Friday, September 19, 2008

More on financial regulation

From David Brooks:
We gotta have smart regulation that offers security but doesn’t stifle innovation. We gotta have rules that inhibit reckless gambling without squelching sensible risk-taking. We should limit excesses during booms and head off liquidations when things go bad.

It all sounds great (like buying a house with no money down), but do you mind if I do a little due diligence?

In the first place, the idea that our problems stem from light regulation and could be solved by more regulation doesn’t fit all the facts. The current financial crisis is centered around highly regulated investment banks, while lightly regulated hedge funds are not doing so badly. Two of the biggest miscreants were Fannie Mae and Freddie Mac, which, in theory, “were probably the world’s most heavily supervised financial institutions,” according to Jonathan Kay of The Financial Times. ...

We don’t even have a clear explanation about the past, yet we’re also going to need regulators who understand the present and can diagnose the future.

We’re going to need regulators who can anticipate what the next Wall Street business model is going to look like, and how the next crisis will be different than the current one. We’re going to need squads of low-paid regulators who can stay ahead of the highly paid bankers, auditors and analysts who pace this industry (and who themselves failed to anticipate this turmoil).

We’re apparently going to need an all-powerful Super-Fed than can manage inflation, unemployment, bubbles and maybe hurricanes — all at the same time! We’re going to need regulators who write regulations that control risky behavior rather than just channeling it off into dark corners, and who understand what’s happening in bank trading rooms even if the C.E.O.’s themselves are oblivious.

My thoughts are here and here. Some of these thoughts are that the reason a lot of derivatives come about is to evade regulation on capital.

Update: MR links to an old post that confirms this.
Pundits continue to link the Enron debacle to a need for increased regulation, especially of derivatives. What most of these people...don't appreciate is that regulation and/or accounting rules are the most fertile breeding ground for derivatives and synthetic or packaged securities. Regulations and accounting rule-inspired transactions describe the bulk of the well known derivative-related blow-ups of the last two decades. Proscriptive regulation and the derivative trade have a symbiotic relationship.

Investors and operating companies buy derivatives for two basic purposes: speculation and risk transfer. A derivative, (a financial contract based on the price of another commodity, security, contract or index) either eliminates an exposure, creates an exposure, or substitutes exposures. That last one, substituting exposures, is important to heavily regulated investors.

For example, insurance companies were a goldmine for derivatives salespeople in the last two decades, only slowing down in the late 1990s. The fundamental reason for this is not because insurance executives were stupid, but because they manage their investments in a thicket of proscriptive regulation. Insurance companies have to respond to their national regulatory organization (the NAIC), their home state insurance department and the insurance departments of states in which they sell or write business. They file enormous statutory reports every quarter using special regulatory pricing, and calculate complex risk-based capital reports and "IRIS" ratios regularly. ...

A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing - they decrease frequency of loss but increase the severity. So they blow up infrequently, but when they do it's often a big mess. Ratings-packaged instruments are less risky than the pool of securities they represent but often riskier and less liquid than the investment grade securities for which they are being substituted. As a result, they pay a yield or return premium (even net of high investment banking fees). That premium may or may not be enough to pay for their risk. But they pass the all-important credit rating process and are therefore sometimes the only choice for ratings-restricted portfolios reaching for yield.

...[Frank] Partnoy is a former derivatives salesperson, and he clearly suggests that regulation is often the derivative salesman's best friend. Complicated rules encourage complex transactions that seek to conceal or re-shape their true nature. Regulated entities create demand for complex derivatives that substitute proscribed risks for admitted risks. If a new risk is identified and prohibited, the market starts inventing instruments that get around it. There is no end to this process. Regulators have always had this perversely symbiotic relationship with Wall Street. And the same can be said for the ridiculously complicated federal taxation rules and increasingly byzantine Financial Accounting Standards, both of which have inspired massive derivative activity as the engineers find their way around the code maze.

Jim Hamilton disagrees:
And I agree with the Financial Stability Forum that the key changes we need to make to avoid such problems are more transparency in accounting and stronger capital requirements. Transparency is vital so that that creditors, shareholders, fund investors, and regulators can better perceive the risks to which they are exposed. Stronger capital requirements are necessary to ensure that the principal actors are risking their own capital and not just somebody else's.

But here is Rogue Economist:
Building on a previous post I had on Basel capital adequacy standards, I’d like to add that this well-intentioned set of international standards also contributed indirectly to the current mess. Basel standards recommends banks to have at least a 10% capital-to-risky assets ratio. That means, a bank needs to have at least 10% as much in capital as the amount of risky assets it invests in. By risky assets, we mean all bank lending and investments in risk-weighted assets. By capital, we mean equity capital, and in no way includes funds coming from bank deposits or bank borrowings. Generally, the riskier an investment is, the more risk-weight it is given by Basel. A credit-grade mortgage loan will be given 50% risk weight, while a credit-grade regular consumer or corporate loan will be risk-weighted at 10%. Only investments in relatively risk-free government securities are given zero risk weight. That means, the more a bank allocates its funds to risk-weighted loans, the more it needs to have in equity capital. The more loans in a bank’s books, the higher its equity capital needs to be to maintain a capital ratio deemed adequate by Basel standards. But raising bank equity does not happen in a vacuum. Just because a bank has sufficiently high deposits to loan out doesn’t mean shareholders will be flocking to provide it with new capital. To attract these investors, the bank would have to provide a comparable return to other investment alternatives. But to maintain the capital adequacy, the bank would have to redeploy this equity capital in low risk weight assets. Government securities have zero risk weight, but in the environment of low Fed funds rate, the liquidity that resulted ensured that government securities provided meagre yield. Certainly not enough to increase bank earnings sufficient to attract new equity holders. So a good number of banks and insurance firms chose to put these funds into the asset class available at the time that had the next to lowest risk weight , AAA-rated CDO bonds. Of course, the fact that these toxic CDOs made up of sub-prime loans were ever rated AAA by ratings agencies has already been widely discussed in public forums. But the fact is, banks and insurance firms, compelled by international best standards to maintain adequate equity cover, for loans in the case of banks, or for cover liabilities in the case of insurance firms, but also compelled by equity holders to provide the highest possible yield at reasonable risk, investing in AAA-rated CDOs seemed like a reasonable thing to do. Granted, much more due diligence should have been done on the underlying assets backing up these securities, but then, the presence of a rating meant that reasonable due diligence had already been done by experts on these matters.

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