Bank Regulators: One Foot On The Gas; One, On The Brake.

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Includes: BAC, C, CME, GS, JPM
by: Kurt Dew

Summary

Too Big to Fail and financial derivatives are a public focus this election year.

But Congress, not Big Banking, deserves most of the blame for the problem.

Yet instead of taking its foot off the derivatives gas, Congress has left the throttle open.

Then it put its other foot on the brake.

The abused engine of banking will eventually burn up.

Ain't that a shame? You're the one to blame.

-- Fats Domino

In the mythical world of election speeches, the Too Big to Fail (TBTF) Banks and their evil spawn, financial derivatives, sprung into existence following the passing of the Gramm-Leach-Bliley Act of 1999. As the story goes, it was deregulation, not regulation, that created them.

The first effort to resolve these problems, Dodd Frank, is now discredited. Like an evil genie, it turned Congress' wishes -- to reduce the size of the TBTF banks and to eliminate derivatives' risks -- into nightmares.

This article focuses of the disastrous government management of derivatives, attacking the idea that banks, not government, created the problem. The derivatives dealers [the usual suspects, Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), and JPMorgan Chase (NYSE:JPM)] were complicit, through their lobbies. But they have suffered mightily from the inefficiency of government regulation of derivatives markets, which is largely responsible, along with poor management, for these banks' current anemic stock valuations.

Proactive banking and regulatory attempts to improve the efficiency of these markets - by the concerted effort of banks, exchanges, and regulators - is the solution to putting our financial engine back into better repair. In the current leadership vacuum however, this is apparently not in the cards.

Congress opens the derivatives throttle. Without government involvement from the beginning of derivatives' development, there is every possibility that the banks would have made changes to derivatives markets themselves, that would have eliminated systemic risk long ago. All that was needed was for the banks to introduce negotiable versions of derivatives.

Derivatives are an issue today because, from the very beginning, bank regulators put the derivatives gas pedal to the metal. Congress changed the bankruptcy code to exempt derivatives dealers from the bankruptcy judge's "equitable" division of the estate's assets.

In the view of Congress, fair, for derivatives dealers, is to put them before other creditors -- allow them to seize any collateral at their disposal. Dealers are then expected to ask three of their closest friends whether it's fair to keep all the collateral they see fit, then return whatever their friends suggest to the estate. If they have no friends, they can decide how much to seize for themselves.

That interesting change in bankruptcy law opened the throttle and kicked in the afterburner derivatives needed to reach the stratosphere of profit banks enjoyed during the 20 years or so before the Crisis.

So "What to do about derivatives?" Congress asked after the Crisis. Congress could not take responsibility for the crisis and still face the voter. To change the bankruptcy code would have conceded a responsibility for the Crisis it could not accept. The decision was made to leave Congress' foot on the gas while simultaneously putting Congress' other foot on the brake. The heart of the matter was to deny that derivatives' systemic risk was the effect of legislation, but instead to lay the blame on bank skullduggery.

The primary measure taken by Dodd Frank was that dealer banks (defined as banks with derivatives portfolios exceeding $8 billion, a small portfolio by the standards of derivatives) were mandated to clear their positions at over-the-counter (OTC) clearing houses. Pretty timid stuff.

At the time there were two clearing houses for interest rate swaps -- CME Group (NASDAQ:CME) and LCH:Clearnet (LCH), a subsidiary of the London Stock Exchange (LN). Subsequently open interest at CME Group has gone into a swoon, apparently because the two clearing houses substantially disagree on the market values of identical interest rate swaps (the largest kind of derivative trade, by market value). The business now belongs to LCH, for all intents and purposes, apparently because it was the larger of the two.

This article makes three points about the regulation of derivatives:

  1. Derivatives would not have been systemically risky if Congressional legislation had not made them so, attempting to send the risks of bank derivatives portfolios into legal hiding. Encouraged by the banking lobby, Congress tried legislating derivatives risk out of existence, ignoring centuries of judicial experience with insolvency resolution. Derivatives were exempted from the stay in bankruptcy, placing them outside bankruptcy court jurisdiction. This decision proved disastrous in the failure of Lehman Brothers. Dodd Frank did nothing to address this issue.
  2. Dodd Frank's mandate for dealers to clear derivatives trades, while a reasonably good idea, did nothing to eliminate derivatives systemic risks. It did ease the implementation of the emergency measures Congress has vowed to avoid. It also made derivatives markets easier to analyze, more transparent.
  3. The capital regulations and other restraints, such as "living wills," and Comprehensive Capital Analysis and Review (CCAR) regulations, arguably not bad ideas if implemented with reasonable consideration of their costs to the large banks that must deal with them, have been implemented instead at maximum bank expense. The result has been chaos and cratering big bank share prices.

Regulation has become Chinese water torture. Drip. Drip. Drip. The banks are being squeezed. These regulations seem destined to become more stringent until big banks capitulate and shrink.

Clearing Houses. OTC clearing houses, while a weak reflection of the dramatic reduction in systemic risk that negotiable derivatives would have, were a Dodd Frank measure that shows some beneficial effects.

Front and center is the fact that Notional Principal Amount (NPA) has been reduced in cleared trades at LCH, bringing it from something in excess of $1 quadrillion to a mere $330 trillion or so, an adjustment called "compaction". This claim of improvement from NPA reduction is accurate, but a little ironic, since it fits so uncomfortably with the ubiquitous disclaimer of dealers' quarterly reports: that NPA greatly misrepresents the risks of derivatives trades. Compaction reduces the ratio of derivatives open interest (NPA) to total historical volume from 1 to approximately 33%.

If derivatives were negotiable, the ratio would be comparable to that same ratio for securities and futures trading, close to zero. Then the dramatically reduced size of NPA would be a useful measure of exchange and trader risk, as is open interest in futures markets.

Compaction, while doing absolutely nothing to reduce risk, does present the relationship between NPA and risk more accurately. What compaction actually does is to find payments that a dealer is making to itself, and cancel them. That dealers could not do this for themselves is not easily explained, but it is good that someone has addressed it.

NPA measures risk poorly, but now, with clearing, it measures risk more accurately.

Without taking its foot off the derivatives gas -- reforming poorly conceived rules encouraging excessive derivatives trading -- Congress has simultaneously put its foot on the derivatives brakes as well, increasing capital charges through an unnecessarily complicated and unclear relationship between increased capital banks must hold and the derivatives portfolios they trade, bringing the banks into something of an eclipse.

The effect of these two inconsistent policies is predictable. The banking brake pads are wearing thin; the bank profit engine, laboring. Without a change, the big banks -- the United States' engine of economic growth -- will need to be replaced.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.