banks from putting insured deposits at risk. Their inventiveness in finding ways to lose money knows no bounds, and the most time-honoured money-loser of all – making bad loans – remains available.

I would not go quite as far as the FT: the Obama proposals will probably increase stability. But they will indeed not remove all risk from the financial system, and indeed we want some risk, because there is a trade off between financial system risk and the maximum achievable economic growth. Being forced to eat their own lunch – to keep credit risk they originated – does at least provide a good incentive structure for banks, even if this is the traditional way for financial institutions to lose money.

It remains that case that well designed capital rules remain the cornerstone of financial stability. They provide damping, limiting leverage, and leveling the playing field between diverse types of risk. Simply banning banks from carrying out certain activities, especially activities which will be carried out in unregulated institutions, is no substitute for trying to write good capital rules.

Posted in: Regulation by David /
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I rather doubt it, but these are worrying times for those that have not yet decanted from the Wharf to Mayfair. As Bloomberg says: President Barack Obama will offer proposals to limit financial institutions’ size and trading activities as a way to reduce risk-taking, an administration official said… The proposals could affect trading at some of the nation’s largest banks, including New York-based Goldman Sachs Group Inc., Morgan Stanley and JPMorgan Chase & Co., said Frederic Dickson, chief market strategist at D.A. Davidson & Co. in Lake Oswego, Oregon. Banks conduct proprietary trading for their own benefit, not for that of their clients. This is probably more effective than a new Glass-Steagall: universal banks with minimal prop operations would pose a lot less risk than broker/dealers with them, and the idea that a Goldman sans lending is not too big to fail is not credible. I fear the curbs will not be effective, but certainly I applaud the desire to prevent too big to fail firms from costing the tax payer too much. *Any suggestions that this title is just there to provide spurious justification for the picture will be ignored. Update. John Hempton points out that the definition of prop trading is not entirely clear. I agree: drawing the line is difficult, and likely to be arbitrageable. That does not mean that some attempt to limit bank’s prop risk is not sensible however.

Posted in: Regulation by David /
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The market’s reaction to the latest Basel committee document was swift and severe: bank share prices fell significantly. However, a close reading of the proposals suggests that those falls might be overdone. Here’s the good news/bad news skinny: (where I’ve used ‘good’ to mean ‘good for the banks’ – the skeptical might well take that to mean ‘bad for financial stability’)

Bad news: the predominant form of capital will eventually be common equity and retained earnings. Funkier capital instruments, such as innovative tier 1 instruments (a form of callable step up bond) will be phased out.

Good news: not yet. Moreover, existing instruments will likely be grandfatherered. Furthermore, the calibration of the new capital levels is going to be based on an impact study, making it likely that banks that are average or better will be fine. There is no firm indication, in this document at least, that most banks will have to raise more capital.

Bad news: unrealised gains on available for sale instruments may not be acceptable capital.

Good news: that was only important in a few places, such as Japan, anyway.

Bad news: goodwill and deferred tax assets are a deduction from capital.

Good news: the market thought that they were anyway.

Bad news: significantly higher capital requirements for counterparty credit risk.

Good news: this provides a great lever for firms to use to persuade their counterparties to sign tighter margin/collateral agreements. Renegotiation of credit support annexes could remove much of the extra capital required.

Bad news: an overall constraint on balance sheet leverage.

Good news: again, set using an impact study, and hence likely only to impact outlier institutions.

All in all, this is much better than the industries’ worst fears. Whether you think that is good news or bad news depends on your perspective.

Posted in: Basel, Capital and Contingent Instruments, Credit, Regulation by David /
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…now get more capital.

That seems to be the message anyway. The press release is here, with links to two consultative papers. Full analysis follows next week, but on first glance there does not seem to be anything particularly unexpected in the document: leverage ratios, countercyclical capital requirements, high standards of liquidity risk management, and high quality capital are all there.

Posted in: Basel, Regulation by David /
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A few weeks ago, I discussed the idea that we could reduce both moral hazard and the profitability of banking by charging banks for the cost of the option the bank has to be rescued by the state. In related work, Elijah Brewer and Julapa Jagatiani at the Philadelpha FED have attempted to estimate how much banks are willing to pay to become too big to fail (and thus ensure that they have that option). The paper is here: hat tip (as so often) FT alphaville.

Posted in: Mother of all Bailouts, Regulation by David /
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Why do both Felix Salmon and Paul Krugman think that it is OK to say thank bank regulation is boring? Aren’t these people actually paid to take an interest in it? If supposed experts can’t rouse any interest in the most fundamental topic in finance right now, what hope is there?

Update. The Epicurean Dealmaker, in contrast, does a pretty decent job of highlighting many of the important issues at least in the US. Add in some changes to capital requirements too, for instance as we discussed here, and you would have a really rather sound manifesto.

If non-professional commentators like this can have a decent working knowledge of regulation, I don’t think it is too much to ask Krugman and Salmon to knuckle down and read the Basel Accords. And the revisions to them. It’s only a few thousand pages, and it is much more interesting that Krugman’s usual reading matter.

Posted in: Regulation by David /
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The two first introduce Limited Purpose Banking, or LPB. They then write, in How to take moral hazard out of banking:

Mutual funds are, effectively, small banks, with a 100 per cent capital requirement under all circumstances. Thus, LPB delivers what many advocate – small banks with more capital. Will this work? It has. Unlike so much of the financial system, the mutual fund industry came through this crisis unscathed. True, the Primary Reserve Fund broke the buck by investing in Lehman and had to be bailed out. But under LPB only cash mutual funds (invested solely in cash) would never lose investors’ principal. The first line of all other funds’ prospectuses would state: “This fund is risky and can break the buck.”

(The full FT article is here.)

Um, no. First, mutual funds don’t have a 100% capital requirement: they have a 0% one. All their funding is debt. This makes them highly risk averse: at the first sign of trouble, they sell, exacerbating liquidity problems in the short term note and CP markets. Using short term notes to fund longer term risk taking is a recipe for disaster. Instead we do at least know that historically using insured retail deposits to fund loans is relatively sound, provided that capital requirements are high enough. Splitting originating loans from taking the risk on them doesn’t work as there is no alignment of interests: splitting deposit taking from risk taking doesn’t work either due thanks to mismatch in the term of funding.

Turning now to Felix Salmon, we find:

if investors think that huge losses are coming around the corner, or that a bank is incapable of making sustainable profits over the long term, then no amount of capital today is likely to reassure them that a bank is safe.

This is not true. Some amount of capital will certainly reassure them: an amount equal to the plausible worst case losses, plus a bit, say. OK, that might be quite a bit more than 2% core tier 1 ratio permitted under Basel, but that’s fine.

stock-market investors don’t necessarily reward well-capitalized banks and punish those with only thin layers of equity — in fact the opposite is true much of the time.

Duh, as Homer would say. High leverage = high returns in the good times = high equity price. Of course the equity markets reward high leverage most of the time: most of the time, high leverage is fine. It’s just that when it isn’t, the costs are enormous. No, I wish I had a better recipe than the universal bank under high capital requirements, but I don’t, and I don’t think anyone else has either. Unless of course you know different.

Posted in: Commercial Paper, Liquidity and liquidity risk, Regulation by David /
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Here is an interesting idea. The FDIC are suggesting that if a

large systemically important institution is put into receivership by the FDIC and there are not enough assets to cover the cost of unwinding it to the government, all secured claims would be automatically converted into unsecured loans with a haircut of up to 20%.

The original Reuters story is here, and comment from Across the Curve, based on Barclays research, is here.

This idea appears to be gaining traction. FT Alphaville reports on an amendment which passed yesterday in the House. Proposed by representatives Miller (D) and Moore (D), this would implement the FDIC proposal. In particular, as Across the Curve points out, it would have significant implications for the repo market, since even a fully secured repo would take a 20% hit in the event of FDIC intervention.

Is this good or bad for financial stability? It is frankly rather difficult to say.

On the one hand, it would encourage creditors to review the credit quality of counterparties rather better. But it would equally encourage a rush for the exit as an institution became troubled, and exascerbate funding liquidity risk. Remember it was counterparties declining to roll repos that caused the demise of both Bear Stearns and Lehman. So this rule change, if enacted, would make it more likely that secured funding is withdrawn as confidence is lost. That is pretty likely anyway, however, so it could be argued that the downside is not great. It might well encourage the development of a market in CDS on repo receiveables though…

Posted in: CDS and Negative Basis, Credit, Liquidity and liquidity risk, Regulation by David /
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See the sun! Ignore the muddy puddle. That’s the regulators’ way, according to a great post at Interfluidity:

In good times, regulators have every incentive to take banks at their optimistic word on asset valuations, and therefore on bank capitalization. It is almost impossible for bank regulators to be “tough” in good times, for the same reason it is almost impossible for mutual fund managers to be bearish through a bubble. A “conservative” bank examiner who lowballs valuation estimates will inevitably face angry pushback from the regulated bank… Valuations can remain irrational much longer than a regulator can remain employed…

When a “systemic” banking crisis occurs, regulators’ incentives are suddenly aligned with bankers: to deny and underplay, to offer forbearance, to allow the troubled banks to try “earn” their way out of the crisis. Regulators, in fact, can go a step further. Bankers can only “gamble for redemption”, but regulators can rig the tables to ensure that banks are likely to win. And they do.

The whole post is definitely worth reading. The key point though – that banking crises make regulators look silly, and thus they have an incentive to underplay the seriousness of the issue and to covertly help the banks earn themselves back into the black – is very well made. Now would be a really good time to be highly suspicious of asset valuations, loan loss provisions, and other counterparty performance evaluations.

Posted in: Mother of all Bailouts, Photography, Regulation by David /
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Capital is protection against loss: the more capital you have, the more losses you can withstand without being insolvent. So far so obvious.

One popular way of thinking about this is to think of the value of a firm’s assets as varying: the firm is insolvent if the value of their assets falls beneath the value of their debt (or liabilities or whatever). Clearly the more capital a firm has, the less likely this is, as the further the assets must fall before disaster strikes. But with any leverage at all – any non zero amount of debt – insolvency is possible.

Suppose that a bank is a entity that the state must rescue (or at least protect some of the depositors of). Further suppose that the state demands fair compensation for this protection from bank shareholders. If liquidity risk is not an issue (which in reality it is, but bear with me), then the state should charge an appropriate amount given the risk of insolvency.

How might we work that amount out? This is essentially a problem in the theory of capital structure: we have to figure out what the appropriate model of asset value is, and hence how likely it is for the asset value to fall beneath the liability value. The simplest model that would allow that to happen is Merton’s: there are a number of more sophisticated alternatives.

The basic idea, though, is quite simple and interesting, even if the details are complex. Banks pay a premium each year to the deposit protection agency (FDIC, central bank, whatever) based on their actual risk including how volatile their assets are and how much capital they have. These numbers will be large, too, especially for firms whose capital ratios are not substantial. Institutions would be able to choose higher leverage structures, but only at a very considerable immediate cost to their shareholders. Safer banks would pay less.

Of course, the devil here would be in the details. We would want to ensure that the state got an appropriate return for the expected costs of rescues, plus sufficient compensation for bearing the risk that those costs would be larger than expected. The estimates of those costs would be rather sensitive to the assumed asset dynamics. But there has been a lot of work in this area that could be applied, and advantages in terms of reduced moral hazard would be considerable.

Posted in: Capital and Contingent Instruments, Regulation by David /
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One more thought about contingent convertibles. Clearly as designed having one of these convert is a really bad sign: they are designed to convert only in event of severe stress. Indeed the Lloyds structure was tweaked to go from converting at a Basel ratio of 6% to 5%, in order to make conversion less likely. This of course makes the instrument more attractive to investors. But I think from a stability perspective, it is a bad thing. What we want instead is a structure that converts gently and much more often. That way, conversion is not confidence sapping.

How about this. Ten year structure. Each month, a percentage max(0%, 12 x (12% – Basel ratio)) converts. The monthly observations fits with regulatory capital reporting. It means that even mild losses cause a topping up of capital to occur. Of course you can tweak the thresholds and multipliers, but the basic idea of an instrument that converts early and often is I think much better than one that converts only in an emergency – and by so doing, screams this is an emergency.

Posted in: Capital and Contingent Instruments, Regulation by David /
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More goodies from from Piergiorgio Alessandri and Andrew G Haldane: Hedge funds started this crisis in the doghouse. Yet they are the dog that has not barked. Their industrial structure may explain why. Unlike banking, the hedge fund sector does not comprise a small number of large players, but rather a large number of relatively small players. The largest hedge funds typically have assets under management of less than $40bn, the largest banks assets in excess of $3 trillion. Unlike banking, concentration in the hedge fund sector is low and has been falling. The top 5 hedge funds comprise around 8% of total assets, down from 30% a decade ago. Unlike banking, the business models of hedge funds are typically specialised rather than diversified… It may be coincidence that the structure of the hedge fund sector emerged in the absence of state regulation and state support. It may be coincidence that the majority of hedge funds operate as partnerships with unlimited liability. It may be coincidence that, despite their moniker of “highly-leveraged institutions”, most hedge funds today operate with leverage less than a tenth that of the largest global banks. Or perhaps it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation. If so, that is an important lesson for other parts of the financial system. The point is excellent. While there have been hedge fund losses during the crunch, the hedgies have not endangered financial stability to anything like the extent that regulated financial institutions have. This could well be because they are diversified in their risk taking, relatively small, and typically not highly leveraged. It is clear that 10,000 small, diverse, low leverage firms form a much more stable financial system than 10 huge, similar, highly leveraged ones.

Posted in: Hedge Funds, Regulation by David /
3 Comments

Gordon comes out with a bombshell – or at least supports an idea that, despite its obvious and considerable merits, has not been mainstream. If there is one thing you could do to transform your legacy, improve the economy and enhance financial stability, it is to get agreement on a Tobin tax. Go Gordon go.

Posted in: Regulation, Taxation by David /
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Chart of the day, on a Friday morning. This is as of the end of October, so we may be higher by the end of the day.

Source: thechartstore.com via Calculated Risk.

Posted in: Mother of all Bailouts, Regulation by David /
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The inspiration here comes from an article with a great title by Jim Jubak: Why Big Banks Hate Banking (via the big picture). I would make the argument slightly differently…

• Retail banking can be reasonably profitable, but the ROE can suck, especially in a downturn. You can’t do much about that as the capital is set by the regulators.

• There is a lot of competition, and you need to be rather efficient to do it well.
• But, if you are big, you have lots of cheap funding and (almost certainly, thanks to all that capital the regulators made you keep), a good credit rating.
• Therefore do banking for the funding and the rating, then leverage those to do business with a higher ROE – trading (both proprietary and flow), derivatives structuring, and principal investment.

That has been the universal bank model as practised by banks from Citi through UBS and Deutsche to Westpac for many years. It views the actual banking as a necessary evil, with other activities generating most of the return. The question policy makers face is the extent to which they want to let deposits be used for these other activities. Broadly it seems that many informed commentators think that the right answer is not so much, but US regulators in particular do not seem to have the balls to act on that view.

Posted in: Regulation, Rules by David /
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I have blogged before about most of the proposals in this document from the commission, including the incremental risk charge in the trading book and the revised treatment of resecuritisation (CDO squared) positions, but I have not said much about stressed VAR. So without further ado:

Each institution must meet, on a daily basis, a capital requirement of:

1. The higher of (1) its previous day’s value-at-risk number; and (2) an average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by the multiplication factor;
   plus

2. The higher of (1) its latest available stressed-value-at-risk number; and (2) an average of the stressed value-at-risk numbers over the preceding sixty business days, multiplied the multiplication factor (m);
   plus

3. The sum of its weighted positions (regardless of whether they are long or short) resulting from the application of point 16a of Annex I (the treatment of securitisation positions);
   plus

4. The higher of the institution’s most recent and the institution’s 12 weeks average measure of incremental default and migration risk according to point 5a (the IRC charges).

(Note those pluses.)

The description of stressed VAR is fairly vague:

Each institution must calculate a ‘stressed value-at-risk’ based on the 10-day, 99th percentile, one-tailed confidence interval value-at-risk measure of the current portfolio, with value-at-risk model inputs calibrated to historical data from a period of significant financial stress relevant to the firm’s portfolio. This stressed value-at-risk should be calculated at least weekly.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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Continuing a long line of dry posts about regulatory capital, a summary of some of the most recently proposed changes to the CRD:

• … credit institutions should… build up through-the-cycle expected loss provisions for credit risks during good times … and use these provisions during a downturn to cover (some) of the incurred losses. Through-the-cycle expected loss provisioning is essentially a countercyclical measure for timely capturing expected losses due to inherent credit risks that have not yet materialised as ‘incurred’ losses. The through the cycle provisioning should be applied to items on the balance sheet (such as loans) and possibly to off-balance sheet items (such as guarantees). It is different from countercyclical regulatory capital approaches that basically provide a capital buffer for unexpected losses.

• … the Commission is considering imposing additional and specific capital requirements for loans for residential property that are denominated in a currency other than that of the income of the borrower.
  Those additional requirements would apply above a specified loan to value ratio: up to a low and conservative loan to value ratio…

• There is also some measure of harmonisation of various areas of national discretion within the rules.

The illustration is a roadmap of CRD changes: subsequent posts will address some of the other areas.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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The standard argument that credit derivatives are not insurance runs in brief:

• They require no insurable interest;

• They require no proof of loss; and in particular
• The payout is independent of the counterparty

All of this is standard, and goes back to an opinion of Robin Potts. Now, with ill-advised US action to regulate some credit derivatives activity as if it were insurance deferred, there is a new and more comprehensive account of the issues from M. Todd Henderson.

Henderson does a reasonable job, although the case seems a little over-argued to me. In particular, credit derivatives product companies (CDPCs) are much like insurers in financial substance – as was the Financial Products Group of AIG. So arguing from the perspective of the need to regulate insurers not applying to companies engaging in CDS may involve ground that is not firm. Where Henderson is good, though, is pointing out where risk shifting and pooling contracts in other spheres do not constitute insurance. For instance, if I set up a company to sell naked puts to commodities producers, and invest the premium, then I am acting as a pooling and risk shifting enterprise, but not an insurance company. The paper is worth a read if you have an interest in these matters even if it does seem to me a little propagandist.

Update. It is worth pointing out that the ‘insurance’ vs. ‘not insurance’ question is about more than regulation. It also affects accounting – insurers have their own accounting framework which is rather like accrual – and taxation. Given that much of the need to regulate CDS relates to counterparty credit risk, it seems that a much more cost effective fix to the vulnerabilities revealed by AIG is simply to do what we are doing anyway – set up a central clearing and market data reporting entity. Add in a reclassification of financial insurance as a derivative, enforce fair value requirements, and prudent capital requirements, and you would have a reasonably robust regulatory framework without the need to get insurance regulators involved.

Posted in: Credit, Insurance and Actuarial Practice, Legal Risk and Trade Documentation, Regulation by David /
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A few interesting observations from FSA’s discussion paper on A regulatory response to the global banking crisis:

• Pure narrow banking, whereby deposit takers buy gilts with deposits, and lending is separated from deposit taking, is not possible at the moment. There are not enough gilts out (c. £800B) there to soak up all the deposits (c. £950B), especially as lots of gilts (c. £300B) are owned by pension funds or insurance companies. Isn’t that amusing?

• Here’s a plot of bank size vs. Tier 1 ratio.

  

  Capital gets (relatively) smaller as banks get bigger. That is the opposite to what you want. As FSA say, there is a strong case for applying some form of capital (and perhaps liquidity)
  surcharge to systemically important banks.

• National regulation is back. FSA seeks greater emphasis on the standalone sustainability of national subsidiaries, with an overt global understanding that home country authorities will not consider themselves responsible for the rescue of entire groups.
• Despite steps in this direction already, there will be further reforms to the trading book capital regime [which] should significantly increase capital requirements and differentiate more strongly between basic market-making functions which support customer service, and riskier trading activities, with a bias to conservatism in relation to the latter.
• The resolution plan, aka living will, is definitely under discussion for large and/or complex firms.
• Here is a strong statement: There is a strong international consensus that the global framework for prudential regulation must be radically reformed to create a more robust and resilient financial system. I am not sure that it is true, but it is a hell of a way for a regulator to start the chapter in a discussion paper. Bravo.

  There is more going on in Basel than one might think here. Here’s a summary of the work under progress:

  

Posted in: Mother of all Bailouts, Regulation by David /
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Let’s (grit our teeth and) read the text of the new UK rules on liquidity. What follows is from the FSA’s PS09_16:

12.2.1 R (1) A firm must at all times maintain liquidity resources which are adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due.

(2) For the purpose of (1):

(a) a firm may not include liquidity resources that can be made available by other members of its group;

(b) an incoming EEA firm or a third country BIPRU firm may not, in relation to its UK branch, include liquidity resources other than those which satisfy…

[They are]:

• under the day-to-day control of the UK branch’s senior management; and

• held in an account with one or more custodians in the sole name of the UK branch; and
• unencumbered; and
• (for the purpose of the overall liquidity adequacy rule only,) attributed to the balance sheet of the UK branch.

Now this is very interesting. It is the nastiest part of the new rules by far as it means that the UK branches of foreign banks cannot rely on the parent for their liquidity: they have to have adequate levels of cash or near-cash assets locally. It is interesting that this is even legal under EU law: the relevant section of 2006/48/EC is The host Member State’s competent authorities should be responsible for the supervision of the liquidity of the branches and monetary policies. This allows FSA to be tough, and it has been tougher than any other major regulator thus far. It will be interesting to see if others follow suit. But in the mean time, we can at least salute their courage.

Posted in: Liquidity and liquidity risk, Regulation by David /
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According to Bloomberg:

Bank of England Governor Mervyn King stepped up his call for governments to tackle the dangers posed by banks that are “too important to fail,” saying new capital rules won’t shield taxpayers from funding any future bailouts.

So far, so reasonable. From here it gets interesting though:

He added it is “hard to see why” proposals such as those of former Federal Reserve Chairman Paul Volcker to separate proprietary trading from retail banking are “impractical.”

One’s immediate reaction is that any steps to break up the too big to fail banks would be a good thing. But I am not sure that King’s proposals are practical. In theory one could split insured deposit taking from investment banking, with the latter enjoying no government guarantee, but in practice few governments could resist saving a large, systemically important investment bank. Look at what happened when they let Lehman – not the largest investment bank by a long way – go down.

So yes, break up the behemoths. But a new Glass Steagall is not the way to do it. Rather, let’s see lots of smaller fragments cloven from too big to fail banks. That would produce a more stable financial system than the fiction that we can avoid guaranteeing the dominant securities market or derivatives market players.

Posted in: Mother of all Bailouts, Regulation by David /
1 Comment

The usual asset liability orthodoxy is that assets should be funded in the currency they are denominated in, so if you make a Hong Kong dollar loan, you fund it using a HKD liability.

There is no comparable orthodoxy for capital. This is usually held in the firm’s home currency only. It occurred to me today that that is odd for at least two reasons.

First, capital is funding. If you make a $100M loan and take an 8% capital requirement, that $8M is funding too. You only need $92M of deposits or debt to fund the rest.

Second, if that $8M happens to be held in yen, because the bank concerned is Japanese, it is 726M JPY at 90.75. But if dollar/yen moves to 100, that 726M JPY is only $7.26M and the capital is no longer adequate simply due to an FX movement. Which is not helpful.

Surely then, at least roughly, it would make sense to keep capital in the currency of the asset it was supporting. In some cases – notably VAR where diversification makes it hard to say what is supporting what – this is not easy. But in many cases it is. Is there a good reason firms do not do this?

Posted in: Capital and Contingent Instruments, Regulation, VAR by David /
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The Quantitative Impact Study from the BCBS is here. Broad brush conclusions:

• Trading book capital roughly doubles, overall capital up c. 11%

• Three components are of very roughly the same size: the incremental capital charge; stressed VAR; and the new specific risk charges.
• The stressed VAR is on average 2.6x the unstressed VAR.

More analysis will follow once I have had a chance to digest the details.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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Barry Ritholtz writes:

I believe the brain trust behind the Obama White House has made a huge tactical error.

As Rahm Emmanuel likes to say, one should “never waste a crisis” — and the White House has done just that…

There was widespread popular support for a full reform of finance. What the White House should have pursued was: 1) Reinstatement of Glass Steagall; 2) Repeal the Commodity Futures Modernization Act; 3) Overturning SEC Bear Stearn exemption allowing 5 biggest firms to leverage up far beyond 12 to one; 4) Regulating the non bank sub-prime lenders; 5) Continuing high risk trades to be compensated regardless of profitibility; 6) Mandating (and enforcing) lending standards, etc…

Instead, we have a White House that appears adrift, and the most importantly, may very well have missed the best chance to clean up Wall Street in five generations.

I agree with the conclusion: and it is deeply depressing for those of us who have devoted a lot of energy to arguing for reform.

Ritholtz’s prescription isn’t quite mine: I am less convinced about the benefits of a Glass-Steagall style split, not least because many European banks managed to be universal without being dangerous; rather I would prefer to see action to split up too big to fail institutions, combined with increased regulatory capital requirements that really constrain leverage for all systemically important risk takers. But the details don’t really matter: doing something does.

Posted in: Regulation by David /
1 Comment

John Kay in the FT comments on a theme that is central to this blog:

Any engineer will tell you of the importance of making complex systems robust. You need inspections to prevent failure, to be sure: but since failures are inevitable it is equally important to try to ensure that the consequences of such failure are contained.

This observation is as relevant to economic and financial systems as to technological ones. Designing them with components too important to fail is a prelude to disaster, as we know. In the financial sector, the problem of disruptive linkages between components has become known as the problem of systemic risk… the main source of systemic risk is within large financial conglomerates themselves.

Kay gets the solution wrong though. He suggests that the risky component as he sees it – investment banking – should be isolated from the rest. That’s foolhardy on two grounds. First, it wasn’t investment banking that caused the crisis. Derivatives weren’t the problem, after all: it was mortgage lending. The lesson here is that the risk often isn’t where you think it is, and so isolating the risky part of the business is not straightforward.

Instead we should accept that any component might fail, and thus to keep the linkages between all components sufficiently loose that no failure can bring the whole system down. That involves increasing capital and liquidity requirements, decreasing counterparty exposure, and taking a particularly conservative view of systemically important institutions.

Posted in: Regulation by David /
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Glorious, glorious, glorious is the day: yet more Basel. Here’s a key passage from BCBS158:

Factors that are deemed relevant for pricing should be included as risk factors in the value-at-risk model.

If you took the committee at its word, here, no one would have a VAR model. Just consider an equity derivatives book on underlyings in the Eurostoxx. There are 50 underlyings, 50 dividend yields (more if you consider the term structure of dividend yields), at least 20 interest rates in Euros, and as many implied volatilities as you have (strike, maturity) pairs for your options. A decent sized book will have many hundreds, perhaps many thousands, of risk factors. No one has a VAR model with all of those factors in it. So, what is a bank to do? Let’s turn back to the committee:

Where a risk factor is incorporated in a pricing model but not in the value-at-risk model, the bank must justify this omission to the satisfaction of its supervisor.

Ah lovely. So if you have a tolerant supervisor, perhaps because you are in a small country, or because you are a national champion bank, all is well. If not, you will have some hoops to jump. This provision in short is a charter for regulatory arbitrage. The next part is even worse:

In addition, the value-at-risk model must capture nonlinearities for options and other relevant products (e.g. mortgage-backed securities, tranched exposures or n-th-to-default credit derivatives), as well as correlation risk and basis risk (e.g. between credit default swaps and bonds). Moreover, the supervisor has to be satisfied that proxies are used which show a good track record for the actual position held (i.e. an equity index for a position in an individual stock).

If this doesn’t make players with big trading books redomicile to somewhere small, low tax and friendly, I don’t know what will.

Posted in: Basel, Regulation by David /
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Posted in: Regulation by David /
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Medium rare being of course far from tough. From the Times:

The City regulator said some fines could treble in size as it seeks to address concerns that penalties thus far have not proved much of a deterrent in improving company behaviour.

It also announced proposals for a minimum fine of £100,000 for individuals found guilty of market abuse offences such as insider dealing. Up to 40 per cent of an individual’s salary and benefits could be taken, it said.

Why not 100%? Why not ‘all their assets’? Drug dealers have all of their assets seized – are we really saying that selling grass to make thousands is completely evil, but insider trading for millions is only 40% evil?

Posted in: Regulation by David /
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I flatter myself that I was one of the first bloggers (although far from the first academic) to comment on the need for anti-cyclical capital rules. Three years later, this is becoming accepted wisdom. People still seem to think that identifying the cycle is difficult. I’m sure it is not, and I identified a number of indicators that could be used to set capital levels in my book. Now the BIS annual report has reviewed several possible indicators: credit spreads, changes in real credit provision, and a composite indicator that combines the credit/GDP ratio and real asset prices. And, rather unsurprisingly, they all work to a reasonable degree.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
2 Comments

	From Mark Gilbert on Bloomberg: If the aftermath of the credit crunch is a financial landscape featuring fewer banks, each even bigger than before because of government-engineered mergers and opportunistic takeovers of weaker brethren, then we should all be very afraid. That, though, is exactly where we are headed. The whole article is spot on: I recommend it.

Posted in: Mother of all Bailouts, Photography, Regulation by David /
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FED, OCC, OTS, FHFA, CFTC, SEC, FDIC, NAIC, …

It seems that Obama and co. do not have the balls to sort out the alphabetic mess that is US supervision. Even the obvious targets – the OTS, who supervised AIG (yes, technically AIG was a Thrift), the SEC’s regulatory capital regime, which did such a good job there are zero out of five large firms left on it – may be left to waddle on. Antiques may have an attractive patina, but sometimes you need something that is fit for the modern age. We won’t get it, though. I am very tempted, like .the Epicuran Dealmaker, to give up on this crap

Posted in: Regulation by David /
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Lord Turner, a decent, thoughtful regulator, told the Treasury select committee yesterday that there should instead be a “tax on size” by requiring the big banks to set aside more capital when they expanded beyond a certain size. Quite right too, and nice to see an idea I championed being mentioned in such august circles. The bad news is that Turner also warned the MPs that the radical changes to regulations needed in the wake of the banking crisis may not take place because of the emergence of green shoots of recovery and “exhaustion”. Regulatory reform is a marathon not a sprint and I share Turner’s doubts that we have the stamina to do a good job at it.

Posted in: Capital and Contingent Instruments, Regulation by David /
1 Comment

The Telegraph reports an idea of Paul Tucker’s: making the banks pay to clean up their own mess:

The banking industry could be told in advance that, if ever there was another crisis, the ultimate cost would come from banks themselves. In the midst of a crisis, that would not be possible. A government would have to pump in new equity. But when the dust had settled and the government had sold its shares, the loss (if any) could be calculated – and then collected from the industry via a levy.

This isn’t a bad idea. But there is a better one. Make them pay before the crisis.

There are various ways to do this. One is to take cash from the banks, via a beefed up version of the way the FDIC works. In order to be a financial institution, you need an annually renewable license, and the license should be expensive.

A more intriguing one, though, is to make the banks hand over each year not cash, but one year call options on their stock. The regulator would then hedge these options. The bank’s shareholders would only be diluted if the stock went up, sugaring the pill for them, while the hedging process would ensure the regulator made money whether the stock went up or down. Indeed, as the position is long gamma, a big fall would be particularly profitable to the hedging strategy.

Posted in: Capital and Contingent Instruments, Derivatives, Hedging and Convexity, Regulation by David /
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One of the nice things about Foyle bookshop – despite its Waterstoneisation – is that the staff selections are still charmingly eclectic. Leonardo Sciascia’s Equal Danger was one a few weeks ago. Sciascia is an oddity, a novelist who write political polemic disguised as detective stories, a stylist rather than a plotter.

Here’s a nice little section. The speaker is talking about Pascal’s wager. He generalises:

Today the possibility of making the wager has shifted from metaphysics to history… I would risk losing everything were I to bet against the revolution. But if I bet on it, I lose nothing if it doesn’t take place. I win everything if it does.

I feel the same way about regulatory reform. If it isn’t necessary and we do it properly, we lose very little. But if it is — if failure to reform just bakes more systemic risk into the financial system – then failing to reform properly means that we lose a great deal. In this context the gutless Obama plan is worse than thin: it is a bet that may ruin us.

Posted in: Regulation by David /
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The Obama administration is proposing that originators should retain a 5% stake in securitisations. This is not enough. 20% or 25% would achieve the desired alignment of interests. 5% gives 20:1 leverage. Yet another missed opportunity.

Posted in: Regulation, Securitisation and Tranching by David /
5 Comments

As weeks have dragged into months, my frustration at the lack of real financial reform has hardened into anger edged with ennui. I don’t expect much to happen now, and it irritates me. Ruth Sutherland sums up the situation quite well in the Guardian:

the Obama administration in the US, which still has plenty of wind in its sails, stepped back from radical moves to downsize pay packages on Wall Street, opting instead for modest improvements to corporate governance… The credit crunch led to a recognition of the need for a deep rethink of the Anglo-Saxon capitalist model. We are, however, in danger of missing the moment as the City takes advantage of political disarray to regroup. The belief of the resurgent financial sector, as another FT headline puts it, is that the market is confounding the left. Tentative suggestions that the recession is already over only strengthen the currents pulling us back towards business as usual.

Every ‘House prices rise’ or even ‘House prices fall less fast’ headline is ammunition for people like Angela Knight, who has suggested that even FSA’s current modest proposals for improving banks’ liquidity do not strike the right balance.

Instead of trumpeting any green shoots, however implausible, we need a wide discussion of the issues, and we need the willingness to be bold. Back to Ruth:

There should be a proper debate about a form of Glass-Steagall Act to separate “casino banks”, which would have no recourse to the public purse if they run into trouble, from financial utilities, which would continue to be backed by taxpayers.

I personally don’t think that this is possible, as all systemically important financial institutions have (whether we like it or not) an implicit recourse to the lender of last resort, but Ruth is right – we should talk about it.

There should be dynamic provisioning, so that banks are compelled to build capital cushions in the good times. Another idea is a levy on the sector to cover taxpayers against the risk they will have to bail out banks in the future.

But the point is less about the specific measures than about the need to change the culture.

That is absolutely on point. This crisis has already been a tragedy for many people – people who have lost homes and jobs. It would be really tragic if we learned absolutely nothing from it, if the net result was just to carry on, with exactly the same rules and the same mindset, to the next financial meltdown.

Update. As Barry Ritholtz points out, the gap between the US administration’s rhetoric and its actions is huge. Here are the principles Larry Summers laid out for reregulating the markets:

1. The government must have the authority to take over and liquidate failing nonbanking financial institutions.
2. Regulators must be able to make certain that financial institutions have enough capital to weather crises.
3. Regulated entities must not be able to choose their regulators,
4. Regulators should not have to fight each other for jurisdiction.
5. The interests of consumers must trump the interests of regulated companies.

Good foundations, those. It’s a shame the Obama administration have erected a makeshift shack on them. They are poodles when we need heros.

Posted in: Regulation by David /
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Less regulation of financial institutions. More leverage. After all, look how well that worked the last time… No? No. So it is rather a surprise that there is even any discussion of Goldman Sachs moving back from being a commercial bank to being an investment bank. The Reuters story is here. The regulatory regime Goldman used to operate under before the change – in the days after the collapse of Lehman – was so flawed that the SEC ended it. Given that it is not possible to be a CSE any more, if Goldman wanted to shed its bank holding company status and the regulation that goes with it, what exactly would they do?

Posted in: Capital and Contingent Instruments, Regulation by David /
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In a comment on the non-classical cost benefit analysis post of a few days ago (a title, I think you will agree, of gigantic pretention), Dave said:

I agree with your conclusions: that uncertainty and moral hazard can make CBA unreliable and sometimes it is better to rely on qualitative objectives.

But I disagree with your applying these to systemic risk. Firstly, with systemic risk it is the “worst-case scenario” that is important. If regulators had used the great depression as the worst case scenario, they wouldn’t have been far wrong.

Often, though, the worst case scenario can be hard to identify. The worst case scenario in much of finance for instance is that all claims are worthless and all liabilities come due immediately. We might as well all go home if that comes true, and barricade the doors. ‘Plausible’ worst cases have a nasty habit of turning out to be too optimistic: wasn’t it David Viniar from Goldman who said that 2008 was much worse than the most pessimistic scenario they looked at?

Secondly, I can’t see how systemic risk regulation would cause bankers to take greater risks. So, I don’t see where moral hazard fits in.

Fair enough – bankers are not people riding bikes. (Quite literally, usually – Wall Street tends to view cycling to work as only marginally less strange than coming by elephant.) So probably bankers did not take more risk because they were regulated. Some of them did, however, take as much as they could subject to regulation, because that was the way to maximise returns to shareholders.

Thirdly, how do you take a “moral” position on systemic risk? I don’t think this gets you very far.

Well, I think that the key idea of Anglo-Saxon capitalism – that the first and only duty of a firm is to its shareholders – is simply immoral. Of course, like any ethical judgement, you can disagree with that. But I also think, and I’d like to think that I can prove, that a system that has a wider burden of responsibilities, including a responsibility to the financial system, would be less likely to go into crisis, cost the taxpayer less over the cycle, and deliver slower but less volatile growth.

Finally, the main impact of systemic risk regulation would be to encourage smaller banking/trading institutions. I would think that this a good thing in itself. And I disagree with James Kwak that “countercylical measures in a boom dampen economic growth”. Surely the opposite is true (in the long run).

Absolutely. We need a lot of small banks, not a small number of large ones. The hard part is how we get to there from here.

Posted in: Cost Benefit Analysis, Economic Theory, Regulation by David /
2 Comments

The beginnings of control theory can be summarised as ‘nail it in the right place’. Suppose there’s a plank over a barrel. You can keep the plank level by putting a weight in just the right place, so that it balances.

The problem with this is that any perturbation will cause the plank to swing away from the level. A gust of wind might even do it: the equilibrium is unstable. Therefore control theory 101 would suggest that you move the weight dynamically to keep the plank balanced. If one end swings up, move the weight slightly that way until it swings back.

Over the years, a lot has been discovered about how to control unstable objects moving in unpredictable environments. Modern fighter aircrafts are in some ways a triumph of control theory: without the computers which control their flight surfaces, they would fall out of the sky. And what the computers do is determined by control theory.

One of the many reasons that the current regulatory capital regime is pants (not to put too fine a point on it) is that it is stuck with static control. That is, think of a number, and that’s the amount of capital that you need. In reality, the regime needs to be dynamic: the anticyclical capital of earlier discussions is one piece of this puzzle. What struck me as I walking home from a lecture last night (one which touched in passing on control theory) is that we do not even have the right inputs to develop a control theory of bank capital. That is, we don’t really know what the equivalent of the angle of the plank (or the speed, pitch, yaw and so on of the fighter) is. One can think of some things that it might make sense to monitor, like credit spreads or the availability of interbank liquidity, but so far as I am aware, there has been no systematic study which discusses the indicators of health of the banking system, let alone identifies how they respond to changes in regulation. That would be the basis of a serious control theory of banking.

Posted in: Engineering, Regulation by David /
2 Comments

The WSJ reminds us that despite the SEC’s lamentable record, US regulatory reforms seems as far off as ever. How badly did they do? Here’s my assessment.

• Supervisor of investment banks: 0/5. There are none left. That really does tell you all you need to know.
• Market supervisor: 2/5. Rule SHO didn’t stop naked shorts, and the SEC’s record dealing with market abuse and insider trading is not wonderful. Nevertheless, they have sometimes acted prudently in the equity markets in the past.
• Information gatherer: 4/5. Edgar is very useful, and Idea seems like it will be even better.
• Hedge fund regulator: 1/5. They could have found Madoff in 2002.

It seems to me, then, that the SEC is a great website with a deeply flawed supervisor bolted on the side. So why hasn’t Geithner done anything?

Posted in: Regulation by David /
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The current furore over FSA regulation of building societies is interesting. A whistle-blower alleges that

A culture of apathy and complacency marked the FSA in the period of its nadir, with anyone standing up against light-touch official policy criticised for rocking the boat and branded a troublemaker.

I have no idea of the truth of this, but three points are worth making.

• In a regulator, the status of staff depends to some extent on who they regulate. The big swinging dicks are the ones who regulate the biggest banks. Building societies are not glamourous, and hence the quality of regulator here may well have been lower than elsewhere.
• Many regulators are really quite bureaucratic. The scope for individual staff, especially line staff, to make decisions is limited. Anything of substance is likely to go up the chain of command. Therefore if there have been failures, it is the senior people who are likely to have been responsible.
• Building society supervisors are likely to be a conservative lot – even more conservative than bank supervisors. What they think is dangerous may be a rather large class – and one that includes some reasonable innovations.

Posted in: Regulation by David /
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There is a meme going around at the moment concerning size in banking. The basic idea is that too big to fail banks are a bad idea. Various people have various ideas of what ‘too big’ is, with numbers like 300B total assets (a number floated in a nice post at Dealbreaker) being discussed. Interfluidity also has a good discussion here.

My own take is that limits – whether $100B, $300B or some other number – are hard to impose and liable to manipulation, e.g. through off B/S financing. Rather I would make regulatory capital a function of equity. The more Tier 1 you have, the less you can leverage it. At $1B of Tier 1 or below, say, you are allowed a Tier 1 leverage ratio of 25. At $17B, it would be 12, so the formula would be something like

permitted leverage = 20 – 0.5 x [max($1B, Tier 1) - $1B]
total permitted assets = permitted leverage x Tier 1

This formula has a maximum at Tier 1 = $20B, where it permits total assets of $200B (and of course total assets would be defined to include off B/S assets as well as on B/S ones).

Posted in: Regulation by David /
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The FT article is titled Geithner lays out new financial rules, but that is a little misleading. Rather our lad Timmy has laid out a framework under which new rules will be written, but we have no idea what the rules will be yet. What details there are do not allow one to form any precise conclusion. The principles seem reasonable, but the devil will be in the details (and in the inter-agency battles).

Posted in: Regulation by David /
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Martin Wolf is a little harsh on Lord Turner in the FT. He says:

First, it does not explain why we can hope to contain the behaviour of companies too important to fail.

True, but increased capital requirements will certainly help, along with better supervision of liquidity risk. The devil is in the details, I know, but Turner has not clearly not addressed this.

Second, it does not demonstrate that regulators can contain regulatory arbitrage by profit-seeking financiers.

Third, it does not deal with risks posed by institutions that may be too big to rescue by some host countries.

Stronger supervision of on-shore entities without too much respect for home country supervision of the parent will help. And Turner is surprisingly harsh on the EU passport regime. Clearly there is a limit to the extent of the UK’s extra-territoriality, but within that Turner is certainly looking in the right direction.

Fourth, it does not explore the room for charging heavily for guarantees.

Fair point. I should like to see a UK version of the FDIC scheme where all banks pay a premium for the deposit insurance the government sells to them. This premium should I believe be strictly based on the notional of deposits, and not on any risk measure of the deposit taker (which will always let the big boys off lightly).

I still like the idea of taking this deposit insurance premium in the form of a call option on the bank’s stock (which the regulator would hedge, hence locking in its value), but obviously this is fairly left field.

Posted in: Photography, Regulation by David /
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The FSA’s regulatory response to the global banking crisis is out: see here.

My first reaction is that it is fairly sensible. Some highlights:

• Section 1.1 is a really nice summary of the development of the crunch.
• There is an interesting, and perhaps surprising, insistence on the inadequacy of current transnational arrangement to cope with global banking groups. A quote from Mervin King sets the tone: The essence of the problem … is that global banking institutions are global in life, but national in death. There is then surprisingly strong language on the inadequacy of current arrangements: Until and unless there is a willingness to change this approach and to move to a much more unified approach to global financial supervision and even fiscal support, mechanisms such as colleges of supervisors can make an important but still limited contribution… they cannot deliver fully integrated global supervision…. On European arrangements, the tone is similarly harsh: The crisis has shown the philosophy [of European supervisory arrangements] to be inadequate and unsustainable for the future… It is essential that the European Union now considers the appropriate way forward. This willingness to contemplate radically new arrangements is definitely positive.
• There are seven key suggestions on changes to the FSA regulatory regime. Several are unsurprising and have been suggested by FSA or the BCBS already. Thus bank capital requirements will go up, with trading book capital requirements in particular increasing. There will be a bigger focus on core Tier 1, and a gross leverage ratio backstop.
• Turner goes further than I had thought that he would in embracing anti-cyclical capital, and anti-cyclical reserving. This is a big change for a major regulator and is definitely to be applauded.
• As expected, the status of liquidity risk increases, with consideration being given for the first time to an overall core liquidity ratio which would limit firm’s appetite for liquidity risk.
• Turner has come down firmly on the side of regulatory consistency regardless of legal form. He says: regulation should focus on economic substance not legal form. Off-balance sheet vehicles which create substantive economic risk… must be treated as if on-balance sheet for regulatory purposes. Prudential oversight of financial institutions should ideally be coordinated in integrated regulators (covering banks, investment banks and insurance companies)… And regulators must have the power to obtain information and identify new forms of financial activity which are developing bank-like characteristics, and if necessary to extend prudential regulation to them, or to restrict their impact on the regulated community. For the avoidance of doubt, this means hedge funds too.

Posted in: Regulation by David /
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Paul Volcker suggests that:

the US could perhaps do with a new version of Glass-Steagall, this time splitting hedge funds, private equity funds and proprietary trading off from Wall Street banks.

How would you enforce it, though? You can’t force them to take no risk, not least because banks cannot precisely maturity and FX match their funding, and so banks are net long liquidity which they need to invest. So you would have to have a de minimis risk limit. But how would it be expressed to prevent gaming? Remember that one of the reasons we got into this mess in the first place was that AAA subprime tranches looked very low risk in VAR models. Still, the idea merits discussion.

*No disrespect intended to Senator Carter Glass.

Posted in: Regulation, VAR by David /
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It is an interesting question. First, note that Ben’s recent call for US regulatory overhaul is welcome, if overdue. Both the politics and the practicalities of any change are formidable, however necessary it is.

Even the question of role of the central bank is redolent with issues. If they are not the stability regulator, then how is the interaction between financial stability and monetary policy managed? But if the central bank does take this role, how do they balance the needs of the broad economy (which typically suggest looser policy) with financial stability? This is especially difficult as many central banks (yes, I’m thinking of you guys in Frankfurt) have a rather conservative attitude. Moreover Northern Rock shows that if stability is divorced from supervision then problems can fall in the gap between the two agencies. An uber-supervisor of insurers, hedge funds, banks and broker/dealers with both markets and financial stability responsibilities and the ability to strongly influence monetary policy is one alternative. But if a body like this gets it wrong, there is no check or balance.

I honestly don’t know what the right answer is. But I certainly believe that the current US answer – FED, SEC, OCC, FDIC, OTS, OFHEO, CFTC, State Insurance commissioners, and UTC (Uncle Tom Cobley) isn’t ideal. And when you factor in the global dimension, as the FT emphasises, things get even tougher.

Update. There is an interesting update from the FT here. The salient idea: There are arguments for adopting the ‘twin peaks’ model of Australia and the Netherlands, with one regulator handling consumer issues such as product sales and the other prudential supervision. Would that come with damn fine coffee?

Posted in: Regulation by David /
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There is at least one piece of good news in troubles that the Obama administration are having with filling some jobs. As the WSJ reports, Annette Nazareth, who was expected to be tapped as deputy Treasury secretary, has withdrawn. Annette was responsible for the consolidated supervised entity program at the SEC that was so successful at supervising the big 5 broker/dealers that one failed, two were sold in conditions of distress (extreme distress in the Bear’s case) and two became banks. Why anyone thought that she should be Timmy’s deputy is beyond me.

Posted in: Broker/dealers, Regulation by David /
2 Comments

A correspondent of mine asks, apropos this story:

AIG, whose reach is so vast that the government warns letting it fail would cripple the very world financial system

Why are companies allowed to get this big? The answer is of course that they shouldn’t be, if you care about financial stability and moral hazard, at least. What we need is capital requirements which are a strong increasing function of size, so that larger companies are forced to have a lower ROE than smaller ones, and hence so that they have an incentive to split. The current rules of course are the opposite: the ability to use internal models within Basel, and the advanced capital models that big insurers use, have the effect of making capital requirements lower for bigger companies. You don’t need a crystal ball to figure out that that is a bad idea.

Posted in: Capital and Contingent Instruments, Regulation by David /
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They say… CDOs of ABS (so-called “resecuritisations”) are more highly correlated with systematic risk than are traditional securitisations. Resecuritisations, therefore, warrant a higher capital charge. Fine so far. But then look what they do:

(The new capital charges are in the grey hatched columns.) So the capital charge for a senior charge of a AAA-rated CDO-squared will be 1.6% of notional (20% x 8%). Anyone who thinks this is adequate was clearly taught in the Jimmy Cayne school of Structured Finance.

Update. I’ll try to post more on the Basel 2 revisions (and in particular the trading book changes) in a few days. Meanwhile here is some good sense from Adair Turner, via the FT:

Lord Turner told a hearing of the Treasury select committee that tougher measures would include requiring banks to hold up to three times as much capital against their trading assets.

Posted in: Basel, Regulation by David /
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It is clear by now that the lender of last resort function – and especially the capital provider of last resort function – is valuable. How should the state be paid for this function?

The historical answer has been that this is a gift to the banking system, with the state attempting to recoup its investment (and perhaps even make some money) from the liquidity and capital that it provides. At the moment however it seems likely that some of these state investments will not give taxpayers a positive return, so it is reasonable to ask how else we could structure things.

One answer is that financial institutions should pay. The model here is deposit insurance: in the US, for instance, banks are charged by the FDIC, and these premiums are pooled together to support bank rescues where necessary. However it seems that these payments are not adequate, and so deposit insurance premiums are being increased – just at the worst possible time. It is easy to argue that they should have been higher in the past. In practice however banks’ success at promoting deregulation and cost reduction in the good times means that fixed fee schemes are always vulnerable.

There is an alternative. Banks could be made to pay by writing call options on their own stock. Suppose every year a bank gives to their regulator, as payment for the lender of last resort and capital provider of last resort functions, one year at the money call options on 5% of their regulatory capital. The regulator then hedges these to lock in their value. The hedge is to short stock, so if the option ends up in the money, the regulator ends up selling the stock position. The profit from delta hedging these ‘free’ options is then available to recapitalise banks when needed, and so the taxpayer does not lose out (as much) when support is needed. The people who suffer are bank shareholders, but they only suffer dilution when the stock price is increasing, and anyway they are the ones who should be paying for the implicit support the state provides.

Posted in: Mother of all Bailouts, Regulation by David /
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This is so far beyond sarcasm that I am going to report it straight. Bloomberg tells us: Former Securities and Exchange Commission member Annette Nazareth is the leading candidate to become deputy U.S. Treasury secretary, according to people familiar with the matter. Nazareth ran the SEC division of market regulation… when it designed a program to monitor whether Wall Street’s five biggest securities firms had adequate capital and liquidity. This program worked so well none of the five are around in their prior form: two are bankrupt, one was forced to sell itself in a hurry, and two turned themselves into banks. Truly failure is its own reward. (OK, I lied about the sarcasm.)

Posted in: Photography, Regulation by David /
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There is a story, probably just a rumour, that there used to be a man at the Bank of England who had a “not read” stamp. He would use it to stamp documents he wanted to be able to claim he had not seen before returning them to the sender.

The fact that this story is vaguely plausible is a big part of the problem with regulation. Epicurean Dealmaker suggests:

Staff the SEC, or whatever “Super Regulator” the government decides to deputize to oversee this mess, with a bunch of highly-paid, tough-as-nails, sonofabitch investment bankers. You will have to pay them millions, just like regular bankers. (You can tie their incentive pay to improvements in the value of securities held under TARP and TALF, if you like.) Pay them well, and investment bankers won’t be able to treat them like second-class citizens at the negotiating table. Pay them like bankers, and your regulators won’t hesitate to read Jamie Dimon or Lloyd Blankfein the riot act, because they won’t give a shit about getting a job from them later.

Trust me, these are the kind of people you will need on your team: highly educated, financially sophisticated, psychotically hard-working, experienced professionals who know or can figure out CDOs, SIVs, balance sheet leverage, and credit default derivatives just as easily as the idiots who created and trade this shit. Leading your enforcement and supervision teams you need a bunch of smooth, smart, plausible, grandiosely self-confident senior bankers who will not hesitate to tell Vikram Pandit to go fuck himself, his mother, and the cow she rode in on if he ever tries to fuck with the United States government, the US taxpayer, or the pizza delivery boy again. You know: psychopaths.

Of course he is right in that such people, properly empowered and paid, would indeed regulate quite well. They would get it in a way that most public servants don’t. The same argument applies to the tax authorities: if you staffed them with ex tax lawyers and investment bankers who got to keep 10% of everything they saved the taxpayer, you would collect an awful lot more tax and there would be many fewer tax avoidance schemes.

So it would work. But no government would ever have the courage to try it. You would have to fire a lot of the current senior regulators or tax collectors, and completely re-engineer the culture. Mr. “Not Read” wouldn’t last ten minutes in a psychopath-enabled regulator. Which is both the reason it should be done and the reason it won’t be.

Posted in: Organisational Culture, Regulation, Taxation by David /
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Sam Jones has an excellent post on FT Alphaville picking up on a momentous, and well concealed volte face from FSA. The regulator has (finally) embraced procyclicality.

We have continued to give consideration to appropriate long term changes to the bank capital regulatory framework. We believe that it would be preferable for the capital regime to incorporate counter-cyclical measures which lead to banks building up capital buffers in good years which they can draw down during economic downturns.

The well-concealed part picked up by Alphaville is:

we are amending the variable scalar method of converting internal credit risk models from point in time to through the cycle… These changes will significantly reduce the requirement for additional capital resulting from the procyclical effect.

As Alphaville says:

The FSA is authorising a modelling trick

But a particularly expedient one. Welcome to the bottom of the cycle capital regime. Just one thing. What if this is not the bottom?

Posted in: Capital and Contingent Instruments, Regulation by David /
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Mark to market is great. It gives the users of financial statements the best information available about the value of a company. But, as we have seen over the last year or so, it also has the drawback – at least when applied to banks and such like – of encouraging procyclicality. On the way up, mark to market gains, once audited, form retained earnings, and so contribute to capital. This capital can then support more risk. On the way down, losses reduce capital and so inhibit risk taking just when it is vital for the economy that financial institutions to step up to the plate.

So…. let’s split the link between unrealised gains and retained earnings. Specifically, I propose splitting the retained earnings component of tier 1 into two pieces. The first, retained realised earnings, would be as before. The second, retained unrealised earnings, would be the sole component of a new class of capital, tier 4. (Tier 1 is equity and highly equity like capital; tier 2 is reserves and certain types of long term sub debt; tier 3 is short term sub debt.)

Unrealised gains and losses would change tier 4. There would be constraints on the total amount of capital that could come from tier 4, just as there is today on the total that can come from tier 2. Exactly what would work needs some research, but my guess is that, say, having a rule like tier 1 must be 8 times bigger than tier 4 would work. On the way up, this would restrict the benefit available from unrealised gains. That buffer would then be available to absorb losses on the way down without restricting risk taking.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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The FT reports that The European Central Bank could be given significant extra powers as part of measures to boost eurozone bank supervision, its vice-president has proposed. I don’t know whether the ECB has the resources to do this job, but otherwise it seems a good idea.

Certainly other arrangements have proved flawed. The SEC’s CSE regime worked much less well than FED regulation. So one regulatory framework is a good idea. The separation between the Bank of England (lender of last resort) and the FSA (supervisor) worked badly in the case of Northern Rock. So uniting those roles is a good idea too.

Posted in: Regulation by David /
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There has been a lot of comment over John Gieve’s comments to the BBC. The programme has not been broadcast yet, so let me confine myself to one point. Gieve apparently says

Maybe we need to develop something which bridges that gap and directly addresses the financial cycle and prevents the financial cycle and the credit cycle getting out of hand… I think we need to complement interest rates, which are a blunt instrument – you set one interest rate for the whole economy – with something which is more financial-sector specific.”

I would suggest we have at least two such things already. One is capital requirements. The other is monetary policy, specifically the implementation of policy via the money supply, which collateral qualifies at the window and the exact rules concerning bank reserve balances.

Update. I have now seen the program: it is mostly a Robert Peston hagiography, which I had hoped was beneath the BBC. Still I suppose if Jonathan Ross can’t get fired for what he did it is too much to expect the Corporation not to laud Peston’s rumour mongering.

The most interesting remark in the program for me came from John Varley. Asked if banks had taken too much risk before the Crunch, he said that they did. But he then went on to say that regulators and politicians `acquiesced in this extraordinary boom’. As a judgement that struck me as very much on the money.

Posted in: Liquidity and liquidity risk, Photography, Regulation by David /
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MTM means for course `mark to me’. It appears that AIG has determined the most reliable source of fair values for some transactions is — itself. Think of a number. Wow, the number I just thought of was … the number I was thinking of. I must be right.

I exaggerate of course. Let Bloomberg take up the story:

AIG swaps not covered by the government program include guarantees on $249.9 billion of corporate loans and residential mortgages, most of them made by banks in Europe…
[These swaps] are different because they didn’t insure against losses… they were bought to take advantage of European accounting rules that allow the banks to use the swaps to reduce the capital they’re required to set aside as loss reserves.

The swaps are kept in place only until new accounting rules, known as Basel II, are phased in. Those rules eliminate the ability of financial institutions to reduce the capital they need to set aside by buying swaps.

[AIG has] unwound $95 billion of these regulatory-capital swaps without any losses as of the end of the third quarter. And Gerry Pasciucco, hired from Morgan Stanley on Nov. 12 as interim chief operating officer of AIG’s financial-products subsidiary, said the company continues to “experience early terminations according to our schedule at par.”

As a result, Lewis [AIG risk officer] said, even if the assets underlying the remaining swaps fall in value, AIG isn’t required to mark them to lower market levels.

That’s because, as the insurer said in its third-quarter filing, it “estimates the fair value of these derivatives by considering observable market transactions.” And the only relevant transactions are the swaps AIG has successfully unwound with the European banks, according to the filing.

There is more to trouble an AIG investor, European bank regulators, the SEC, the FED, and AIG’s auditors in this, if it’s true, than you can shake a stick. Here are a few of the issues.

Firstly you would have thought that the Gen Re case had taught AIG that doing transaction purely for regulatory manipulation without risk transfer is a bad idea.

Secondly, what do European bank regulators think of this? (I’ll leave Basel 2 being described as an accounting standard as a signal that this new item may not be entirely reliable. And while we are asking questions, where exactly in Europe hasn’t Basel 2 been implemented yet? And what is a default swap that does not transfer losses, and how exactly does it qualify for capital relief?)

Thirdly, if both the transaction and AIG’s accounting for it are correctly described, why on earth do their auditors, PWC I think, let them get away with this? Hasn’t AIG had enough auditing issues at AIG FP already?

Fourthly does the FED really want an almost 80% state owned company doing this kind of transaction? And accounting for it this way?

Posted in: Accounting, Insurance and Actuarial Practice, Regulation by David /
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From Willem Buiter’s blog on FT.com, the cry of the small enterprise reverberates:

The very fact that we are not systemically important makes us systemically important.

The whole post is most amusing.

Posted in: Regulation by David /
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The Aleph Blog has a remarkably wrong-headed piece on insurance regulation here, suggesting that federal insurance regulation is a bad thing and that the FED should have let the AIG parent fail.

Some comments. First, the US is the only major economy that does not have a national regulatory framework for insurance. Instead it is regulated at the state level. Some of the states do it well, some less well. Many of them are different. How can it possibly make sense to have over 30 regulatory frameworks for the same product in one country?

Secondly US insurance regulation is a long way behind the curve even in the best states. While the EU is on solvency two, with fairly sophisticated capital modelling, the US framework does not require enough capital for credit risk, which is why the monolines and AIG got into so much trouble in the first place. Their leverage was not effectively constrained by their capital requirements (and in some cases their accounting framework encouraged them to take risks more cheaply than banks would). The U.S. needs to address the arbitrage whereby it is significantly cheaper for some insurance companies to take credit risk than for banks.

Thirdly, letting AIG fail was not a realistic option however much moral hazard its bailout presented. I continue to dislike the bailout. However depriving the banks of hundreds of billions of dollars of protection is simply not sensible at the moment: you would only have to spend the money recapitalising them.

Posted in: Insurance and Actuarial Practice, Regulation by David /
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This, originally from Bloomberg and then picked up by FT alphaville and many others, is attracting a lot of attention:

Despite some rather histrionic claims that it `proves’ the bailout is inadequate and much more money is needed, I am not so sure. For one thing, banks are deleveraging, so they will need less capital. For another, various tricks are being employed, such as the FED’s forebearance of capital requirements for the Bear portfolio at JPM. So the argument that the system needs as much capital as before right now is not clearly correct. Of course, capital requirements will go up eventually. But at the moment I tend towards the idea that supervisors are willing to tolerate a less well capitalised banking system at least while the crisis lasts. The banks might need more capital than is available in the bailout in due course but I am not convinced that they need it immediately.

Posted in: Capital and Contingent Instruments, Regulation by David /
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I have sniped, perhaps too much, at Basel 2. So it only seems reasonable to outline some alternative proposals, particularly as Lord Turner is apparently open to significant change. Here goes.

Scope. Capital charges should apply to assets, derivatives, and to asset/liability mismatch. In particular funding mismatch and the heavy use of confidence sensitive short term funding like repo should generate a capital charge.

Risk types. There should be capital for market risk, credit risk, counterparty risk and funding liquidity risk. If there is a need for an operational risk charge, it should be a simple expenditure-based requirement.

Models. Given the spectacularly bad performance of risk models, these should be banned for regulatory capital purposes. In particular no diversification benefit should be given. Total capital requirements should be derived by adding up the capital requirements for each risk type.

Asset Liquidity. This should be explicitly included in capital requirements, with market risk capitals being scaled by root t for assets whose liquidation horizon is longer than typical. (Implicitly the current horizon is ten days, so this is a good start.)

Haircuts. These should reflect a prudent move across the cycle. For equity indices, for instance, a reasonable capital charge would be the biggest loss resulting from an 8% move up or down in the index. [For any reg. junkies out there, what I am envisioning here is rather similar to the CAD 1 approach used before the 1996 market risk amendment.]

Anti-cyclicality. There should be a capital buffer over and above the calculated minimum, varying from 25% or more at the good points in the cycle to essentially nothing in a crisis. The availability and cost of leverage, volatility measures, and market returns should be used to determine where we are in the cycle.

Credit risk in the banking book. The revised standardised approach in Basel 2 is not too bad for corporate risk, but it is far too generous for retail and mortgage risk. It’s badly designed for securitisations. Revisions will be needed to these capital charges.

Credit instruments in the trading book. These charges need to be completely redesigned.

Posted in: Basel, Regulation by David /
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The first from Clusterstock:

Many of our financial institutions are insolvent. They aren’t healthy victims of bank runs. They are ailing institutions barely kept alive by frantic rounds of capital raising. The lessons of the Great Depression simply don’t apply here.

In fact, we’re probably making things worse. Allowing insolvent institutions to fail and requiring worthless and worth less assets to be fully written down would provide transparency to the market. Instead, we’re dedicated to the post-Lehman proposition of “Never Again.” The various programs of our government continue to obscure asset pricing and conceal insolvency. This means that you can’t trust the market to tell you which firms are failing.

Twisting the arms of bankers to lend to institutions that may be insolvent is a recipe for deepening the crisis. We’ve just been through a period of malinvestment–we spent too much borrowed money on junk. Borrowing more to spend on junk only digs us in deeper.

Bank lending won’t get going again until trust in the markets can be restored. Fighting a Great Depression era problem probably won’t help. More transparency, which means more write-downs and failures, is probably necessary if we’re going to get through this.

I don’t think we know enough about the current situation to know if this is true, but it certainly could be. Unfortunately the recent accounting changes make it harder to find out, too. The Japanese lost decade certainly suggests that keeping failed institutions on life support is the wrong approach – but equally Lehman showed that letting firms fail in the wrong way is catastrophic for market confidence. We need banks to be able to prove to the market’s satisfaction that they are solvent, and prove that fairly soon. If the government recap gets us there, then fine. If not, even more drastic remedies are going to be needed.

Second, from an interview by Lord Turner in the FT:

Lord Turner said regulators would also now have to examine mark-to-market accounting, bankers’ bonus structures, the way in which financial institutions transfer risks, and the frameworks for regulating banks’ liquidity and capital.

He said the capital reserves imposed on banks last weekend were necessary to restore short-term confidence, and that the watchdog would have to work on a longer-term framework for setting capital.

He warned, however, that it could be some time before an international agreement could be reached. Some regulators believe it is necessary to scrap the Basel II framework, while others believe it can be adapted.

[Emphasis mine.] It is most reassuring to see that the new head of the FSA is willing to contemplate scrapping Basel 2. The Basel 2 capital regime has served us very badly: it’s pro-cyclical, imprudent in places and aggressively conservative in others, full of model risk, and far too complicated. Let’s start with a clean sheet of paper, and demand that the rules be simple, demonstrably prudent but fair across risk types (and accounting methods), and as little dependent on models as possible.

cut+me.jpg

Posted in: Basel, Mother of all Bailouts, Photography, Regulation by David /
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I have detected a slightly more sarcastic tone than usual in my recent posts and I had resolved to be nicer. But then something like this comes along:

The Basel Committee/IOSCO Agreement reached in July 2005 contained several improvements to the capital regime for trading book positions. Among the revisions was a new requirement for banks that model specific risk to measure and hold capital against default risk that is incremental to any default risk captured in the bank’s value-at-risk model. The incremental default risk charge was incorporated into the trading book capital regime in response to the increasing amount of exposure in banks’ trading books to credit-risk related and often illiquid products whose risk is not reflected in value-at-risk. At its meeting in March 2008, the Basel Committee on Banking Supervision (the Committee) decided to expand the scope of the capital charge to capture not only defaults but a wider range of incremental risks, to improve the internal value-at-risk models for market risk and to update the prudent valuation guidance for positions subject to market risk of the Basel II Framework.

The details are here and here.

What’s wrong with this? Well, at least three things. Firstly we still have VAR as the basis of market risk capital. Until Basel throws that out and comes up with something more prudent, probably based on stress tests, the Basel 2 market risk capital framework will rightly remain a laughing stock.

Secondly, not only have the supervisors kept VAR, they still believe that procyclical, miscalibrated risk models are a good idea, and they want more of them, even though they know banks cannot model the risks they are trying to capture:

Because a consensus does not yet exist with respect to measuring risk for potentially illiquid trading positions, it is anticipated that banks will develop different IRC modelling approaches. For example, a bank could develop a comprehensive asset pricing model incorporating both diffusion and jump processes for price movements over liquidity horizons

Finally, the proposed incremental capital charge is much higher for liquid, trading book assets than for held to maturity assets of the same risk profile in the banking book. That is simply wrong. So, Basel Committee, step away from the rule book: you have lost any credibility you might have had before the Crunch. Let’s start again, ideally with a different set of rule makers. Perhaps the white rabbit is free.

Posted in: Basel, Regulation by David /
2 Comments

A few desiderata, to assist in the reform process.

Safety, at least for retail deposits. People want to know that their money is safe and available at short notice.

Availability of credit at a fair price. It should be possible for all, individuals and corporates, to borrow at a spread that reflects the risk (in both directions – not too high nor too low). Financial institutions can make profit in this process, but that profit should not be unreasonably high. Therefore we need some measure of competition in lending.

Return requires risk, and that risk should sit with the risk taker alone. If you want a higher return than government bonds, it should be perfectly clear that you are taking a risk to get that return, and hence if things turn sour, you and you alone should bear the consequences of that decision*. Risk takers should not be allowed to take risk in ways that endanger more than themselves – low altitude parachute jumps over uninhabited desert are OK; driving at 100 mph in built up areas is not.

Ummm, I am sure there is more, but aren’t those the most important things? Right now I am a bit like the financial system — suffering and not working very well — thanks to a nasty coldy flu thing. I hope my recovery will be easier and faster than finance’s. And certainly I hope less radical surgery will be required.

* That extra 1% return on an Icelandic bank account came with a risk. Live with it.

Posted in: Cost Benefit Analysis, Regulation by David /
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Only four years too late, the New York Times has an article on the SEC CSE regime and how it didn’t do enough to constrain the broker/dealer’s risk taking. It’s nice the Times is finally getting around to this kind of thing, but no one was interested in financial regulation and the scandal that was the US broker/dealer capital regime when there actually were some big broker/dealers around to take advantage of it.

Posted in: Broker/dealers, Capital and Contingent Instruments, Regulation by David /
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With Bloomberg reporting that the bailout has been agreed after days of intense debate, the last few days have been a great time to sneak out financial news that you do not want too well read. One would never suspect the SEC of acting that way, of course, but it is interesting that the audit of the SEC’s oversight of Bear Stearns came out on the 25th. The two parts are here and here, and they do not reflect very well on the SEC’s Trading and Markets Division (TM). For instance:

TM became aware of numerous potential red flags prior to Bear Stearns’ collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain Basel II standards, but did not take actions to limit these risk factors

The broker/dealer capital regime (CSE, introduced in 2004 by the SEC as an attempt to fend off EU regulation of the broker/dealer’s European subsidiaries) does not fare well either:

Bear Stearns was compliant with the CSE program’s capital and liquidity requirements; however, its collapse raises questions about the adequacy of these requirements

The SEC was in such a hurry to offer their 5 big clients a friendly capital regime that it approved their applications before it had even completed the inspection:

The Commission issued four of the five Orders approving firms to use the alternative capital method, and thus become CSEs (including Bear Stearns) before the inspection process was completed;

Go and read both the documents: they are peaches.

To be fair, the SEC admits there are problems. Chairman Cox released a statement saying `the CSE program was fundamentally flawed from the beginning’ and ending the program forthwith.

Posted in: Broker/dealers, Regulation by David /
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The US now has zero broker/dealer. Bloomberg reports:

Goldman Sachs Group Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken.

The Federal Reserve’s approval of their bid to become banks ends the ascendancy of the securities firms,

Now it gets interesting. I assume they will have to do bank capital adequacy calculations. And when they do, we will finally have a direct comparison of how inadequate the SEC’s regime was…

Posted in: Broker/dealers, Regulation by David /
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Amid extraordinary scenes – the failure of Lehman, the purchase of Merrill, a $85B FED line to AIG (albeit it at L + 850) – it is appropriate to consider the big questions that face the Americans.

Firstly, note that the FED has acted, but that what it has done is very much policy making on the fly. Suspension of Section 23a of the Federal Reserve Act, for instance, may well be illegal. And in the AIG support, the FED is off the edge of the US regulatory map. The politicians want to get involved, and in due course they will.

So what are the questions?

Firstly, is there any role left for separately regulated broker/dealers? My sense chimes with the majority opinion that the answer to that is no. With 2 big clients left out of 5 at the start of the year, the SEC (and specifically its capital regime) does not emerge covered in glory. How should the broker/dealers be supervised going forward?

Secondly the insolvency regime for financials needs to be addressed urgently, in the UK just as much as the US. In particular exactly when can the regulator seize the vehicle, what happens to the holders of subordinated claims at that point, how derivatives claims (with their effectively supersenior definitions of termination events) interact with that, and the issues involved in making cross border insolvency fair need to be thought about hard.

Thirdly and perhaps even more controversially, what about insurers? US state insurance regulation is complex, capital requirements for financial risk are simplistic, and the US regime has not come out of the Crunch looking good. Think of the monolines as well as AIG. I am not sure the European answer is much better, but at least Solvency 2 is an attempt to address the issues.

Finally, a lot boils down to leverage. Capital rules were supposed to constrain leverage. They didn’t, thanks to numerous failings. Free passes to SIVs and conduits, the lack of capital for liquidity risk, VAR based market risk capital which ignored fat tails, capital based on rating, the Basel 2 treatment of residential property: all of these were gross failures of regulatory prudence. It is, I fear – and I know how many careers this would threaten and how unlikely as a result it is to happen – time to throw away Basel 2 and start again. We need a set of capital rules which are appropriate for a wide diversity of risk taking, from AIG FP through Cheyne Finance and MBIA to Lehman Brothers (R.I.P.) and on to traditional banks like Santander. They need to be anti-cyclical, and they need to be fair. That means no grossly preferred asset classes, accounting methods, nor ways of taking risk. It is a big job, but it desperately needs doing. Whither Basel 3?

Posted in: Capital and Contingent Instruments, Photography, Regulation by David /
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The Onion has the answer:

Posted in: Fun, Regulation by David /
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It occurred to me as I was sweeping up the fallen leaves from my Hebe this afternoon that the marxist critique of capitalism would be stronger if it included the destructive effects of leverage. After all capitalism implies a duty to maximise ROE, and doing that requires leverage. But too much leverage gives you a banking crisis.

Partly these observations were motivated by a very fine article on Naked Capitalism. It points out that regulators still seem to be struggling with three evident truths:

• The need to address information asymmetries in securitisation while preserving the risk distributions benefits it offers;
• The importance of anti- rather than pro-cyclical capital requirements in promoting financial stability; and
• Banks will always play capital games to maximise their ROE while appearing to be well capitalised and it is regulators duty to stop them.

If these three are not obvious to the supervisory community then there will be another crisis.

Posted in: Capital and Contingent Instruments, Regulation by David /
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What were the ratings agencies doing really? Frank Portnoy writing in the FT, tells it like it is:

the rating business has shifted from providing information to selling “regulatory licences”, keys that unlock financial markets. Consider Constant Proportion Debt Obligations, the financial Frankensteins that the agencies’ flawed mathematical models said were low-risk. Does anyone believe parties paid for triple A ratings of such instruments because those ratings gave them valuable information? More likely, ratings were valuable because they permitted investors to buy something triple A-rated that paid 20 times the spread of other triple A-rated instruments.

In other words ratings can only really be objective when they are not used for anything. The SEC has already removed reliance on ratings from many of its rules, but I am not holding my breath waiting for Basel to do the same. However sensible an idea it might be, I doubt regulators are willing to admit how ill-conceived the Basel credit risk rules really are.

Posted in: CPDO, Ratings, Regulation by David /
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This was my favourite blog title of the day: And now young monoline… you will die. Accrued Interest makes some good points, and indeed it must be frustrating trying to run a monoline when one’s de facto regulator, the ratings agencies, keep changing the capital model. However:

• It was clear that the capital models used up to mid 2008 were flawed, and so volatility in capital required for a AAA was to be expected.
• One of the key parts of an insurer’s business model is time diversification. Business underwritten in one year diversifies that written in another, and losses in one year – subject to enough capital being available to continue – can be offset by higher premiums the next year. For the monolines though this does not work any more as there is much lower demand for muni wraps and those that are getting done are mostly being written by Berkshire. So the agencies are right to account for this change in their re-rating of the monolines.

Anyway, Bill Ackman might fancy being able to buy another small country, so it is about time for another wave of monoline downgrades.

Posted in: Capital and Contingent Instruments, Monoline, Photography, Ratings, Regulation by David /
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The WSJ reports that JP Morgan’s CEO is skeptical of the broker/dealer’s newly published capital ratios:

“I challenge those numbers,” Mr. Dimon said, throwing a verbal roundhouse at rivals Goldman Sachs Group, Morgan Stanley, Merrill Lynch and Lehman Brothers.

He went on to question whether the methods the investment banks used to calculate a measure of financial strength known as the Tier 1 ratio were the same as those used by commercial banks.

In fact Dimon wasn’t tough enough. He went on to say: “I’m not sure that those investment banks are using true Basel II type numbers, but we don’t know the detail.” In fact we do know that the SEC capital requirements are definitely not true Basel II type numbers. So Lehman’s “Tier 1 ratio”, say, at 13%, doesn’t mean what you might think it does. Caveat lector.

Posted in: Broker/dealers, Capital and Contingent Instruments, Regulation by David /
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A post on VoxEU discusses the debate between Larry Summers style ‘the FED must drop money on Wall Street until the problems end’ interventionists and the moral (and I believe broadly correct) position that banks ought to be left hanging to pay for their sins. Governments ought to be worried about their taxpayers, not bank shareholders. VoxEU calls this the Willem Buiter position, which is not entirely accurate (Buiter’s position is more nuanced) — but let’s run with it.

The argument is that the moral hazard in permitting a Summers style bail-out is too great to permitted:

once banks know that they can play the high-risk, high-return game, pocket the profits, and let taxpayers face the risks, bailouts provide a temporary relief but set the ground for the next crisis.

…Bank of England Governor Mervyn King nicely sums up the situation: “’If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time, the parties will become wilder and wilder.”

This would be true without regulatory capital. But if it works as intended regulatory capital should stop the party from getting too rowdy. The current crisis came about because capital requirements were not effective in constraining banks’ risk. The solution for now is a rescue with shareholder expropriation where necessary for the protection of depositors and the financial system. The solution for the future is getting regulatory capital requirements right. And minor changes to Basel 2 won’t do that.

Posted in: Capital and Contingent Instruments, Moral Hazard, Regulation by David /
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FT alphaville is I fear too tough on some of the European Commission’s proposals to alter the Capital Requirements Directive. There is in fact much to like about the Commission’s original approach (if not its subsequent pirouettes). The key section of the original is:

the originator credit institution shall calculate the risk-weighted exposure amounts … for the positions that it may hold in the securitisation. The risk-weighted exposure amounts for the originator credit institution shall not be less than [15%] of the risk-weighted exposure amounts of the securitised exposures had they not been securitised.

This is really good. It means that institutions cannot get rid of more than 85% of the capital, whatever they do, and so they are encouraged to keep at least 15% of the risk. I would feel happier with 25%, but 15% is a good start at ensuring alignment of interests.

Of course the objection to this is that – since this is an EU rather than a Basel proposal – it leads to a competitive disadvantage to EU banks. For here we get the Commission’s suggestion of a requirement that any originator keeps 10% of any risk if they want to sell to an EU bank. That, admittedly, isn’t a very sensible suggestion. The original proposal was just about portfolio credit risk transfer, not syndicated loans, not single name CDS. Rather than frantically making alternative proposals the Commission should stick to the original idea, and ideally try to persuade the Basel Committee to agree to it too. Capping regulatory relief on securitised exposure at 85% is sensible. Bravo Brussels. Now don’t stuff it up by panicing when the Banks say they don’t like it. They don’t have to like it. It just has to be the right thing to do.

Posted in: Basel, Capital and Contingent Instruments, Photography, Regulation, Securitisation and Tranching by David /
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The Economist points out something really cute about the GSE’s having access to the FED window:

The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press.

I just love the way unintended consequences sometimes result from attempts to make things better, don’t you? But fortunately no one could think that Fannie or Freddie would abuse their access to the window, so the Economist is just engaging in idle speculation, isn’t it?

Posted in: Federal Agency, Regulation by David /
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A post on Accrued Interest concerning Fannie and Freddie caught my eye. Two quotes. First:

delinquencies on their guarantee portfolio remain relatively small (0.81% for Freddie Mac and 1.22% for Fannie Mae)…

And second

Under current statues, the GSEs minimum capital required is 0.45% of of their guarantee portfolio

So their current level of losses is roughly twice the capital requirement – a level of capital which was presumably intended to cover unexpected losses at a high degree of confidence. If a more craven example of the supine nature of the US regulatory environment were needed, I don’t know where to find it.

Posted in: Capital and Contingent Instruments, Federal Agency, Regulation by David /
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The commission has bottled the capital treatment of securitisations. According to Bloomberg:

European Union officials scaled back a plan to stiffen capital requirements for asset-backed bonds, responding to banking industry objections the measure would have hurt European lenders without reducing risk.

The revised proposal, posted online last week, would let banks freely invest in securitizations — such as the mortgage bonds that sparked the credit crisis of the past year — as long as the issuer owns 10 percent of the assets. Banks wouldn’t have to set aside any capital for those holdings. An earlier version would have forced issuers to retain 15 percent.

15 was already too low. 25 or 30 is more like it. 10 does little to align interests between securitisation buyers and sellers, which is the key issue.

Posted in: Capital and Contingent Instruments, Regulation, Securitisation and Tranching by David /
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News flash: Bernanke has been speaking on consolidated supervision of US institutions. According to Bloomberg:

Federal Reserve Chairman Ben S. Bernanke said Congress should give a single federal regulator enhanced power to set standards for the capital, liquidity and risk management of investment banks.

(The emphasis is mine.)

Posted in: Broker/dealers, Capital and Contingent Instruments, Regulation by David /
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