Rogue Traders and Economic Capital

Events of the past couple weeks in the financial markets illustrate two types of risk - liquidity and operational. These events seem to support our view that a) some of the larger, universal banks need permanent increases in minimum capital requirements and b) the regulatory treatment of structured finance and OTC derivatives needs immediate attention.

First, consider the operational risk at Société Générale attributed to a "rogue trader." The bank's statements blames one individual for losing $7 billion trading equity derivatives. While the magnitude of the SG loss is remarkable - even incredible -- such events are increasing in frequency among large banks, in part because the financial instruments prevalent in the markets today enable and encourage this type of behavior. Call it the entropy of risk embedded in an unlimited variation of derivative products.

The lesson of the SG event, to us, is that no amount of systems and controls can "manage" the risks of the derivative marketplace, a market where gambling is equated with classical investing. When securities "derived" from something else enable you take unlimited amounts of risk in any asset class or market, but without the discipline of a direct, physical connection to the supposed basis, and often with minimal or no margin requirements, the risk is unlimited as well.

The very same index trading strategy employed by SG trader Jerome Kerviel is the stock in trade of most global financial institutions. Had Kerviel's unauthorized positions been profitable, we'd never hear about it. Young traders create innovative transactions based upon a "correlation" between say a US equity index and a commodity, and consider the position risk neutral. Under Basel II such a position might likewise be considered "hedged," but the combination of human beings and derivatives defies risk definition or limitation efforts.

One operations officer tells The IRA that his biggest headache is policing the tendency of equity traders, for example, to take punts in commodities or other asset classes, often using the same type of cash settlement index instruments employed with horrible effect by Mr. Kerviel. Such shenanigans are made possible due to the wonders of cash settlement derivative contracts. Financial contracts which settle in cash and do not require the seller to deliver some tangible asset upon maturity are gaming instruments, not investment vehicles.

Such contracts actually enable young masters of the universe like Mr. Kerviel to multiply risks exponentially. The settlement procedures for derivatives also provide ample opportunities for a smart trader to game the system, thus the possible permutations of op-risk events are open-ended. The same phenomenon, incidentally, is visible in the way that third-party mortgage originators so handily gamed bank loan approval systems in creating the $1 trillion subprime structured asset debacle.

Whether you speak of losses due to unauthorized trading in index contracts or write-downs of Collateralized Debt Obligations, the common cause in both cases is the unregulated and unrestrained use of derivatives to create instruments and risk exposures which are not transparent and which lend themselves to at least the appearance of intentional deception if not fraud.

Indeed, the SG event and other horror stories of the past several weeks suggest that IRA's fundamentals based methodology for estimating Economic Capital needs for US banks is on target. Rather than rely upon IR spin in SEC filings to try to measure the "value at risk" of a given bank business model, observing how banks deploy their portfolio assets, and the returns generated by such choices, seems to us a more sound approach to safety and soundness monitoring.

The summary Economic Capital measures from The IRA Bank Monitor for some of the larger US bank holding companies are shown below. The EC benchmarks are based upon a "bank only" rollup and include calculated risk factors for lending, investing and trading.

Leave aside the rogue French trader for a moment and now consider how the increased leverage due to the use of derivative assets such as CDOs and more generically Structured Investment Vehicles ("SIVs") creates both market and liquidity risk issues for some of the largest banks - part of the reason why Citigroup (NYSE:C) and other global houses reported huge losses from on and off balance sheet assets over the past half year or more.

Last week we checked in with Professor Joe Mason at Drexel University as part of our research on the bank ratings we're launching with the release of Q4 2007 data by the FDIC. Using the Economic Capital model in The IRA Bank Monitor, we will begin to publish quarterly ratings for all US banks starting next month.

Mason did his early academic research on the regulatory response to the banking crisis of the 1930s. For an excellent background on the issue of securitization, read his 2003 working paper, "Credit Card Securitization and Regulatory Arbitrage," which he co-authored with Professor Charles Calomiris of Columbia.

"Nobody wants to talk about bank liability management," says Mason, who recalls OCC officials being aware of risks from securitization as early as the mid-1990s, when he and others raised questions about the "true sale" of off balance sheet securitization vehicles for credit card receivables -- off balance sheet vehicles which are functionally similar to the SIVs of today.

In the above cited article, Mason & Calomiris recall that "A true sale may not contain terms whereby the issuer will be responsible for the subsequent performance or condition of the collateral. Otherwise, terms tying subsequent performance back to the original issuer would constitute recourse and require that the issuer hold regulatory capital against the full value of the collateral transferred."

Mason warns that the contingent liability of banks to support off-balance sheet assets is a huge source of volatility in the financial markets and that a system which supports over $9 trillion worth of GSE and private label securitizations atop $6.7 trillion worth of US bank deposits is "inherently unstable." We agree.

The growing crowd of Sell Side analysts who express concern about bank capital adequacy at institutions such as C are right, but for the wrong reasons. It's not that some banks need to top off capital levels and then keep doing business as usual. Rather, we believe - and have argued for the past several years - that the banks with ratios of Economic Capital to Tier One Risk Based Capital over 1:1 arguably should hold more actual capital to support their business models and probably deserve lower ratings from the NRSROs.

Had the true trading book risks to banks operating in the heavily derivative global financial markets been reflected in Tier One Capital today, meaning capital levels say 2x current minimums, then banks such as C and their shareholders would not be forced to go hat in hand, giving away equity to sovereign wealth funds just to survive. Or in macroeconomic terms, if you applied even a partial capital charge to the banking industry for the $9 trillion in total securitizations, then the entire industry would be considered woefully undercapitalized and the largest bank's would be sub-investment grade.

With many publicly listed banks trading well below book and discussions again heard as to the accounting treatment for negative goodwill, a public debate about the capital banks require to navigate the modern day financial markets seems long overdue. The use of SIVs and other types of derivatives structures to increase effective bank leverage and thus risk exposure is a matter of global public policy concern. We shall be discussing this question and others in our remarks on "The Global Risk of Subprime" this Wednesday at the FRB Philadelphia.

Instead of desperately trying to delay the day of reckoning by cutting interest rates three quarters of a point - an embarrassing display of weakness by the US central bank - Fed Chairman Ben Bernanke and the leaders of the financial community should instead begin to discuss the global legal and regulatory changes required to bring bank capital requirements and risk taking in areas such as derivatives and securitization back into alignment.

Comments

[helplessobserver]

Most of this banking stuff is for the pros. Resting on common sense my question is: Why are not all assets and liabilities posted on the bank and corporate balance sheet? They used to be in the old days. I wonder if the banking professionals even know how incrediably stupid they look. Ah yes, Puff the Magic Dragon makes those swimming numbers on the computer monitors seem dreamy and keeps the viewer feel real good. Let the good times continue to roll.

[MNRTrading]

Chris, I strongly agree with your general argument, and I have been making the same argument since August. Also refer to Part III of "High Noon at the Wall Street Corral"

mnrtrading.blogspot.co...

However, I disagree with you regarding the Feds further easing. They have no real choice at this point in time. They need to stabilize the financial markets long enough to unwind things. Then let's get down to talking serious reform.

By the way, I cite your work in that August post.

mnrtrading.blogspot.co...

[what the ?]

the bank's gaming licenses should be revoked!!

wait a minute, they don't have a gaming license do they?

I should have invested in casino stocks instead.

[MSmailbox]

I've heard that mortgage salesmen receive a front-end commission, when they approve/close a deal... Often, this same person then leaves the company, cash in hand. Wouldn't it be better if he received a flat salary, plus an annual bonus, equal to the pro-rated portion of his gross commissions, for the loans which he made, that are continuing in good order?

[thannagan]

Chris - I need to read this again - on paper. I print the ones worth studying. Thanks

[Daniel Jones]

"While the magnitude of the SG loss is remarkable - even incredible -- such events are increasing in frequency among large banks, in part because the financial instruments prevalent in the markets today enable and encourage this type of behavior"

I absolutely agree with that observation, Chris. The gun-slinging traders are in a heads-I-win, tails-the-bank-losses type of arrangement. They are incentivized to be as aggressive as possible. The "hedged" nature of a trade setting up one commodity vs. an equity index based upon correlations that have held up in the past is questionable at best. Nothing says both positions can't tank at the same time, or that risk premia can't act irrationally longer than the traders can remain solvent. (apologies to Keynes for butchering his quote).

While many will point to in-house risk management teams doing their jobs, there could be a strong need for a discussion on how to rein in some of the trading desks and hedge fund risk takers as well, in my opinion.