Tuesday, June 19, 2012

NYT's Peter Eavis Part IV: New bank regulations riddle with loopholes that allow excessive risk-taking

In a New York Times' article, Peter Eavis looks at how all the new bank regulations that have been put in place since the beginning of the financial crisis contain loopholes that allow the banks to continue to take excessive risk.

Regular readers know that the fundamental reason these regulations do not prevent excessive risk taking is that they are an inadequate substitute for ultra transparency.

Under ultra transparency, banks are required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this information, market participants can exert discipline on the banks to reduce their risk.

For example, transparency greatly reduces proprietary trading.  After all, proprietary trading is betting and who would bet at a poker game where they are the only one at the poker table who is required to show their cards at all times?
Bank regulators are casting new nets to catch excessive risk-taking in the financial system. 
But future London Whales may find plenty of ways to slip right through them. 
The story of JPMorgan Chase’s multibillion-dollar trading loss is now well known....
The motivations for the trades were unclear. While the bank says they were intended to offset other risks on the books, the strategy also appeared to have a speculative element. 
Nearly four years after the collapse of Lehman Brothers incited a worldwide financial crisis, such blowups are all too probable. 
Banks in the United States are still operating in a sort of regulatory no-man’s land. Many of the new post-crisis rules have not yet become effective. And even when they do, the loopholes remain large. 
The Volcker Rule, part of the Dodd-Frank legislation that will be phased in over the next two years, is intended to catch certain types of trading. But it may not snag the wagers of JPMorgan’s Whale. 
While this regulation prevents banks from doing speculative trades with their own money, it will not stop hedging activities, which JPMorgan has said were at the root of the trading losses. The Volcker Rule contains guidelines that are meant to help regulators decide whether a hedge masks a proprietary bet. But even with these prescriptions, speculative trading could still slip through..... 
Other parts of Dodd-Frank try to temper risk in more subtle ways. 
The regulatory overhaul tries to move many derivatives onto central clearinghouses, entities that handle the underlying payments on a trade. This is supposed to strengthen the derivatives markets, because the clearinghouses will force participants to back their trades with margin payments made in cash or very safe securities. 
In theory, the financial burden of supplying margin to clearinghouses could make Whale-type trades prohibitively expensive, and therefore less attractive for banks....
But some analysts think the extra margin may not be a sufficient deterrent. “If it is a trade you really believe in, you may still go ahead and do it, even if it is more expensive,” said Olu Sonola, an analyst at Fitch Ratings. 
Another effective measure may stem from the new international banking regulations set by the Basel committee. On paper, they will force banks to hold a lot more capital against certain trading positions, even ones using centrally-cleared derivatives.....
Under Basel, a bank sets capital as a percentage of risk-weighted assets. Consequently, a tripling of the position’s risk-weighted size would lead to a tripling of capital held against it.....
But again it seems there may be an out. 
In his testimony, Mr. Dimon implied that JPMorgan thought the large bullish bets would actually make its credit derivatives portfolio less onerous under new Basel rules. It’s possible that JPMorgan misread the Basel rules, or miscalculated the risks of the trade when setting its risk-weighted value. 
Even if both are true, it remains that the bank thought tens of billions of dollars in new trades — trades that ultimately blew up — would sail straight through Basel net. 
All that means the Whale is far from extinct on Wall Street.
Only ultra transparency catches the Whale every time.  And it does so before the position gets to be too large.

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