Wall Street shows both the will and way to circumvent US derivative rules

Wall Street continues to make a mockery of the combination of complex rules/regulations and regulatory oversight as a restraint on its business practices.

US derivative rules are the latest example.  Reuters reports that Wall Street will avoid these rules by running derivative trades through their stand-alone subsidiaries based in London.

Regular readers know that the combination of complex rules/regulation and regulatory oversight is a substitute for transparency and market discipline.  A substitute that our current financial crisis shows is doomed to fail as Wall Street has an incentive (to make money) to finds ways around these complex rules/regulations.

The better choice is to focus on bringing transparency to all the opaque corners of the financial system.

Banks, for example, should be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With ultra transparency, it does not matter where in the world the banks enter into a derivative contract. This contract is reported to investors.  Investors who can use this information in their independent assessment of how risky the bank is and in setting how much exposure they can afford given the risk of the bank.

Wall Street banks are looking to help offshore clients sidestep new U.S. rules designed to safeguard the world's $640 trillion over-the-counter derivatives market, taking advantage of an exemption that risks undermining U.S. regulators' efforts. 

U.S. banks such as Morgan Stanley and Goldman Sachs have been explaining to their foreign customers that they can for now avoid the new rules, due to take effect next month, by routing trades via the banks' overseas units, according to industry sources and presentation materials obtained by Reuters. 

The rules, a result of Washington's Dodd-Frank reforms, aim to prevent financial catastrophes in the over-the-counter (OTC) market - a huge, opaque market which is partly blamed for felling Lehman Bros in 2008 and fuelling a global financial crisis....

Wall Street has launched a last-minute effort to show foreign counterparties how they can keep doing business together and still keep trades out of the U.S. regulatory net. 

The banks' solution is to route trades via their non-U.S. affiliates - subsidiaries with their own separate balance sheets, often in London - rather than the parent banks. It is a detour that could eventually be shut down by foreign regulators, but for now offers shelter from the U.S. regulatory storm. 

"What we are seeing now is a gamesmanship dance in which firms do whatever they can to avoid regulation, which is an age-old phenomenon," said Thomas Cooley, a professor of economics at New York University's Stern School of Business.

There is no reason to subject the stability of the financial system to Wall Street's ability to avoid regulation, now or in the future.

By requiring the banks to provide ultra transparency on all of their global exposures, the stability of the financial system is insured as the banks are subject to market discipline to restrain their risk taking.

Felix Salmon joins the bandwagon supporting ultra transparency

In his post on Why JP Morgan's gamblers need to be spun off, Felix Salmon puts forth the principle that the Too Big to Fail should not have any trading desk that needs to operate in secrecy to succeed.

Regular readers know that this is simply a restatement of requiring the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  Ultra transparency effectively puts an end to these trading desks.

There’s a much deeper issue here as well — which is whether big commercial banks should have hotshot trading desks staffed by the likes of Achilles Macris and Bruno Iksil at all. 

Both Peter Eavis and Jonathan Weil have new columns decrying the opacity of JP Morgan’s public disclosures: the bank seems to make it as difficult as possible for its owners to find out just how much risk it’s taking and where. 

And not just its owners, either: the owners’ representatives on the board, JP Morgan’s risk committee, is deliberately staffed by muppets. 

There’s a good reason for that, of course: hedge funds need to operate in secrecy, because if the market can work out what their positions are, it will move sharply against them. 

Please re-read the highlighted text as it nicely summarizes what your humble blogger has been saying since the beginning of the financial crisis.

JP Morgan’s CIO is a hedge fund in all respects except the fees it charges, and clearly the CIO (and the CEO) want its activities to be effectively unsupervised. That’s almost certainly the reason that the CIO is effectively based in London: it’s largely outside the scope of US regulators, there, while UK regulators tend not to care too much about the actions of foreign banks, when those actions don’t present a big risk to the UK economy.

As long as regulators have an information monopoly, it will always be possible for the banks to hide the risk of their positions.

This is a result of the simple fact that regulators do not approve or disapprove of individual positions.  Rather, they try to guess if the bank is adequately capitalized to absorb any potential losses from a given position.

So here’s another principle, which might be helpful alongside the Volcker Rule, in any principles-based regulatory regime: if you’re a too-big-to-fail commercial bank, you shouldn’t have any desk which needs to operate in secrecy in order to do its job effectively.

Agreed.  Thanks for the support of ultra transparency as it ends the secrecy needed to by these desk to operate effectively.

How banks foil Dodd-Frank Act and similar regulatory efforts

Bloomberg carried an interesting column on the various techniques that the large, global financial institutions use to blunt the impact of the Dodd-Frank Act and similar regulatory efforts.

The authors argue that to be successful, financial regulation needs to focus on economic function and rather than legal form.

An example of the type of reform they feel should be pursued is transparency.

Deutsche Bank AG (DBK) recently separated its U.S. investment bank from its bank holding company, removing it from supervision by theFederal Reserve. 

So far, U.S. regulators have reacted passively to such moves by foreign banks to avoid the heightened capital requirements mandated by the Dodd-Frank Act. 

That’s because Dodd-Frank failed to heed a fundamental law of architecture: Form must follow function. For financial regulation to be effective, it should focus on economic function, rather than legal form. If it doesn’t, institutions will quickly find new forms that free them of regulatory constraints. What walks like a duck and quacks like a duck must be regulated as a duck, even if it is legally a goose. 

All too often financial regulation misses this obvious point. The result is regulatory arbitrage, as intermediaries alter their legal form to minimize their costs. 

That would be fine if the costs of the risks carried by a large, complex investment bank -- a prime example of a “systemically important financial intermediary,” or SIFI, that Dodd-Frank sought to regulate -- were all its own. But that isn’t the case. When such institutions take risks, they can threaten the financial system and require public bailouts....

If a SIFI’s insolvency threatened a run on its counterparties, resolving it under Dodd-Frank rules could force less risk-prone intermediaries to bear the costs. Over time, that process would promote a risk-taking race to the bottom. 

The form versus function dilemma extends far beyond investment banks and, in some cases, even beyond SIFIs. It drives shadow banking as a whole. Why are money-market mutual funds still permitted to offer depositlike instruments -- creating the risks of a run -- without being subject to bank rules? Why were bank holding companies allowed to minimize capital by creating off-balance-sheet mechanisms (such as “special investment vehicles”) that were prone to panic? Why was the world’s largest insurer, American International Group Inc. (AIG), allowed to shop for a weak regulator (the now-shuttered Office of Thrift Supervision) that was ill-equipped to understand its business? 

Once we allow form, rather than function, to guide regulation, the classic problem of “time consistency” becomes acute. Time consistency refers to the overwhelming incentives, in bad times, for policy makers to renege on the commitments they made when things were going well. 

Imagine that a group of intermediaries has engaged in regulatory arbitrage to reduce their capital buffer or to take liquidity risks (say, by excessive reliance on short-term funding) that jeopardize the stability of the financial system. Suppose that regulators respond by warning that -- in a future crisis -- they won’t provide emergency liquidity or other bailout funds to such intermediaries. Unfortunately, the regulators’ threat is largely empty, because carrying it out could lead to economic catastrophe and both parties know this to be true. 

As a result, the promises of policy makers often lack the credibility needed to discipline systemic risk-taking. 

This time-consistency problem is particularly challenging for advocates of so-called narrow banking, a regulatory approach that focuses almost exclusively on form, rather than function. 

Under a narrow banking rule, government crisis backstops -- such as Federal Deposit Insurance Corp. guarantees or Fed discount lending -- would be available only to narrowly defined depositories that provide the economy’s basic payments mechanism. These banks would then be tightly regulated like public utilities. Outside this protected sphere, anything goes. 

Narrow banking sounds attractive because it seems to focus the losses in bad times on those non-narrow banks that took the risks in good times. If that were the case, the resulting incentives would help make the financial system safer. But would it really work that way? Not if people doubt the official commitment to let intermediaries outside the narrow banking world fail en masse. 

Even if legislation forbade bailouts (as Dodd-Frank does), would a modern government stand by in a full-blown financial crisis if doing so threatened another depression? Probably not. 

Indeed, one reason to establish thoughtful rules governing an official lender of last resort -- such as the Fed -- is that some part of government inevitably will play this role in a crisis. As a consequence, it’s better to do so through an institution of established integrity that limits the potential for corruption and fraud. 

If regulation by function rather than form is critical, why do we often fail to pursue it? Part of the answer is that it’s quite difficult to do. Another, no less troubling, part is that regulated financial entities are politically powerful. 

In some cases, they can persuade Congress and their regulators to exempt them from discipline. If the costs of that protection ultimately are borne by a large, diffuse group of taxpayers only in a crisis, taxpayer resistance can be overcome in good times.

The most straightforward solution to this problem is to regulate financial instruments and markets (say, through collateral and margin requirements), rather than just regulating institutions. Another is to promote transparency and infrastructure that empower greater market discipline. ... 

But not all systemic risks are easily amenable to this approach. History shows that increased regulation of instruments and markets also will create incentives for innovations that avoid it. Such innovations may be quite profitable, even as they undermine efforts to limit systemic risks.

Wall Street will continue to create opaque products.  The challenge for regulators is to continue to require that the bright light of transparency is shown into these products.

Eurozone banks manipulation of Tier 1 capital ratio confirms it is meaningless

In an article, the Financial Times highlighted how easily banks can manipulated their Tier 1 capital ratio.

What makes this article significant is it highlights how monetary policy and the regulatory policy of forbearance directly contributed to manipulation of the capital ratio.

Concern is growing that banks in Europe and elsewhere are moving to meet new tougher capital requirements by tinkering with their internal models to make their holdings appear less risky.... 

All of these requirements are aimed at making banks more resilient by forcing them to have more capital to absorb unexpected losses. But banks, faced with volatile markets and low share prices, are reluctant to issue equity right now. 

So many of them are instead trying to reach the required ratios by reducing the denominator, through what they call “risk-weighted asset optimisation”. In some cases, that means selling or running down risky assets, but in others, it means changing the way risk weights are calculated to cut the amount of capital that will be required. 

Regulators, who must approve bank models, are alive to the problem and the European Banking Authority’s board has essentially set a floor on how low the risk weights can go when it comes to calculating the EU’s 9 per cent target. 

“The language of RWA optimisation is basically regulatory arbitrage,” said one senior EU regulator. 

But that hasn’t stopped many banks from doing their best to boost their ratios....

Some of the optimisation is encouraged by the regulators. Banks effectively get an risk-weighted asset break when they switch from the old Basel I rules – which apply standardised risk weights to loans based on their category – to the “internal ratings based” system that is the basis for Basel II and III. 

Under the internal ratings system, banks come up with models that predict the probability a particular loan will default and the likely loss if that occurs. The numbers are then plugged into a formula that assigns a risk weight. 

In general, using internal ratings produces somewhat lower risk weights – and therefore requires less capital – than the standardised approach because regulators want banks to build good models and improve risk management.... 

Of course, the best way to "model" these loans would be to disclose them to market participants.  The market would then assess the risk of the loans.

But there is a second kind of optimisation that regulators are more concerned about. When banks create models, regulators then back-test them and will only approve those that produce probabilities of default and predicted losses that are higher than real-life experience. 

But the current recession has produced lower loan default rates than past downturns – partly because interest rates are low – so many bank models are currently producing results that are significantly more conservative than real life. 

And partly because of regulatory forbearance...

That creates room for banks to tweak their models, and some are doing so in a deliberate effort to cut their capital needs, industry participants say.... 

Supervisors in the UK and elsewhere also said they will be looking carefully at bank plans to reach their new capital requirements and intend to come down hard to anything they see as cheating.

No market participant believes this.

If regulators were really going to come down hard, they would require that banks disclose their current asset, liability and off-balance sheet exposure detail.  This would allow the market participants to monitor if regulators come down hard on how banks reach the meaningless capital requirements.

Banks practicing regulatory arbitrage to boost profits

A Bloomberg article discusses how multi-national banks are exploring ways to shift where they book their business to minimize capital and liquidity requirements.  Regular readers know that there is nothing unexpected, surprising or fundamentally wrong with this behavior.

It simply highlights a fundamental problem with the practice of banking regulation and supervision.  The problem is that there are opportunities to benefit from regulatory arbitrage as it is difficult to get every country to adopt the same regulations.

One of the reasons that this blog has pushed for disclosure of current asset and liability-level data is that it is not subject to regulatory arbitrage.  Either a financial institution discloses all of its data regardless of where it is booked or it does not.

If it does disclose all of its data, market participants should reward it with a lower cost of and better access to capital because they are able to do a better job of analyzing its risks.

If it does not disclose, market participants know that it has something to hide and should increase its cost of and decrease its access to capital to reflect this risk.

Banks in Europe are exploring ways to cut costs by routing more of their trades and other business through overseas subsidiaries, a plan that may shift tax revenue away from London and loosen European regulators’ influence over the lenders. 

Nomura Holdings Inc., HSBC Holdings Plc (HSBA) and UBS AG (UBSN) are among lenders preparing plans to book as much business as possible through legal entities in jurisdictions where tax rates are lower and rules on capital and liquidity are less onerous, the banks and lawyers and accountants working with them say. 

“Every bank is trying to work out the best way to be structured under the new rules,” Chris Matten, a partner at PricewaterhouseCoopers LLP in Singapore, said in a telephone interview. “It’s not just a question of what activities banks are in. It’s about which entities they put that business through and in which jurisdictions.” 

Banks could record as much as 30 percent of the value of their trades through Hong Kong, Singapore and other jurisdictions instead of hubs such as London and New York without running into trouble with regulators, Matten said. 

Such a move would hurt traditional hubs such as London because assets are treated for tax and regulatory purposes in the country where they are booked. It would also allow banks to sidestep the U.K. bank levy, introduced last year to raise 2.5 billion pounds ($4.1 billion) from lenders operating in Britain, as well as any financial transaction tax imposed by the European Union.

“It is really about trying understand where all the different regulatory pressures are going to squeeze the hardest and looking to see if there are more efficient ways of reorganizing the booking model and business model so as not to have too many restraints,” Matten said in an interview with Bloomberg TV today. 

Lenders aren’t required to publish which entities they book their assets through globally.... 

“Capital scarcity has meant there is greater focus on where activity takes place and where it is booked,” Peter Muir, a London-based tax partner at Deloitte, said in a telephone interview. “People are likely to be looking to arbitrage the rules in a fair way to see if they can avoid more highly regulated markets.” 

... The most attractive booking model will vary from bank to bank, according to analysts and lawyers. Options under consideration include setting up new branches or subsidiaries in more favorable jurisdictions such as Hong Kong and Singapore, where taxes and capital surcharges are lower; booking a higher proportion of trades through multiple existing entities rather than through one global hub; and switching from a model based on a network of global branches to one based on a series of ring fenced, fully capitalized global subsidiaries.