Eric Falkenstein writes:
How much capital for derivatives? Good question. Should it be weighted by risk? If so, how does one measure risk? Considering that risk is a function of the collateral, which comes in many different flavors (traded debt, pools of mortgages, pools of bank lines), and then are structured very differently, with differing levels of subordination, differing rules for the waterfalls of cashflows depending on various metrics of collateral quality. It’s a mess.
…You may think this is no different than regular lending, but you would be wrong. For example, lets say you have two swaps, but they both offset each other almost exactly for interest rate risk, but as they have different counterparties, they have differing credit risk. How about swaps from the same counterparty, but differing interest rate exposures, partially netted. How much should capital be netted? And if the US banks have capital requirements greater than economically necessary, how many seconds before all swaps would move offshore?
I take him to be saying that financial institutions can never be transparent in their risk-taking, or at least not in the sense that can be made accountable to a regulator. Read the whole thing. Read also Doug Colkitt’s comment here. Note by the way that Bear Stearns, at the time of its collapse, had met Basel capital requirements.
Mark Thoma writes:
I’d argue that even though Basel was not perfect it was much better than having no regulation at all…If the regulations under Basel caused banks to move assets off the books, then without regulation they wouldn’t have needed to move them, but the assets still could have been used in the same way, financial institutions could have taken the same risks and would have had the same or more incentive to do so without regulatory oversight, and they could have caused the same troubles. I don’t see how the regulations themselves caused the risk taking. Regulation caused evasion of regulation, and Basel II is trying to deal with that problem, but the regulations did not cause the risk-taking itself.
Currently my view is closer to Thoma’s. The case against regulation requires that derivatives risk is observable (by the bank itself, and of course if it is not observable to anyone run the other way!) but not verifiable to an outside regulator (otherwise it could be controlled by regulation). Even in that case, however, more informal systems of regulation should work, albeit imperfectly. Yes banks will sometimes lie and trick the regulators but at least another layer of protection is in place.
There’s lot of talk about the government buying up mortagages. Even if you favor that plan, it’s a one-off measure, not a long-term solution to stop a future crisis. There is in fact a paucity of good regulatory proposals on the table. There are plenty of ideas for how to stop what went wrong "last time" but fewer good ideas for how to stop the next version of a financial crisis.
I’m surprised no one is talking the corporate structure and decision-making processes which led Bear Sterns to essentially commit suicide. That we would have a system of investment which produces those sorts of incentives seems like its both incredibly silly and not something which would survive in a competitive market (of markets).
Um, wait a minute. Isn’t Falkenstein saying that you can’t quantify risk? I’d suppose that there’s quite a bit of empirical evidence connecting leverage to riskiness– enough for a first approximation, anyhow.
The case against regulation requires that derivatives risk is observable (by the bank itself, and of course if it is not observable to anyone run the other way!) but not verifiable to an outside regulator (otherwise it could be controlled by regulation).
No, the case against regulation requires something else. And that is:
1) you cannot regulate BAD investment decisions – there is nothing like ex-ante bad investment decisions. All investment decisions are ex-ante good. You can regulate only investment decisions as a whole – both good and bad. Regulation will simply limit investment which will limit BOTH good and bad investment.
2) the case for regulation is based on assumption that non-market driven regulation will choose as good policies as market-driven regulation. That is tantamount to saying that central planning works.
3) if the government starts to regulate then the investors often feel an implicit government guarantee (the Fed vindicated people who expected that). therefore it creates moral hazard – not only from owners (which can be offset by capital requirements), but mainly from creditors.
4) see ‘american dream downpayment initiative’. The government supported the bad investment decision – they DID regulate and the regulation did promote bad decisions. How is more regulation supposed to fix it? That seems awfully like the famous ‘socialism didn’t work THIS time, but if we “do it right” it will work next time’?
The whole thing boils down to: Why did the investors make collectively bad investment decision? What can we do to assure that investors don’t do such mistakes – it is in their interest!! The ‘regulation idea’ is based on the idea that investors knowingly do decisions that they expect to turn bad.
I fear the answer is simple: stable money, free market so that it can get to equilibrium fast (the fed is impeding house prices to crash (get to equilibrium fast), thus motivating people to continue making bad decisions), no regulation, no implicit nor explicit government guarantee. Will that happen? No. Because this problem is caused by free market and not by government-induced moral hazard, government incentives to make bad decisions, government manipulation of money supply and interest rates. Rule #1: Nothing is ever government’s fault. They are here to help you.
Tyler wrote:
“Note by the way that Bear Stearns, at the time of its collapse, had met Basel capital requirements.”
You need to examine the scope of the Level 3 Assets. These are assets that the institution cannot value because there is no market or the market is so thinly traded that there are not enough recent transactions. So how do you Mark-to-Market when there is no market? Wall Street Wizards came up with Mark-to-Model. Voila! The assets have “value”. Why? Because the model says they do.
Last November Bear Stearns reported $20 billion of Level 3 Assets. That is 155% of capital.
So as long as those Level 3 Assets are permitted to be called assets then I suppose you have enough capitalization.
Now go examine some of the Q1 2008 financial tricks. Looks like some are using Mark-to-Model to write UP their assets.
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You can’t really assess why the Fed had to act so decisively until you include Credit Default Swaps into the mix. but that is for another post.
Forgive my naivete, but I still don’t see why “moving assets off the books” is ever legitimate. For a publicly traded company to move assets someplace where investors cannot take proper account of them when making investment decisions just seems like straight-up fraud. What am I missing?
Conversely, if there were no such thing as off-the-books assets, you could make a straightforward argument against regulation, viz: everything this company has is clearly listed where investors can see it. If they don’t understand the risks the company is taking, or don’t agree with the company’s assessment of those risks, they can sell their shares.
Why isn’t the general answer to these problems to require a lot more disclosure so that there is more informed consent on the part of people putting up their money?
So, why again do regulations that didn’t stop the last failure, and wouldn’t stop the next failure get foisted onto the non-failures?
“that they would make more money putting money into investments that were basically a bad idea….and it worked for a while.”
Its not about good vs bad investments.
Its about risky vs less risky investments. The aim of regulation is to ensure that banks do not take on too much risk.
Andy is correct in saying that it is only possible to know that an investment is bad after the fact. So regulation can’t prevent bad investments.
Maybe though it can prevent risky investments. That of course depends on whether risk can be determined ex-ante. Obviously to a certain extent it can for investments that are well understood like: most equity, fx, and interest rate type derivatives, bonds, stocks, etc. In fact I would say it can even be understood for CDOs, credit default swaps etc.
The real problem is that there are two kinds of markets. Normal markets where everything is liquid, correlations follow historical norms etc blah blah. And crazy markets where everything is unpredictable.
In order for effective regulations to work things need to be predictable. So I don’t think regulations can deal with crazy markets.
“Its not about good vs bad investments.
Its about risky vs less risky investments.”
Wrong. It’s not even about risk – it’s about high leverage in combination with high risk factors.
It seems to me that this is really a matter of culture: why don’t people in the financial industry think like engineers? An analogy: people who buy high-performance cars care about performance, but also about safety, and even car companies who lean more towards performance are serious about building safer cars. The car industry stopped fighting Ralph Nader a long time ago and now competes on safety features.
Why aren’t customers of the financial industry as well-served as customers of the auto industry? What could we do to change that?
We need a competitive monetary market. Anyone who holds reserve monetary bonds issued in a competitive monetary bond market, can have access to the discount window.
The fed can arbitrage monetary bonds to keep them trading withing a band. Bonds that drop in value will cause a decrease in the reserve holding value, so there is an early signal for weak bonds.
Large funds who want to hedge cash can issue monetary bonds, and hold the required reserves of monetary reserves in these bonds. When they need cash to cover shorts, they automatically get the cheapest discount rate.
As the economy goes through turbulence, the fed can let the bonds trade in a wider band, and visa versa. The monetary system then matches the aggregate yield, by default, always.
Fixing finance
Apr 3rd 2008
From The Economist print edition
Crises are endemic to financial systems. Attempts to regulate them may do more harm than good
AS IF collapsing prices were not enough, American mortgage firms now have to cope with home rage. Borrowers vent their fury on the system that is repossessing their properties by smashing holes in walls and tipping paint over living-room carpets. Something similar is going on in the house finance built. Faith in open markets has been poisoned by a crisis that has spread from one asset to the next. First there was disbelief and denial. Then fear. Now comes anger.
For three decades, public policy has been dominated by the power of markets—flexible and resilient, harnessing self-interest for the public good, and better than any planner-in-chief. Nowhere are markets deeper and more liquid than in modern finance. But finance has stumbled and there are growing calls from all sides for bold re-regulation.
New rules became inevitable the moment the Federal Reserve rescued Bear Stearns and pledged to lend to other Wall Street banks. If taxpayers are required to bail out investment banks, the governments need to impose tighter limits on the risks those banks can take. This week Hank Paulson, America’s treasury secretary, unveiled a longer-term plan to deal with this and other weaknesses in America’s regulatory system (see article); and next week the G7 finance ministers will meet in Washington, DC, where they will discuss a report on the crisis by the Financial Stability Forum.
It is natural and right that regulators should seek to learn lessons. The credit crisis will damage not just the reputation of the financial system but also the lives of those who lose their houses, businesses and jobs as a result of it. But before governments set about reforming financial regulation, they need both to be clear about the causes of the crisis and to understand just how little regulators can achieve.
Arm’s-length finance
The history of financial markets is not a stable one. They have imploded every decade or so, whether because French and Spanish kings reneged on their debt in the 16th century or because speculators inflated railway stock in the 19th century. But this crisis is unusually shocking, if only because the mild business cycle and the fast pace of world economic growth in recent years had lulled people into a false sense of security.
The view that the only sensible response to the 21st century’s first serious financial crisis is a wholesale reform of the system is now gaining ground. Josef Ackermann, über-capitalist and chief executive of Deutsche Bank, summed it up in a call for governments to step in: “I no longer believe in the market’s self-healing power.† The implication is that, if the market cannot heal the wounds it sustains as a result of its own risky behaviour, then it must be discouraged from taking such risks in the first place.
But there are two reasons to hesitate before plunging headlong into a purge of the system. First, finance was not solely to blame for the crisis. Lax monetary policy also played a starring role. Low interest rates boosted the prices of assets, especially of housing, which in turn fed into complex debt securities. This created a spiral of debt that is only now being unwound. True, monetary policy is too blunt a tool to manage asset prices with, but, as the IMF now says, central banks in economies with deep mortgage markets should in future lean against the wind when house prices are rising fast.
The second reason to hesitate is that bold re-regulation could damage the very economies it is designed to protect. At times like this, the temptation is for tighter controls to rein in risk-takers, so that those regular, painful crashes could be avoided. It is an honourable aim, but a mistaken one.
The inevitable crash
Finance is a brain for matching labour to capital, for allowing savers and borrowers to defer consumption or bring it forward, for enabling people to share, and trade, risks. The smarter the system is, the better it will do that. A poorly functioning system will back wasteful schemes and shun worthy ones, trap people in the present, heap risk on them and slow economic growth. This puts finance in a dilemma. A sophisticated and innovative financial system is susceptible to destructive booms; but a simple, tightly regulated one will condemn an economy to grow slowly.
The tempting answer is to try to wriggle free from the dilemma with a compromise that would permit innovation but exert just enough control to squeeze out financial failure. It is a nice idea; but it is a fantasy. The experience of the past year is an object lesson in the limited power of regulators.
Just look at their mistakes. Before the crisis, hedge funds were regarded with suspicion as vulnerable and irresponsible. But, with a few notable exceptions, they have weathered the storm less as culprits than as victims. Instead, the system’s own safety features turned out to be its weakest points. The copper bottom fell out of AAA bonds when housing markets failed to do what the rating agencies had expected. Banks avoided rules requiring them to put aside capital, by warehousing vast sums off-balance sheet with disastrous results.
It would be convenient to blame the regulators for all that, but the system is stacked against them. They are paid less than those they oversee. They know less, they may be less able, they think like the financial herd, and they are shackled by politics. In an open economy, business can escape a regulatory squeeze in one country by skipping offshore. Once a bubble is inflating many factors conspire to discourage a regulator from pricking it.
And even if you could put all that right, regulators would still fail, because of the nature of finance itself. Financial progress is about learning to deal with strangers in more complex ways. The village moneylender, limited by his need to know those he did business with, was gradually superseded by ever-broader impersonal markets that can cheaply mobilise colossal sums and sell more complex products. The remarkable thing is not that finance suffers from booms and busts, but that it works at all. People who would not dream of lending £1,000 to that nice family three doors down routinely hand over their life savings to strangers in a South Korean chaebol or an Atlantan start-up. It all depends on trust.
Regulators cannot know how trust will ebb and flow as new markets develop the experience and practice they need to work better. They therefore cannot predict the peril of new ideas. They have to let new markets develop, or stifle them. The system learns—dangerous junk bonds are reborn as respectable high-yield debt; bankers will now be scared of extreme leverage—but it is delicate, as the world learned last summer. The regulator is condemned to muddle through.
The notion that the world can just regulate its way out of crises is thus an illusion. Rather, crisis is the price of innovation, so governments face a choice. They can embrace new financial ideas by keeping markets open. Regulation will be light, but there will be busts. The state will sometimes have to clear up and regulation must be about cure as well as prevention. Or governments can aim for safety and opt for dumbed-down financial systems that hobble their economies and deprive their people of the benefits of faster growth. And even then a crisis may strike
I have less knowledge and therefore a less interesting opinion on the capital requirements question. I do think that this ebbs and flows as people perceive the market, though, and certainly hope that regulation is not that specific.
On the question of fair valuation (and specifically L3 valuation): if BS was too aggressive in their valuation under FAS 157, it was Deloitte — as their independent auditor — that should have pushed back and, if necessary, refused to sign the K. They carried an asset on the books. Deloitte signed off on the valuation of that asset. (Just like an auditor signs off on the valuation of any asset, with an observable market or not, or any liability, like standard accounting for doubtful accounts.)
The regulations in place essentially already deputized Deloitte to dig deeper. What does this all say about SoX?
On the question of fair valuation (and specifically L3 valuation): if BS was too aggressive in their valuation under FAS 157, it was Deloitte — as their independent auditor — that should have pushed back and, if necessary, refused to sign the K.
Quarterly audits of a derivatives-heavy operation like Bearn Stearns are obsolete by the time they are published. Bear went from flush to allegedly broke in less than a week, and most of that in the last 24 hours before the J.P. Morgan deal. Such is the pace of a bank run in the era of computerized derivatives.
What is needed are independent daily, and perhaps even hourly, audits of the creditworthiness of not only banks, but also of all the partners with which they carry outstanding derivatives positions. Auditors need to be able to peer into a bank’s books, and even more importantly run its derivatives simulations, on a practically continuous basis. Needless to say, such audits, which reveal the deepest trade secrets of the banks to the auditors, must carry the highest degree of confidentiality and trust.
Financial markets WILL be regulated, one way or another. Either by government fiat or by participants in the free market. Government should only do it if the transaction costs of the free market doing it exceed the value.
Manager: So, you used this new part that was just developed in a critical component?
Engineer: Yes.
Manager: Did you test it?
Engineer: No, the manufacturer advertised it as safe.
Manager: Well, people died. You are fired. Oh, and the court date is coming up. You might go to prison.
Engineer: Doh! I should have gone into finance!
There is only one way to stop financial crises and that’s to abolish central banking.
Was there no such thing as a financial crisis before the advent of central banking?
http://www.indiana.edu/~econweb/econeduc/wicker.html
See Banking Panics of the Gilded Age.
And was Nelson Aldrich the epitome of pure evil or what?
There’s your author of the Great Depression. What a thug.
How much back up money (to stay alive) should one have before going into casinos and placing “side bets” at the craps table?
Run that through Black-Scholes.
Could they do that at Baccarat?
Wealth transfer backwards in point 1 above.
“The reason is that finance is much more complex than engineering.”
“Bull. We are still learning about physical phenomena. All the good ideas in economics and finance have been figured out and are now in need of refinement. But rather than refinement, financiers have moved on to mucking up.”
Andrew that is not the type of complexity that I am talking about. I’d say as far as that type of complexity finance and engineering are about the same why do you think so many Physics Phd go into finance.
The problem with finance that makes it much more complex than engineering is that you cannot trust the past to be an indicator of the future.
Imagine firing a cannon or building a bridge when the gravitational constant was not guaranteed to be the same today as it was last year. You can only guess at what it will be.
As you suggest people DID test some of these structures and they worked well for quite a while. And all of the correlations and default rates used by the ratings agencies and the banks were based on past observations.
The problem is that many of those parameters changed. In finance you cannot always trust the past as an indicator of the future. Now I would argue that someone with some foresight should have seen the potential for those parameters to change, but many smart people who were willing to put up their own money disagreed with me.
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