Now if I am trading complex derivatives (of whatever kind, FX, IR, Credit, Equities), I need to understand how it will move given various industry movements and internal characteristics. Also called as the Greeks. Now for quoted derivatives (either on an exchange or on broker pages), the risks are reasonably well understood and priced. But when you move into the exotics, then you are exposed to a new type of risk, that is called as the "model risk". In other words, the models that you are using to price the new instrument are based upon assumptions upon assumptions upon assumptions upon actual prices. So while you do do testing to a very large extent with loads of scenarios, you cannot test every eventuality.
And they blow exactly when you least want them to blow, when there are extreme market movements, where the normal relationships break down, the usual assumptions of liquid markets are blown, etc. etc. So that's one strand of the argument. The other strand is to pull in capital discipline. Now forget about the regulators. If you are expecting the regulators to manage your capital, you are already in deep doo doo.
It is so worrisome that so many financial institutions around the world do not have any capital discipline. When you are lending out your capital or putting your capital at risk on prop trading, how many actually kick the tires of the investment opportunity? And as it so happens, very few actually. They might evaluate that opportunity itself, but not the portfolio, not the overall bank risk, nothing. Even if they do the overall and underlying risk analysis, how many have tied their capital usage to the level of risks they bear? And final question, how many firms have actually withdrawn capital from individual desks or businesses on a frequency greater than monthly? In other words, how many banks monitor their risk adjusted capital usage on a daily or weekly basis and ACTUALLY ACTION on those figures? very few.
This is the reason why you have issues such as huge losses appearing out of thin air and people getting nervous, no capital management, no capital discipline, no balls to tell your trading and business MD's that if they run too big a risk, their capital will be withdrawn. If you dont, then you get chucked out of a job. Mind you, you get $150 million as a payoff, so perhaps there is something in this capital mismanagement malarkey!
Market insight: Basel is the root of the banking crisis
By John Plender
Amid high drama in bank boardrooms, the chief executives of Citigroup, Merrill Lynch and UBS have gone in short order. And with good reason, in the light of the huge losses these
men presided over in asset-backed securities.
Yet it is important to recognise, when considering any response to this continuing debacle, that the extreme nature of this financial cycle is partly the product of the very
regulatory systems that govern the operations of large financial institutions.
Likewise, executives’ behaviour has been a direct response to flawed incentive
structures in individual banks.
It was the 1988 Basel Accord that first created the opportunity for regulatory arbitrage whereby banks could shunt loans off the balance sheet. In effect, a new capital discipline designed to improve risk management had the unintended consequence of creating a parallel banking system whose lack of transparency explains the market seize-up since
As the new “originate and distribute” model reduced the incentive for
banks to monitor the credit quality of the loans they pumped into collateralised
loan obligations and other structured vehicles, the Basel rules failed
adequately to highlight contingent credit risk. That is, when conduits and
structured investment vehicles (SIVs) ran into difficulties, credit risk started
to come back on to bank balance sheets, putting strain on bank capital.
Other forms of obfuscation were at work. Where conventional credit markets talked
about risk in terms of credit quality, defaults and ratings, derivative traders
in the shadow world of structured products employed far more esoteric language.
Yet while the cash and derivatives markets were linguistically and mentally at
odds, the fundamental risks were the same. If a company goes belly-up, the
credit event hurts in both places.
Within banks executive bonuses and other incentives have the effect of encouraging a perpetual dash for growth at ever-increasing risk. Why be prudent when you can bet the ranch in the knowledge that a losing bet pays so handsomely? The snag is that in banking, betting the
ranch increases systemic risk.
Note, too, that accountants have connived in the regulatory arbitrage game. After Enron, the accounting for off-balance sheet entities was supposedly tightened. Yet in practice banks have been carrying out the equivalent of sale or return transactions with their conduits and SIVs and booking profits up front regardless.
Then there are the analysts and shareholders. As with Marconi in the dotcom boom, Northern Rock was backed by an enthusiastic capital market chorus who cheered from the sidelines without grasping the risks in the bank’s funding model – although the euphoria this time
was not universal.
So what now? The Basel II regime, which takes effect in January, makes securitisation less attractive to banks and seeks to address contingent risk. Yet it is hard to believe it would have prevented the current mess. Basel II relies on the modelling techniques that led to the subprime
disaster. The new rulebook also depends heavily on the credit rating agencies in
whom investors have lost confidence.As for the evolution of executive pay
structures, there is little to inspire hope. The scale of the losses in the world’s biggest banks points to a failure on the part of bank boards on a monumental scale. That in turn raises the question of whether top executives, let alone non-executives, can really understand the risks being run in such large, complex institutions.
With executive compensation, nothing suggests that American committees have an appetite for addressing the crazy packages that create systemic problems. Nor does it seem likely that
lawmakers would want to introduce a statutory pay policy for the US boardroom.
If there is any good news, it is that market discipline will ensure that the more toxic structured products will not return. But nothing in the regulatory debate so far promises notably less extreme swings in the credit cycle. And the law of unintended consequences remains an ever-present threat.
All this to be taken with a grain of piquant salt!!!