Moody's issued a special comment paper focusing on Basel II amendments already introduced, as well as statements from the Basel Committee on Banking Supervision (Risk.net). The paper highlights enhancements relating to a bank's trading book, securitization, and counterparty credit risk. In particular, the recommendations involve strengthening Tier I capital, introducing tougher liquidity standards, including counter-cyclical provisioning, discussing systemic risk provisions (which is becoming popular in the United States), and including leverage ratios as a supplementary measure. Moody's also believes that proposed Capital Requirement Directive changes to the quality of capital and securitization were also a positive step. In addition, the paper mentions that “One important amendment calls for stricter operational requirements for credit analysis for banks holding securitisation exposures. We believe that the increased requirement for credit analysis for banks holding securitised exposures is going to be an important element of improved risk management, and should ensure that only banks with the necessary information and analytical tools hold securitised products.” Of course, it could also mean that less securitization takes place. While this may be the intended result, the unintended consequence of reducing the efficient flow of capital, or not allowing those who want to off-load or bear risk access to the vehicles they need, will also need to be considered further - either now or later.
Now that the Obama Administration has released its proposed Financial Regulatory Reform: A New Foundation for updating the regulatory structure of the financial system (pdf file of reform, WSJ article), the public debate will begin in earnest regarding the details and proposals in the document. Ironically, while the public seems open to new financial regulation, the release of the document is coming at a time when some citizens are starting to worry about growing deficits and government intervention (see WSJ/NBC poll article), with almost seven in 10 people surveyed saying that they had concerns about federal interventions into the economy. Nonetheless, finding ways to limit risk and prevent another credit crisis through added regulation of banks and hedge funds still rings a populist tone, and is likely to continue to receive support.
Like many others, I feel that there are aspects of the new regulations that seem appropriate and make sense, with others that seem counterproductive. As for those that concern me, I agree with some who point out that it seems odd that the Fed is going to be given greater power (and responsibility) to fix some of the very problems it may have caused or contributed to (see Larry Kudlow article). I also worry that the new proposed Consumer Financial Protection Agency could end up just adding new and potentially unnecessary regulations and red-tape paperwork, along with producing counterproductive limits on rates and fees that will do less to protect individual consumers and more to reduce the availability of needed products that are offered to such individuals. Such restrictions, if not properly crafted, are likely to reduce the earnings of financial services companies, and even worse, limit their ability to effectively manage risk (through fee and rate changes).
The idea of requiring companies to retain 5% of all structured product offerings also has me concerned, even though this specific proposal seems to be generating some of the most support, at least initially. Recently I wrote that I have worries about forcing companies to retain a stake in each securitized product they develop since I believe it could actually make companies more risky (since they cannot off-load and manage all their risk, see previous post). Furthermore, while I agree that forcing companies to have some "skin-in-the-game" would make it less likely that they would offer risky products, it also makes it more likely, in my opinion, that they would offer less structured products. While this may be a desired outcome for some, the impact of this would be less liquidity and available credit at a time when the country can least afford it.
Another area that is generating support involves the idea of controlling systemic risk. I too believe that this is a good idea in theory, but am unclear exactly how this would be measured and acted upon. As recently reported in the WSJ (see article), one potential area to start with is leverage. As the chart below illustrates, financial sector borrowing increased steadily between 2004-2007, before dropping in 2008 as companies began unwinding leveraged positions. It is now well known that banks, hedge funds, and average citizens were carrying too much debt, thereby helping to increase systemic risk, and trigger the credit crunch.
Source: WSJ, Fed dataYale economist John Geanakoplos, who has studied leverage in the economy, believes that regulators need to gather daily data from all market participants and then publish aggregate data. The feeling is that if market participants knew that leverage values were getting to extreme levels, they would be more likely to begin backing-off their own debt and leverage levels in anticipation of eventual market corrections, or restrictions imposed by regulators. Focusing at least in part on debt and leverage seems to make sense.
Unfortunately, measuring system-wide daily leverage changes at banks and hedge funds may be difficult at best, and suspect at worst. Yet, maybe the focus does not need to be on the three person hedge funds that are investing $10-50 million in capital. Getting comprehensive data which includes smaller players may not be necessary. Risk manager Richard Bookstaber - whose book "A Demon of Our Own Design" is recommended reading - believes that focusing on just the largest financial firms and hedge funds would cover roughly 80% of the risk, allowing you to see systemic trends.
At this point it is unclear if such trending information on leverage levels would be enough. Other related areas that could also cause potential cascading effects, such as specific derivative use (i.e., CDS) and counter-party risk, should also be examine - although regulating that which has not yet been developed is obviously difficult. Nonetheless, looking for new ways to measure leverage might be a good place to start for spotting worrisome trends. Such a signal could allow investors, funds, and the Fed (or other regulator) to take action. Of course, what action they take is another area of debate, and potential new area of concern.
ETF Securities is launching an exchange for ETFs that includes a consortium of over 15 global banks and asset managers (see Hedge Fund Review article). The structure allows each exchange member to be able to participate in trading, market making, and index replication activities while allowing counterparty risk to be spread among multiple exchange members. By concentrating liquidity in a single location, ETFs that would normally be unavailable due to low demand and liquidity issues, can now be created and used for more specific purposes, such as hedge fund replication, without the same trading and credit worries. Certainly an interesting idea during a time when many are concerned about those on the other side of the transaction, especially when specialized, low liquidity securities are involved. This may be one way to help reduce both counterparty and liquidity risk for those researching and implementing hedge fund replication products.
As reported at the Financial Times, 60 percent of US and European institutional investors surveyed expect that another big financial firm will collapse within the next 6 months. Another 15 percent think it will happen in 6-12 months. Of interest is that 55 percent of those surveyed have also stopped using one or more financial institutions, other than Bear Stearns, as a counterparty on credit trades due to concerns regarding solvency. This has caused many to cut back their use of credit default swaps and other credit derivatives. US firms in particular were most worried, with 85 percent stating counterparty risk as a serious threat. It appears that many market participants are waiting for another shoe to drop, and at least one more washout and possible testing of the lows before the markets move higher.
As reported in Bloomberg and elsewhere, a group of 17 banks have come together to create a clearinghouse system to move credit default swap (CDS) trades and cover a failure by one of the market-makers. While the amount of potential CDS loss is closer to $2 trillion, and not the entire $62 trillion in notional value that often gets reported, the possible market exposure is still significant and should be addressed. Just a little over a week ago we discussed the CDS counterparty risk issue in an article that mentioned how regulators and the Fed were looking for ways to limit the exposure from a counterparty failing to meet its obligations.
Of concern is not so much the failure of one bank or counterparty, but the possible systematic risk that would be felt by the entire financial system. The new system will allow the market to trade against the central counterparty, mitigating the consequences of failure by a major institution. In addition to systematic risk, the system should also help prevent a Bear Stearns-type of failure since there will be less need to make a run on a specific institution.
Other benefits of the clearinghouse will be increased liquidity and transparency. Providing a clearinghouse will encourage more swap trading, and larger volume will allow for a more efficient market and more reliable mark-to-market process. This will make it easier for investors to have a better idea of the true exposure that a company is taking, allowing for a better valuation and more efficient stock price. Currently, it is difficult for companies to even know what their credit risk exposure is given that the CDS market is thin and delayed, not to mention opaque at best. The new center counterparty system is a good step towards helping to shine light on the CDS market by reducing credit risk, and allowing for more real-time price discovery.
As reported in Financial News and the WSJ, people are starting to talk more about the potential counterparty risk problems with the credit default swap (CDS) market. It often gets reported how large the CDS market has become, from $180 million more than 10 years ago, to over $62 trillion now. Of course, the $62 trillion in notional value is somewhat misleading given that the CDS market is a "closed system" or zero-sum game such that the losses of one party are offset by the gains of another. When looked at like normal insurance, and protection against specific assets, the cost to replace contracts and provide protection is being reported by the WSJ to be more like $2 trillion.
The real issue is the counterparty risk from an investment bank not meeting their obligations. Beyond affecting just one specific type of corporate debt, failure of an investment bank could affect the entire CDS market and the underlying securities (i.e., corporate bonds) upon which the swaps are valued. This effect was seen last March at the height of the credit crisis as Bear Stearns was being bailed out (sorry, purchased), causing CDS cost to rise. A similar increase in cost is now occurring with Lehman Brothers and Merrill Lynch. It is yet to be seen if this is a short-term blip. Nonetheless, you can expect that the Federal Reserve is keeping an eye on this market and be ready to take future action to protect the bond and equity markets, and potential international market contagion.
