Friday, April 04, 2008

Regulatory Capital Recommedation

As a former head of capital allocations at a regional bank, I have some ideas to address the issue of regulating complex financial institutions below. They won't prevent crises from happening, but they are good ideas nonetheless. The basic idea emphasizes disclosure: more accountability for the rating agencies via external monitoring of their ratings performance, more detail on the net positions of investment banks, and finally, a Fed overview that publishes specific deficiencies of an institution's due diligence of their many product lines.

The problem with capital requirements, as opposed to disclosure, is adverse selection and exit. Details matter, so any top-down view invariably will invite adverse selection to the extent details are not specified, such as saying you need 2% capital for all swaps notional amounts. Great, then only swaps where the risk capital insiders feel necessary (economic) is greater than that will be on those books, and firms will contract overseas for the others.

The complexity is insane. At Key, we had 5 major lines of business, such as consumer, corporate, and capital markets. Then 23 primary lines of business, such as within community banking: small business, retail community, commercial banking, and the ubiquitous 'other'. Finally, you have over 100 secondary lines of business. Within, say, commercial banking, you have: upper middle market, community middle market, large corporate, business owner services, and other.

Within each of the 100 secondary lines of business, you have different product types, such as loans, and lines (undrawn loans that are available). Loans, are evaluated differently depending on obligor, so that a bucketing of commercial loans are based on financial statements, consumer loans on FICO scores, and small business on a combination. Within consumer loans, say, some credits look at collateral values (eg, leasing, residential mortgages, equity) and some don't (say credit card). Some look at the vintage of the loans (consumer loans), some don't (commercial). Within lines, there are even different types, that, frankly, I forget the distinction off the top of my head: financial, commercial, and performance lines of credit (but they have real differences in risk!). There are different risk factors applied to each matrix element (line of business/product type/credit score/credit vintage/etc.) based on estimates of loss rates and recovery rates for those types, and a sense of their prospective volatility.

Then there is the high profile capital markets group, which highlights the fact that there are strong forces within every large organization to misdirect even internal management, making the problem even more complex. These groups engage in what I call 'alpha deception', basically, they have a big incentive to inflate their value and present themselves as speculators as opposed to middle men, because that's the only way to justify getting paid >$250k per year to be a clerk, so many people who are just making markets are looking at screens with bids and asks, and then buying at the bid, selling at the ask. I remember a trading head who got very mad at me when I reported his value-at-risk to my boss without telling him--it was too low! It basically said, this group is a bunch of intermediators, not speculators, and middle men don't wear fancy red suspenders and drive porsches.

Now, they need flexibility to do this efficiently--e.g., sometimes you offset an over the counter swap with a series of eurodollar futures contracts--and so they do, occasionally take market risk. The complexity of this task means any manager two level up has really no clue how money is made. For example, we had this swap trader, and he knew how to hedge and price swaps via the eurodollar and large swap market, so a little $10MM loan to Bob's Bakery, at a fixed rate, could be swapped into a fixed rate via this method. With billions of dollars in loans, you just call the CFOs for all your customers, ask them if they think interest rates are falling. If he says yes, then tell him to swap into a floating rate loan fast, so his liability does not increase in value. If he says no, he thinks they are going up, ask if he has any floating rate debt he wants swapped into fixed rate. If he thinks markets are efficient, well, he is unusual.

Now this swap trader made a lot of money when he came, because lots of people wanted to swap from fixed to floating or vice versa, and we simply made money on the spread when we did the swap (e.g., if the market rate was 5.4%, we charged him 5.70%--the price not being obvious to someone who does not monitor eurodollar synthetic forward rates composed of futures and swaps). After his second year, as he made the most money, personally, in the whole bank, he met with the CEO. The CEO had no clue how he was making so much money, and the trader basically implied he made it via 'arbitrage'. But the arbitrage necessitated flow, retail customers, it was not arbitrage, in the sense that a price taking could do it, but that was the impression he gave to the CEO. If he told the truth, that he made X millions off, basically, the franchise value doing something any one of a thousand other people could do, the CEO would obviously see he was being overpaid.

I've mentioned this issue before, but it's important, because I would guess many people think banks and Ibanks make money off savvy directional bets, when this is generally not true and gives a very skewed picture of the nature of bank's risk. I remember reading Marcia Stigum's 900 page Money Markets book, and she noted that one year, a bank made $400MM on an interest rate bet, and noted this with a kind of awe, as if that's the real place banks make money. Bankers are no better than forecasting interest rates than your neighbor, or economists, and most don't bother with that any more. So there's all this misinformation within financial firms about the true nature of risks that makes collecting the really relevant information difficult. But basically capital markets in financial institutions make their money off of flows, customers, not speculating--they intermediate. Thus, the Value-at-Risk for any large organization is generally insignificant (yet still must be monitored to prevent a SocGen type fiasco), because these are driven off sensitivities to indices like the S&P, Tbonds, currencies, even volatility (e.g., the VIX), whereas most banks have merely incidental exposures. Further, the credit risk of their derivatives is generally minuscule due to margining, because for anyone with a rating less than A, they will have to post margin as their derivatives position craters. As a focus of Basel III the VAR of the trading desk is a red herring, but alluring because they are very amenable to a top down approach (just calculate the VAR), as opposed to the bucketing approach applied to the n-dimensional matrix outlined above, where the risk is not so much the final tally, but the identification and description of the weakest links. The real risk for trading operations is the naked, pure bet these guys were leveraging: who knew Bear was levering up on AAA subprime res mortgage paper?

Now, for Bear, one should have had a sense that if residential mortgage CDOs fall 50%, you still have 3x the capital to withstand that loss in market value. But wait, many of these things were rated AAA, and because one's time is limited, and historically AAA paper has had 0.02% annual default rates, one does not do full analysis of this stuff, and a 50% loss rate on AAA paper is unprecedented. If you demand that all your capital requirements cover unprecedented loss rates (e.g., 10 times greatest ever loss rate for that 'kind' of risk), then everything shuts down; it is impractical.

1) Hold the rating agencies more accountable. The AAA paper in this economy is, historically, of very low risk, yet is large in outstanding amounts. AAA stuff is like Treasuries, it acts as cash, and so in that sense is like the money supply. When they screw up on this stuff, it hurts the system. A AAA bond going default, from a bayesian perspective, was wrong (e.g., if something with a 0.02% annual default rate defaults, it is more likely the default assessment was wrong). The rating agencies should be required to post information on their performance, such as by providing to the government all their outstanding ratings, and the performance (e.g., default rates). Currently, the just do this on their own accord, selectively, without any objective oversight, so that, they commonly exclude munis and structure securities--how convenient. It's a small price to pay for their little quasi-monopoly.

2) Have the Fed examine internal risk management systems, and then let them publish their thoughts on the system, and outstanding disagreements and uncertainties. If you can't validate your assumption on the loss rates for RVs, or indirect leases, it will be put out there, and then the CFO will have to do damage control, and either curtail the business or answer the question, or, if the market does not care, do nothing. But then this would take many hundreds if not thousands of trained risk managers working for the government, asking pertinent questions, in an expeditious and fair manner. I will say the Fed does hire better than average people, but then again, I never saw them dig down to the level of an internal person doing capital allocations, so maybe at some point the hamster on the treadmill in their head would stop.

3) Investment banks, as well as banks, to the extent they are net long or short assets, like CDOs of AAA rated residential mortgages, should give an explicit accounting of these assets: rating, specific type (e.g., for structured notes, the more the better). If Bear had to say they were long $10B of AAA subprime mortgage CDOs, we should know it. Banks are levered institutions with opaque balance sheets. To the extent they are warehousing assets, it should be merely highly illiquid ones, because if they want to lever up on traded, risky, assets, they are doing a disservice to investors: they can get that cheaper via mutual funds. Most of a banks portfolio should be little bits left over as inventory for trading, securities for managing liquidity and making the risk-free rate (with a little curve risk, up to 3 years), and unrated stuff that doesn't trade, but therefore also cannot be hedged very well so it won't be levered much.

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