Nonstandardized Derivatives and Complexity

I.   Simplicity and complexityJaffrey Woodriff-Quantitative Investment Management

The problem:  Regulatory complexity has become the goal of banks.

Banks and their lobbyists are slowing down and halting the regulation of equities markets through measures aimed to increase the complexity of the Dodd-Frank regime.  While Dodd-Frank was 848 pages long, its rule-makings alone will likely amount to 30,000 pages.  This has demonstrable impacts on economic growth.  A recent PriceWaterhouseCoopers study including interviews with dozens of CEOs of the world’s largest financial institutions found that “it is clear . . . that it is not simply regulatory change, but regulatory complexity and uncertainty that are really dampening confidence in growth.”

Big banks are largely responsible for this regulatory sclerosis.  Banks have succeeded in lobbying to exempt foreign interest rate swaps from clearing requirements.  Banks have exempted certain activities from Volcker Act prohibitions and have lifted Volcker restrictions during periods of severe market stress.  In 2012, banks convinced a federal judge to strike down Dodd-Frank’s position limits rule, which placed new restrictions on speculative trading in commodities.

Policy proposal:  Mandate simplicity.

Congress should adopt broad concepts and let prosecutors, courts, and the agencies work out the implications.  As Chester Spatt, former Chief Economist at the SEC, has stated in the Harvard Business Law Review: “[R]egulators often would do far better in accomplishing their regulatory goals by adapting relatively simple standards and principles that force market participants to internalize the consequences of their actions.”  A recent presentation by senior Bank of England officials before the Kansas City Federal Reserve also called for the “explicit regulation” of complexity.

One approach would be to adopt a pay-go approach in financial regulation—cutting one regulation or rule-making for every new one that’s added.  The futures market is far simpler than our equities markets.  A study commission could also be authorized to study how equities markets could be modeled after our futures markets.

 II.  Opacity and financial statements

The problem:  Financial statements do not include accurate measurements of risk.

A recent article in the Atlantic by Frank Partnoy and Jesse Eisinger exposed troubling problems in the statements of big banks that mask large levels of systemic risk from shareholders, the public at large, regulators, and policymakers.  The authors subjected to rigorous analysis recent disclosures and statements by WellsFargo, in part concentrating on the “fair value” of assets and liabilities recorded by WellsFargo.

Like other banks, Wells Fargo uses a three-level hierarchy to report the fair value of its securities.  Level 1 includes the reported price of securities, which are transparent and standard.  Level 2 includes derivatives and mortgage-backed securities, which have no active, public markets—so Wells Fargo uses “model-based valuation techniques, such as matrix pricing” to determine fair value, including “observable” inputs such as the prices of similar assets.  This provides only an estimate of fair value.

Level 3 contains the most esoteric financial instruments, such as the credit-default swaps and synthetic collateralized debt obligations that helped cause the 2007 financial crisis. WellsFargo’s Level 3 estimates are “generated primarily from model-based techniques that use significant assumptions not observable in the market.”  “Fair value” at Level 3 is based on no objective data at all.  

Only a small fraction of Wells Fargo’s assets are on Level 1.  Most are on Level 2. And over a third of the capital reserves—$53 billion—are on Level 3.  Scholarly research suggests Level 3 asset valuations can be off by as much as 15%.  This would equate to billions of dollars in misstatements for WellsFargo.  For example, WellsFargo’s statement reports that $8.1 billion fair value of its Level 3 assets are worth exactly the price it paid for them—their “cost basis”).   This seems suspect at best.   The bank is simply using its own internally generated estimates to determine fair value.

Policy proposal:  Standardized “fair value” measurements and full disclosure.

Congress should mandate that the SEC require banks to define “fair value” according to transparent, standardized methodologies that afford investors, regulators, and the public maximum information about levels of risk.  Straightforward standards of disclosure should be enforced.  Different asset classes should be subjected to the same accounting standards.

 III.  “Special-purpose entities”

 The Problem:  Variable Interest Entities are transferring obligations off-balance-sheet.

The Special Purpose Entities Enron used to hide its debts  have now been renamed variable-interest entities (VIEs).  According to Don Young, a former board member of the Financial Accounting Standards Board, these are “Accounting gimmicks to avoid consolidation and disclosure.”  The purported benefit of VIEs is to help a company to transfer the risk associated with financing assets away from shareholders and onto other investors. VIEs are set up to buy a bank’s assets, which improves banks’ balance sheet, because banks use the sale proceeds to pay down liabilities.

Often the VIEs are off-balance-sheet, yet the bank’s obligations remain.  This in effect renders the VIE a hidden loan (therefore hiding risk) from shareholders, the public, and regulators.  Leading up to the financial crisis, Citigroup, for instance, held $292 billion in variable interest entities that did not appear as liabilities on its balance sheet.  In 2007, Citi was forced to buy back $25 billion worth of commercial paper through VIEs at face value, even though the paper was trading at about 33 cents on the dollar, which cost Citi (and its shareholders) $14 billion.

 Policy proposal:  Require greater transparency and honest accounting.

Companies should be required to provide a detailed written disclosure as part of their annual reports of all off-balance sheet activities as well as justify any failure to put these activities on balance sheet.  They should have to disclose in their quarterly and annual reports the daily average leverage ratios and daily average liabilities, which would resolve opacity created by the present requirement that firms only show liabilities and assets as of quarter end and year-end.  Finally, as Frank Partnoy and Lynn Turner argued in the Roosevelt Institute’s Make Markets Be Markets report, firms should be required to disclose information on transactions that were accounted for as sales by the issuer, but have implications for future liquidity.

IV.  Capital requirements for banks

The Problem:  Banks are still over-leveraged.

Banks engage in proprietary trading with too much leverage.  To address this problem, in June 2012, the Fed adopted the Basel III standards by a 7-0 vote, requiring banks to maintain a 7 percent capital cushion relative to the value of their total assets — up from standards that ran as low as 2 percent.   Ben Bernanke explained: “With these proposed revisions to our capital rules, banking organizations’ capital requirements should better reflect their risk profiles, improving the resilience of the U.S. banking system in times of stress, thus contributing to the overall health of the U.S. economy.”

But the rule was delayed in November.  A joint statement from the Fed, the FDIC, and the Office of the Comptroller of the Currency cited “concern” from industry participants about “sufficient time to understand the rule or make necessary systems changes.”

 Policy proposal:  Require more capital.

Stricter requirements would “properly align incentives for megabanks by lessening government support for the financial sector, and reassure financial markets that the U.S. financial system is healthy.”  In October 2012, for instance, Senators David Vitter and Sherrod Brown urged the Fed, the FDIC, and the Comptroller of the Currency to “simplify and enhance the capital rules that will apply to U.S. banks.”   Congress should require these agencies to act and not accept stonewalling and delays from the financial community. 

V.  Glass-Steagall/Volcker Rule

The Problem:  Complexity is undermining the prospects of the Volcker Rule coming into effect.

The banks’ lobbyists have succeeded in slowing down the restoration of the ban on proprietary trading through complex conditions.  One of many examples of such complexity is the distinction between market making and proprietary trading, which the rule untenably tries to discover through the intent of a trade, based on certain quantitative metrics and historical comparisons.

As the International Centre for Financial Regulation explained in a comment letter to the SEC, “The lack of clarity in the aims of the rule is made worse by the level of complexity which is the inevitable result of trying to craft a rule which contains a large number of exemptions.”

Policy proposal:  Pass a simple, clear Volcker Rule.

Congress should pass a far simpler Volcker Rule, e.g.: “Banks are not permitted to engage in proprietary trading.”  The courts and regulators should then interpret the Rule for Congressional intent.  Among others, Senator Elizabeth Warren has supported this approach, calling for “another look at Glass-Steagall, separating the commercial banking activities from the investment activities.”

 VII.  Enforcement

The Problem:  Enforcement has been lackluster and haphazard.

Under the outgoing enforcement chief, Robert Khuzami, the SEC has had only small successes in prosecuting malfeasance, such as Raj Rajaratnam and Rajat Gupta.  The SEC appears to have taken a policy of suing on only one collateralized debt obligation (CDO) per major firm, and then settling.  At DOJ, Lanny Breuer defended the decision not to prosecute HSBC: “Our goal is not to bring HSBC down.  It’s not to cause a systemic effect on the economy.”

The New York Times has harshly criticized the SEC and DOJ for a lack of “creative thinking on the part of federal prosecutors about the web of federal statutes that could be brought to bear on potential cases” and has noted the “institutional determination that it could not win against big banks and top bankers. “  Worse, the statute of limitations—five years for securities fraud and most other federal offenses—is running out, as the financial crisis occurred in 2007.

Policy proposal:  An aggressive, creative approach to prosecutions.

A new approach to prosecutions is needed within the SEC and the DOJ.  More aggressive prosecutors who do not have a prior relationship with the big banks should be hired.  A resourceful, creative approach using every statutory tool available for prosecution of past illegal acts and the prevention of future moral hazard should be employed.  Finally, additional resources should be provided to FBI, Department of Justice, and SEC to investigate and prosecute wrongdoing, as in Rep. Marcy Kaptur’s HB 131, Financial Crisis Criminal Investigation Act, which has been referred to committee.

 VIII.  Breaking Up the Banks

The Problem:  Too Big to Fail.

Banks have become “Too Big to Fail” and are only growing more so.  The current regime of “universal banks” creates high levels of systemic risk because of banks’ dependence on subsidies, their leverage, and their simultaneous creation of, and exposure to, macro risk.  According to Arnold Kling of the Cato Institute, our “big banks are the product, not of economics, but of politics.”  And we are evolving toward “outright corporatism.”

Sanford Weill, the former CEO of Citibank, has called for breaking up the banks:   “What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk the taxpayer dollars.”  This is a striking reversal given that Weil built Citigroup after the repeal of Glass-Steagall.  Other prominent policymakers have also called for breaking up the banks, such as Paul Volcker, Thomas Hoenig, former President of the Kansas City Fed; Sheila Bair, former FDIC Chair, and Richard Fisher, President and CEO of the Federal Reserve Bank of Dallas.

Policy proposal:  Reduce Banks’ Size

A common-sense but politically challenging proposal is to force any bank over a certain percentage of GDP to break into smaller unaffiliated entities, as required by Senator Sherrod Brown’s SAFE Bill.

Setting aside an express Congressional mandate, there are more creative ways to reduce the size of the banks.  Sheila Bair, former FDIC Chair, has also argued that regulators have the authority under Dodd-Frank’s “living wills” provision to require systemically important financial institutions to restructure “if they cannot show that their nonbank operations can be resolved in bankruptcy without systemic disruptions.” According to Bair, megabank operations should be “simplified and subsidiarized” into “discrete, separately managed legal entities” based on business lines.

Former SEC Commissioner Roberta Karmel also has suggested that each of the major banking groups be split into a “narrow bank,” consisting of an institution that could accept deposits and make loans.  Under SEC supervision, each narrow bank would then spin off its risky businesses that potentially threaten its deposit insurance.   The spinoff could be tax-free, with new shares of the spinoff going to the stockholders, thus separating the narrow bank from its former non-commercial banking activities.

22 thoughts on “Nonstandardized Derivatives and Complexity

  1. “The problem: Regulatory complexity has become the goal of banks.” – Replace “banks” with any other crony-centric industry (After all, the seasonal windfall for the tax preparation industry is around the corner) and your statement has near universal application. Good stuff bro. Keep fighting the good fight.

  2. If banks were smaller, all of the rest would be a smaller concern. It’s the potential negative social externalities of TBTF which make the rest of these issues a problem.

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