Streetwise Professor

December 22, 2010

What Could Possibly Go Wrong?

Filed under: Clearing,Economics,Exchanges,Financial crisis,Politics — The Professor @ 1:21 pm

The Basel Committee on Banking Regulation has rolled out Grandson of Basel I, its response to the financial crisis.  One thing that interests me is Basel III’s treatment of exposures to central counterparties.  In two words: very generously:

To address the systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets, the Committee is supporting the efforts of the Committee on Payments and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) to establish strong standards for financial market infrastructures, including central counterparties. The capitalisation of bank exposures to central counterparties (CCPs) will be based in part on the compliance of the CCP with such standards, and will be finalised after a consultative process in 2011. A bank’s collateral and mark-to-market exposures to CCPs meeting these enhanced principles will be subject to a low risk weight, proposed at 2%; and default fund exposures to CCPs will be subject to risk-sensitive capital requirements. These criteria, together with strengthened capital requirements for bilateral OTC derivative exposures, will create strong incentives for banks to move exposures to such CCPs.

Two percent of eight percent is a little more than nothing.  It means a financial institution must hold 16 cents in capital against $100 in exposure to a CCP.

This is actually higher than the current system.  Under Federal Reserve rules, for instance, exposures to CCPs receive a zero risk weight.

This move by the Basel Committee is of a piece with legislative and regulatory efforts around the globe to drive derivatives from bilateral arrangements to cleared ones, under the belief that the former are inherently more systemically risky than the latter.  But the danger is thinking about one risk being inherently greater than another.  Indeed, it is this very kind of categorical thinking that has made previous Basel rules the incubators of crisis.

In earlier incarnations of Basel, government debt was considered very safe–so no risk weight.  Mortgage debt was considered very safe–so a relatively small risk weight.  Agency debt was considered inherently safe relative to corporate debt–so again, a small risk weight relative to the 100 percent applied to corporate debt. Ditto interbank exposures.

Thus, in an effort to make banks “safe”, the Basel rules incentivized banks to invest in government debt, mortgages and better yet, AAA mortgage CDOs, and agency debt, and to engage in massive interbank lending.  And what happened?  These supposedly categorically safe instruments were the sources of the ongoing systemic turmoil.

Now, the Gnomes of Basel are telling the world that cleared derivatives are categorically, inherently safer than bilateral derivatives.  As a result, they are trying to structure the incentive system to drive derivatives onto CCPs.

Based on their track record: be afraid.  Be very afraid.

The problem with Basel generally is that its architects don’t seem to take into account the incentives their rules create.  Historically governments, agencies, mortgages, etc., have been relatively safe.  So give them a favorable treatment.  But this gives financial institutions subject to the rules and who also are driven by perverse incentives to add risk arising from government guarantees (implicit and explicit) the motivation to construct portfolios and design instruments and make lending decisions that are “safe” according to Basel, but which are in fact far riskier than the capital charges reflect.  Moreover, even if a particular category of investment is relatively safe by some measure, if everybody is given an incentive to hold it, when something goes wrong in that category the systemic effects of the problem are far worse than if institutions weren’t facing a common incentive system that encouraged them to engage in correlated trades.

The same dynamic is going on with CCPs.  CCPs went through the recent crisis relatively unscathed.  So Basel is relying on that historical fact to justify the expansion of CCPs, and is implementing incentives to encourage that growth.  But this means that the new CCPs will not be your grandfather’s CCPs.  They will be different–and far riskier.  The incentive system will encourage the shifting of more risk, and more exotic and difficult to measure and manage risks onto CCPs.

Thinking cynically (and believe me, it comes easily), given that it appears that banks have won major victories in the Basel process, I can readily imagine the following train of thought going through bankers’ heads.  Mandates in the US and EU are going to force greater use of clearing.  How can we make this work for us?  Well, if we essentially have to hold no capital against cleared derivatives exposures (yes, I know about margin, CCP capital requirements etc.), maybe the mandate won’t be so bad–and indeed, it might free up some capital and allow us to put on even bigger positions.

I am not alone in my skepticism about Basel III generally.  London Banker has it about right:

And yet, have you heard any regulator take responsibility for regulatory failures yet? I haven’t. In fact, I’ve seen no historic analysis of capital requirements, deregulation of credit markets, securitisation, derivatives, demutualisation, or any of the other regulatory policy innovations which should reasonably be matters for review in assessing the causes of the current crisis.

As the bankers and regulators do not seem keen to be reflective about their own policies and conduct, it’s hard to imagine that they can craft constructive reforms to make the system safer or more efficient in future.

I’ve downloaded the draft Basel Accord III, released this week, for leisure reading. Sadly, I’m trending to the view that all harmonised regulation is likely to end in disaster [welcome to the club!] as it precludes independent judgement and sensible challenge to orthodoxy. Once something has been agreed by a big enough committee, it becomes impossible to question whether it makes sense. Ultimately the unintended consequences of incentives and distortions mean it won’t make sense, but by then it’s far too late to change course and break from the herd.

I also agree pretty much with Falkenblog in his appraisal of the supposed innovation of Basel III–leverage limits, A/K/A non-risk based capital requirements:

The key is that drinker engage in moderation only when they realize hangovers are not worth any temporary high. Unless they believe that in their hearts, they will get around your regulations the same way college kids–who generally are below the 21 year old drinking age–tend to get around restrictions promoting their sobriety. Any top-down rule to prevent excess will simply waste time because you can hide the leverage at the other end, say be investing in assets that are leverage, or who have suppliers who implicitly leverage them (as in the dot-com bubble). Such rules might even make things worse by giving people a false sense of security if nothing bad happens for 10 years, as often is the case.

I used to be head of ‘economic risk capital allocations’ for a bank, and we had very low risk for mortgages. I left before the madness started, but I can see how it morphed because it would be easy for the business line managers pushing product to point to historical losses in mortgages and say they are basically riskless (eg, the Stiglitz and Orzag analysis). Now, some smart people (eg, Greg Lipmann, Andy Redleaf, Peter Schiff, among many others) saw the past data were not relevant once you start lending to people with no money down, or people with no documents, and that depending on collateral prices rising basically was a game of musical chairs. But within large organizations like banks and GSEs these people were demoted, as happened to David A. Andrukonis, the risk manager at Fannie Mae who was fired for getting in the way of Bill Syron’s $38MM windfall. A big idea that is plausible and has many beneficiaries is very hard to resist in real time, and such ideas don’t end via argument, but rather conspicuous failure.

So, define risk–not its correlates like leverage, but actual risk–first. Make sure it isn’t backward-looking, looking at the past couple of crises, but by say anticipating the next bubble in muni debt or education. Unless you can convince people that such risks are real, any leverage rule will be made irrelevant via the creativity of people designing contracts taking into account the letter of the law. That’s really hard, you might say, and we have to do something now. Doing something is not better, unless you are pandering to the mob is a primary objective. If risk management were merely following some simple asset-to-liabilities test, someone would have figured that out by now.

I particularly like the part that says: “Make sure it isn’t backward-looking, looking at the past couple of crises, but by say anticipating the next bubble in muni debt or education.”  That echoes my concern about the CCP exposure weights, which seem to be symptomatic of more of the same, backward-looking, last crisis thinking, rather than looking forward and trying to anticipate how these rules, in combination with clearing mandates, will change the magnitudes of risks and where they reside.  Incentivizing the offloading of risk to CCPs increases the likelihood that they will be the source of the next crisis.

I’d also note that the whole reason for moving to risk-based capital requirements, imperfect as they are, is that simple asset-to-liabilities rules (which is what the leverage ratio is) didn’t price risk at the margin, and hence encouraged excessive risk taking.

It is particularly curious that Tyler Cowen, a (perhaps lukewarm) supporter of leverage limits, and to whom Falkenblog was responding, didn’t heed the recent post of his fellow Marginal Revolution co-blogger Alex Tabbarok, who emphasized the importance of understanding the relevant decision margin:

Lesson two of economics is think on the margin. Lesson nineteen, which we don’t always get to in Econ 101, is to remember that there are many margins.

Basel in all its generations has always mispriced risks at the margin, and the vaunted leverage ratio doesn’t price risk on any margin.  So I’m sure that will work out swell.

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  1. “The problem with Basel generally is that its architects don’t seem to take into account the incentives their rules create. Historically governments, agencies, mortgages, etc., have been relatively safe. So give them a favorable treatment. But this gives financial institutions subject to the rules and who also are driven by perverse incentives to add risk arising from government guarantees (implicit and explicit) the motivation to construct portfolios and design instruments and make lending decisions that are “safe” according to Basel, but which are in fact far riskier than the capital charges reflect.”

    Hell, the only reason government debt is rated where it is (and thus considered “safe”) is because governments don’t follow accounting standards to which private businesses are held. If the U.S. government compiled its books following GAAP, do you really think U.S. treasuries would still be AAA rated? The “architects” give themselves one set of rules for their own political considerations and the rest of the great unwashed masses a different set of rules. The “favorable treatment” of the business of government is a lie foisted upon the people backed by the supposed ability of governments to raise taxes to service the nation’s debt.

    The problem with banking regulation is that it all too often imposes political solutions on economic problems. To get governments to agree how to regulate the banks, political compromises are made. When that happens, it is inevitably just a matter of time that we privatize the gains before we socialize the losses (yet again). In other words, does anyone really think Basel III will change the way things are done in banking?

    Comment by Charles — December 22, 2010 @ 2:47 pm

  2. […] This post was mentioned on Twitter by BertromavichEdenburg, John Kiff. John Kiff said: Streetwise Professor: Basel III’s treatment of exposures to central counterparties seems very generous […]

    Pingback by Tweets that mention Streetwise Professor » What Could Possibly Go Wrong? -- — December 23, 2010 @ 4:38 am

  3. […] regulators cannot possible foresee all the permutations of a dynamic market. Streetwise Professor talks about Basel III here-and it has ramifications for what the CFTC and Dodd-Frank are attempting to do in the […]

    Pingback by CFTC, Centralized Clearing Houses and the OTC Market Points and Figures — December 23, 2010 @ 9:44 am

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