Paying for resolution, practically May 29, 2012 at 9:51 am

So how would this pay for resolution by writing calls thing work?

Well, first you need to calibrate the system. Fortunately Joe Noss and Rhiannon Sowerbutts (HT FT alphaville) have recently analysed the implicit UK taxpayer subsidy to banks, and concluded that it is at least £30 billion per year across the cycle. As a starting point, let’s assume that we want half of that money back.

That means UK banks have to write £15 billion of physically settled one year at the money equity call options on their own stock to the Bank of England every year. You could determine individual bank amounts based on capital (or something else like balance sheet size); so for instance Bank H might have to write each year enough call options to be worth

£15 billion x Bank H RWAs / (sum of all Bank RWAs)

These would be priced using market implied volatilities, and hedged as usual by the central bank shorting bank H equity.

This process would lock in the value of those options, assuming that the hedge was successful – and frankly it isn’t too difficult to hedge one year plain vanilla call options in reasonable size: these are not funky credit derivatives. Big market moves would make the central bank money as it is long gamma and long vega; quiet markets, where all was well in the banking system, would result in the central bank failing to capture some of the calls’ value. That’s OK, though; you don’t mind having less in the pot when times are good providing the pot magically refills in bad times, as it will.

Now let’s roughly size the suggestion. HSBC has roughly 40% of UK bank RWAs, so it should pay 40% of the total. That is, each year, it should write £6 billion worth of calls to the Bank in this model, an amount corresponding to roughly 30% of its earnings. One at-the-money call on HSBC is worth very roughly 60p (I am rounding like crazy as this is all very approximate), so this year it would have had to have written calls on 10B shares. Ooops. That’s half the shares outstanding. There’s no way you can hedge a position that big efficiently, and market knowledge of dilution that large would kill the share price.

What do we conclude from this? Well clearly this idea can’t monetise all of the implicit taxpayer subsidy. But it certainly could monetise 10% of it. £3 billion a year in the pot to cover the costs of RBS/LBG/Northern Rock type events would be a good start.

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