Tuesday, April 20, 2010

On leverage

Here I go with another frivolous post on financial regulation again, even after cautioning myself to back previously. One of the hardest things for regulators after looking through all the policy proposals is the details of implementation.

In the case of leverage, how much restriction is enough? This is highlighted in a comment to Rajiv Sethi's very interesting discussion on naked CDS:

It is very easy to speculate. There are ETF's all packaged up with leverage of 300% to achieve my objectives. And this stuff is listed on the NYSE!!! You can trade it like water. There are no restrictions. Believe it or not this is LEGAL!!!There is no ETF for Greek bonds. If there were I would trade that. But there is not. So what is a poor bastard like me to do with my illegal ambitions to make a buck? CDS.Can you please tell me the difference between the exchange traded short bond ETFs and CDS? Is it more leveraged? Is that what you don't like about it? What is the difference? Is 200% leverage a good thing and 400% leverage a bad thing? Who are you to make this distinction? Why do you get to set the limits on the bets that I can make?

The commenter continues:

The ability to short something is the essence of an efficient market.

I agree but with reservations outlined in Sethi's post. In particular, the only way that hedge funds were able to short the housing bubble was through the CDS market (at least according to my reading of And Then The Roof Caved In. What I was concerned with then was the fact that it appeared that the shorts were able to to take this position without the (apparent) transparency of an open-exchange. What I mean is this: If I go long on a stock and someone else goes short I would like to observe the prices of the puts on the stock to see how great the pressure is.

There is a difference between a stock and and CDS of course and Rajiv explains:

... such contracts allow pessimists to leverage (much more so than they could if they were to short bonds instead). The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation.

In the comment he further elaborates:

A firm can live with a fall in stock price that is driven by purchases of naked puts as long as it's cost of borrowing is not much affected.

The post is about Greece but I think that some of it applies to the financial crisis as well. So the empirical question seems to be: How much leverage (which could potentially be time-varying) is too much before cost of borrowing is affected? And how does market liquidity and transparency play into all of this?

Some back of the envelope calculations in an earlier post indicate that capital requirements equivalent to a 25 percent tax on bank profits may not be too far off. Another possibility would be to increase capital requirements as banks take on more leverage but I am pessimistic because these are hard to monitor and enforce as banks try to keep the leverage "off the books". A change in accouting rules may be required - entities that banks have a stake in e.g. SIVs and SPVs even though they are less than 50 percent owned by the bank have to be "on the books". How much less? Again, the devil is in the details but my feeling is that it may be as low as the 10-15 percent range.

From The NYRB:

The Geneva economists propose a deceptively simple mechanism for linking capital requirements to the changing risks that major financial institutions pose to the entire banking system. They would multiply current or improved capital requirements—the Bank for International Settlements is now considering such a revamped set of requirements—by a series of factors, one based on how fast a bank’s assets and leverage grow; a second geared to the extent to which a bank’s assets are financed by shorter-term borrowing that might dry up in a crisis; and possibly a third based on the degree to which a bank’s bonus and other compensation schemes encourage excessive risk-taking. ...

The Geneva plan would apply to all financial institutions—commercial banks and bank holding companies, investment banks, insurance companies, and hedge funds—whose health might have a significant impact on the entire financial system. And the new capital requirements would take account of the companies’ affiliates and their liabilities, even if these obligations don’t appear explicitly on their balance sheets. The plan is comprehensive, straightforward, and clear—great virtues, especially in the world of opaque bank regulations. But how effective such a system would be will depend on how well the proposed new multiples are chosen. (emphasis added)

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