An interesting analogy in the discussion about the future of financial regulation

The hills are alive – and have been for many moons now - with the ideas on how to regulate financial products. The most recent were the proposals by President Obama. On the whole they were of interest because they recognise the fragmented nature of regulation and how systemic risk is important. So in fact they do not propose to reduce the regulators, but rather to adopt the overall ‘Department of Homeland Security Model’, or if you will, create a super regulator to oversee all the hodge podge of regulators in the US. Curiously nobody is touching the Basel 2 framework (but more about that later on). The FSA is pushing for a liquidity management framework which, while being - in my opinion - conceptually and intuitively appealing, is practically a nightmare to implement and execute. The EU is also going towards the super regulator direction, but I am still not convinced that a super regulator is the answer. It all boils down to giving regulators more data and more coverage and this kind of credit crisis will not happen again. But the regulators already had all this data, coverage and people. If banks are already being labelled as "if they are too big to fail, they are too big", then why isn't the same question being asked of the regulator? If the financial world thinks that banks are too big to manage, what makes them think that a vastly bigger overarching regulator can oversee an entire group of these giant banks?

The BIS is currently going to through some serious debates about the future of regulation. In yesterday's annual report, they threw a wide net across this issue, but in particular, page 126 uses a very curious analogy which I thought was interesting enough to share.

I quote:

Balancing innovation and safety in financial instruments requires providing scope for progress while limiting the capacity of any new instrument to weaken the system as a whole. Balance can be achieved by requiring some form of product registration that limits investor access to instruments according to their degree of safety. In a scheme analogous to the hierarchy controlling the availability of pharmaceuticals, the safest securities would, like non-prescription medicines, be available for purchase by everyone; next would be financial instruments available only to those with an authorisation, like prescription drugs; another level down would be securities available in only limited amounts to pre-screened individuals and institutions, like drugs in experimental trials; and, finally, at the lowest level would be securities that are deemed illegal. A new instrument would be rated or an existing one moved to a higher category of safety only after successful tests – the analogue of clinical trials. These would combine issuance in limited quantities in the real world with simulations of how the instrument would behave under severe stress. Such a registration and certification system creates transparency and enhances safety. But, as in the case of pharmaceutical manufacturers, there must be a mechanism for holding securities issuers accountable for the quality of what they sell. This will mean that issuers bear increased responsibility for the risk assessment of their products.

Regardless of how great an analogy this is, it still opens up questions. Four major questions emerge:

1. Who will be the FDA (USA), EMEA (Europe) or MHRA (UK) to judge the safety of these "drugs"? The point is that the problem with the rating agencies is well known already. (would be good to give an example here, such as …. Etc to drive home the point)

2. Do the regulators have the capacity and capability to really judge these financial products?

3. How will the Basel 2 process be modified to cater for this as this is taking risk rating down to a seriously detailed level and will require far more standardisation than before.

4.Given that the speed of introducing new products into the financial markets is measured in terms of days for example in the OTC derivatives market, this kind of product based regulation will be equivalent to dropping a JCB full of boulders into the world financial system.

Much to think about...

Fire the European Central Bank

Well, since the ECB is now claiming that its strategy for interest rate management is backed by the citizens, then I have a further idea. Lets fire all those expensive chaps sitting on the 18th floor downwards in Euro tower in Frankfurt.

No? but then, hold on, since the rationale for your interest rate management seems to be the backing of citizens and not economics theory and expertise, then we might as well as give over the right to manage interest rates to Gallup or a local newspaper. They will simply go out, ask people, rates up or down? the majority win and the rates move accordingly.

Unbelievable commentary.

Technorati Tags: Inflation,Central Banks

The mother of all "oops" moments for a central bank!

Oops indeed.

The price of real gold is currently soaring Ethiopia's national bank has been told to inspect all the gold in its vaults to determine its authenticity. It follows the discovery that some of the "gold" it had bought for millions of dollars was gold-plated steel.

The first hint that something was wrong reportedly came when the Ethiopian central bank exported a consignment of gold bars to South Africa. The South Africans sent them back, complaining that they had been sold gilded steel.

An investigation revealed that the bank had bought a consignment of fake gold from a supplier, who is now under arrest. Other arrests followed, including business associates of the main accused; national bank officials; and chemists from the Geological Survey of Ethiopia, whose job it is to assay the bank's purchases of gold and certify that they are real.

But what has clearly now got the government even more worried is that another different batch of gold in the bank's vaults has also been found to be fake, and this time it was gold which had been there for several years, after being seized from smugglers trying to take it to
Djibouti.

The Ethiopian parliament's budget and finance committee ordered the inspection of all gold in the national bank's vaults. A report from the auditor-general on the affair is expected to be
presented to parliament during its current session. Gold is mined in Ethiopia in considerable quantities, and a trader selling gold to the central bank has to have it tested and certified by the Geological Survey.

Whether the bank bought fake gold in the first place, or whether real gold from the vaults has been swapped for gilded steel, the fraud has cost the bank many millions of dollars, and it must have involved collusion on a considerable scale.



All this to be taken with a grain of piquant salt!!!

An Asian Currency Bloc?

Now this is extremely interesting news indeed. An Asian currency bloc?

I quote:

Asian central banks appear to be adopting similar monetary policies in a way that suggests they could be preparing for an eventual currency union for the region, according to Deutsche Bank.
Twelve Asia-Pacific currencies – including the yen, the Korean won, the Indian rupee and the Australian dollar – have increasingly traded as a bloc since 2005, the bank’s research has found.
There is an increase in the correlation between the value of Asian currencies as central banks try to keep their export-led economies competitive internationally and also reduce foreign exchange volatility within the region.
This trend is a result of the wider use of trade-weighted currency baskets in India, China, Singapore and Malaysia, the bank says, adding that the patterns show similarities to movements in some European Union currencies in the years before the euro was created in 1999.
“Asia is beginning to look a lot like Europe in the 1980s and the start of the 1990s,” said Martin Hohensee, Asian head of fixed income and credit research, who led the analysis.
“Policymakers and politicians are talking seriously about the possibility of Asian currency union, even if there isn’t a single currency,” he told the Financial Times in an interview.

All this to be taken with a grain of piquant salt!!!

US Financial Regulatory Framework Future: More Comments

Further to my long note about the future of US regulation, seems like the market is also thinking the same! I quote:

It appears as if Europe’s got it right; the push for a regulatory model closely mirroring Europe ’s was all the rage at the annual Securities Industry and Financial Markets Association meeting.
According to MarketWatch.com, the US regulation community is simply looking for an approach that is based on principles… the same approach that UK ’s Financial Services model has used for years. Here, companies do not have to concern themselves with the constant burden of having to answer to regulatory examinations. Instead of being forced to adhere to specific rules, corporations would have the luxury of sticking to guidelines.
With more and more freedom to de-list now materializing for foreign companies, many are doing exactly that.
“Given that freedom, they are leaving,” said Hal Scott, a professor at Harvard University, who spoke of the exodus of business to foreign markets.
Also on the regulatory reform side of the fence is John Thain, chief executive at NYSE Euro next (NYX) and his counterpart at CME Group Inc. (CME), Craig Donohue, who both praise the push for such changes.

All this to be taken with a grain of piquant salt!!!

How much capital should a bank keep?

I have been thinking about corporate performance, capital and corporate governance for some time now. These three are very tightly linked together. In almost every case of a bank getting into difficulties, it was because the firm had bad capital controls and bad capital management. And thus it leads to bad performance and the balance sheet looks like Swiss cheese.

More importantly, if you control the amount of capital you can have very tightly based upon the risk factor, then counter-intuitively, in times of market turmoil, you make the problem worse. For example, say based upon their internal risk measures, you have determined that the capital I need to keep aside is 10 quid. So far so good. But say the markets have dived like a dingo down its hole. Now the risk measures would be saying that I have to either get rid of positions or I have to increase my capital. In the case of the former, I will be exacerbating the market problem by increasing the selling pressure. In case of the latter, you will end up with no take-up of your capital increase (either by a rights issue or bond issue or what have you) (who wants to purchase in a selling market?).

Furthermore, as we have seen in the case of the Northern Rock (btw, did you know that we have spent more on this stupid incompetent fiasco of Northern Rock than the entire military budget of this year? our squaddies are dying because they do not have equipment and our taxpounds are going to save the collective patooties of the government, FSA and the central bank - makes me furious, I tell you!), corporate governance problems kicks in, who wants to purchase it? Hedge Funds? Private Equity? Other banks? What? So what do you do?

Well, here’s one answer: In other words, it is not sufficient to just meet Basel II requirements, but also to go ahead and have a buffer over and above it! But more importantly, certain economies which have a preponderance of bank lending compared to market lending (such as Germany or countries with less developed capital markets such as China and India) will be hit harder despite having buffer capital!. I quote the full conclusion as it is worthwhile reading it.

The problem of cyclicality of the Basel II minimum capital requirements is currently the subject of an intense discussion in the financial and supervisory community. This paper provides two important contributions to the debate. First, whereas previous research has largely focused on fluctuations in capital charges only, it finds that the behavior of capital buffers is crucial to assess the impact of capital requirements on bank lending. Second, it provides an analysis of macroeconomic consequences emphasizing the conceptual difference between the cyclicality of regulatory capital ratios and lending and their pro-cyclical effect on the real economy.

With regard to the cyclicality of lending I find that the capital buffers are likely to mitigate the impact of changes in capital charges. I find that by ignoring this effect one might substantially overestimate any potential lending volatility. At the same time, the capital buffer will only partially absorb the fluctuations in minimum capital (roughly by 50%). It is worth noting that the cyclical effects of regulatory capital on lending are not unique to Basel II, but that they are also present in the old framework with time invariant risk weights.

While pro-cyclical effects occur or are to be expected under the old and the new framework, the capital buffer is found to differ completely. Under the old framework this paper predicts an increase in the capital buffer during an economic downturn due to a reduction in lending (which is in line with previous empirical research). Under Basel II, however, the capital buffer will actually decrease, because the rise in the average risk weights will usually overcompensate the reduction in lending. I think that this finding has important implications for further empirical research on Basel II. In my view, it would be wrong to look at the movements of capital buffers under the old framework and assume a similar pattern under Basel II, as some previous papers seem to suggest.

As to macroeconomic fluctuations, the impact of Basel II on aggregate demand can be significant – even if banks hold significant capital buffers – in particular for economies where bank lending plays an important role in the firms’ investment decisions. However, the pro-cyclical effects on macroeconomic fluctuations will vary among countries. In general, bank-based economies will most probably experience the biggest effects, while the effects in financial markets-based economies will be smaller. The magnitude of any such pro-cyclical effect will depend on various factors, which are not specifically modelled in this paper, such as the firms’ access to outside capital for instance. Among other things, the average size of firms, the sectoral specialization of a particular economy, its accounting framework and the competitive condition in the banking industry play an important role in this regard.16

Finally, I need to mention some other qualifications of the model presented above. First, it assumes that the riskless interest rate remains constant over the business cycle. This assumption was made to separate the pro-cyclical effects of Basel from any potential counter-cyclical measures of the central bank. In the present context this means that the central bank needs to accommodate any income-induced changes in money demand in order to keep the interest rate fixed, and this has an additional effect on real demand. Further research is necessary to assess the interdependence of the prudential regulation of banks and monetary policy. Secondly, the model is not explicitly dynamic but makes interpretations that are dynamic in nature. However, augmenting the model with a dynamic specification is unlikely to change the basic results in principle unless one assumes very high portfolio adjustment costs on behalf of the bank.17 Deviating from the assumption of full flexibility in the portfolio adjustment – for example if assets are illiquid – it suffices to assume that a sufficiently large fraction of loans expires every year.

Frank Heid, The cyclical effects of the Basel II capital requirements, Journal of Banking & Finance, Volume 31, Issue 12, , December 2007, Pages 3885-3900.
Abstract:
Capital requirements play a key role in the supervision and regulation of banks. The Basel Committee on Banking Supervision is in the process of changing the current framework by introducing risk sensitive capital charges. Some fear that this will unduly increase the volatility of regulatory capital. Furthermore, by limiting the banks' ability to lend, capital requirements may exacerbate an economic downturn. The paper examines the problem of capital-induced lending cycles and their pro-cyclical effect on the macroeconomy in greater detail. It finds that the capital buffer that banks hold on top of the required minimum capital plays a crucial role in mitigating the impact of the volatility of capital requirements.


All this to be taken with a grain of piquant salt!!!

Capital Management - a tough one to follow

See this op-ed (quoted in full as its a bit complex!). I would like to comment a bit further on the last aspect which John Plender talks about and that is the risk management model and capital analysis aspects.

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
August.
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!!!

Alistair Darling will not resign because he is incompetent

More brazen lying and incompetence on display over the Northern Rock Saga. As I already said, somebody has to take responsibility. Who is it? And now the thieves are falling out. Mervyn King, the Governor of the Bank of England, points to Alistair Darling as the person responsible for letting the situation become this disastrous.

He also revealed that it was Chancellor Alistair Darling who decided not to
support a Northern Rock takeover bid.

And guess what? this shameless government comprising of Mr. Darling who will duck the responsibility and Mr. Gordon Brown who will simply hide and duck it altogether (cowardly, what happened to leading from the front, Gordon? at least Tony Blair didnt hide!)

All this to be taken with a grain of piquant salt!!!

Another new angle against Iran

The Financial Action Task Force (FATF) is an inter-governmental body whose purpose is the development and promotion of policies, both at the national and international levels, to combat money laundering and terrorist financing.

The thirty-four members of the FATF are: Argentina; Australia; Austria; Belgium; Brazil; Canada; China; Denmark; the European Commission; Finland; France; Germany; Greece; the Gulf Cooperation Council; Hong Kong, China; Iceland; Ireland; Italy; Japan; Luxembourg; Mexico; the Kingdom of the Netherlands; New Zealand; Norway; Portugal; the Russian Federation; Singapore; South Africa; Spain; Sweden; Switzerland; Turkey; the United Kingdom; and the United States.

The FATF has teeth, this body can and does ask all the financial institutions under its ambit and coverage to follow its requirements.

So now see what the chairman is saying:

The Financial Action Task Force (FATF) is concerned that the Islamic Republic of Iran’s lack of a comprehensive anti-money laundering / combating the financing of terrorism (AML/CFT) regime represents a significant vulnerability within the international financial system. FATF calls upon Iran to address on an urgent basis its AML/CFT deficiencies, including those identified in the 2006 International Monetary Fund Article IV Consultation Report for Iran. FATF members are advising their financial institutions to take the risk arising from the deficiencies in Iran’s AML/CFT regime into account for enhanced due diligence. FATF looks forward to engaging with Iran to address these deficiencies.

You know what this means? this means that most risk and compliance managers within any FATF country will now pull down the shutters on almost every transaction to do with any kind of exposure to any Iranian financial institution. And if you are frozen out of these 34 countries (and the observer countries along with the associate countries), you can effectively wave goodbye to any kind of international transactions.

Barter system, anybody? Who is going to hump the big barrels of oil?

Technorati Tags: Anti Money Laundering , Central Banks , Regulation , Iran , terrorism , counter-terrorism , financial Institutions

Managing VaR at a time of liquidity and volatility problems

Value at Risk – the dangers within

The Bank of England warned earlier this year about the propensity of banks to rely on Value at Risk (VaR) models to manage and guide them on risks. We have been here before, for example during the 1990’s Russian Crisis. Almost exactly the same thing happened, at least on the market side. The was a liquidity crunch as everybody rushed to the exit at the same time.

When everybody rushes to the exit at the same time, one side of the bargain (the buy bit) disappears, and therefore the price formation process is seriously out of whack. When that happens, even small movements in price can and do influence volatility and correlations disproportionately.

Now usually, you are ok to measure your VaR at daily intervals and you don’t update your correlation matrices more than weekly (if you are extremely particular, generally, you can go for 3 months without needing to change, market micro-structures do not change that fast). But as we know, markets have fat tails. Extreme events happen at a far greater frequency than what your normal distribution will suggest.

Consequently, what your VaR numbers will be telling you will not be an accurate reflection of the actual situation. In other words, these numbers tell you the risk that you are carrying. But if you decide to act on that risk number, you will find that the market does not support the consequent decision because there is simply nobody out there to offload your risk to. If nobody wants to purchase your debt or paper, then what are you going to do? You simply suck it up. Or you pray to the great gods of the central banks to provide you with some liquidity.

There is another problem and I quote from the FT article:

In the current environment, no bank chief executive who hopes to hang on to that job can afford to give regulators or shareholders the impression that they are being cavalier about risk. And since VAR is often used to define what level of margins – or financial buffers – are set against trades, some banks are doubly keen to cut VAR, to reduce pressure on their own balance sheets.

But as the banks embark on this task, some are finding themselves caught in an unpleasant trap. The easiest way to reduce a risk exposure is to sell risky assets, such as risky loans. In recent weeks, many banks have been trying to do precisely that.

But these sales have been occurring on such a large scale that they have pushed up market volatility. Thus, measured VAR has risen, exactly as the Bank warned all those months ago.

One big investment bank has recently analysed the impact of its own recent asset sales. These suggest that while these sales should have cut VAR by half in recent weeks on constant volatility levels, in practice this gain was more than wiped out by ensuring market price swings.

By scurrying to reduce risk, in other words, the banks may end up simply running to stand still.

The only way to resolve this is by having stringent stress testing or scenario analysis running. But very few banks that I know of have management trip wires or even have management who take action based upon these stress scenario’s. But all I can predict at this moment is that we will again have this issue. See my previous post on Carnegie as an example.

All this to be taken with a grain of piquant salt!!!

The Old Lady of Threadneedle Street is losing her marbles

The Old Lady of Threadneedle Street, the venerable Central Bank of England, the Bank of England, announced today that it is going to bail out Northern Rock, a big building society in England (a morgage lender), who apparently got into trouble as it could not fund its liabilities.

So all this high faluting lecturing about the fact that the current situation was all just a mispricing of risk, central banks shouldnt bail out bad lenders and this creates moral hazard was just bunk then? Here's what the Independent says and I quote

His letter to the chairman of the Commons Treasury Committee was as lucid an explanation and analysis of the crisis that has engulfed the banking system over the past two months as you are likely to see, but that doesn't necessarily mean his conclusion – which loosely translated into plain English reads, "Sod off, you are not getting a penny" – is the right one.

What happened 2 days afterwards? the Old Lady is busy shovelling out money just to save this mortgage lender who had some very risk investments. And dont give me that guff about markets not lending each other. What rot, they are lending each other but only to people who have managed their risk. Not to risky people.

And if others are refusing to lend to Northern Rock, why is the Old Lady taking MY tax money and giving it to these bad risk managers?

Central Bank's reputations rely on a firm hand on the tiller. The Old Lady, after a series of major incompetent issues, such as the BCCI case, has managed to recover and has established a reputation of good sound macro-economic management. Now look at it, I think the chaps inside there are a bunch of blithering idiots.

Actually, I have a very good idea that this was political pressure, and if that was indeed the case, then they are even more contemptible.

All this to be taken with a grain of piquant salt!!!