Kern Economics

Raymond J. Hawkins and Jeffrey K. Speakes

 Reform of the financial regulatory system is now under intensive review.  What steps can be taken to dampen the financial cycle?  What should be the responsibility and authority of the regulators?  We believe that a useful perspective on these issues can be gleaned by examining the protocol of financial exchanges.

Conspicuous in their absence from the rolls of those who have failed in the current financial crisis are financial exchanges and the clearing divisions (or prime brokers) of banks and brokerage firms.  This is remarkable given that they guarantee the performance of their members and/or clients dealing in some of the most highly leveraged financial derivatives.  Could it be that the risk management practices of these firms have something to say about how bank regulation can and should be conducted?  Indeed, it is very illuminating to see what banks and other financial institutions require of those whose performance they guarantee. 

Transparency

You can experience this model of bank regulation yourself by either opening a futures trading account at a retail brokerage firm to trade on an exchange or opening a professional trading account with a prime broker.  A futures account will be familiar in concept, if not in practice, to most people with a brokerage account.  A professional trading account, perhaps less well known, is a version of the retail brokerage account found in the clearing divisions of banks that provide banking services for professional traders, wealthy individuals, brokerage firms, hedge funds and banks:  think of them as brokerage accounts that allow you to trade both on exchanges and in the over-the-counter market.

Exchanges and clearing firms provide a number of services to their clients including leveraging of positions through lending.  They also guarantee the performance of their clients to counterparties.  When you trade an S&P futures contract, the performance of that contract is guaranteed by the exchange, not the person or firm on the other side of the trade.  Similarly, if you trade with a firm through a clearing firm your counterparty faces your clearing firm, not you, as the “other side” of that trade.  If you as a client fail to perform per the contracts you have entered into it is the exchange or clearing firm that faces first loss and they have created market solutions to the inevitable failure of some of their clients.

A key feature these accounts is that all of the assets and liabilities in them are known to the exchange or clearing firm.  While this may seem self-evident for the holder of a retail brokerage account, it is worth reflecting on the fact that this situation also holds for other entities like hedge funds and banks.  It is only through the mechanism of complete transparency that risk measurement and management can be effected.

Risk Measurement

While you are more than welcome to measure the risk in your account, and most holders of such accounts do, the risk and associated capital requirement for these accounts is determined by the exchange or clearing risk management division.  To achieve a uniform measure of risk that can be applied across many (sometimes thousands of) accounts, models are employed to stress test all accounts.  In this manner the risk of both a single retail client and a money-center bank are assessed on an even footing.  The stress tests are parsimonious, their methodologies well documented and their output available to the account holders.

Risk Management

Filling out the paperwork, you will have noticed that you don’t have physical or legal custody of the items in your account; the brokerage or clearing firm does.   This means that if they don’t like the risk you are running they can and will take action to reduce the risk in your portfolio.  It is, of course, customary to give you a (margin) call to inform you of the situation, but should you fail to reduce risk to an acceptable level it will be reduced for you.  Similarly, your removal of cash from the account requires the permission of your clearing firm, and if such a removal will result in too risky a position they will decline your request.

 Reflection

So let us reflect on what we have learned by opening our account.  Our positions are completely transparent to the clearing firm.  Physical and legal custody of the items in our account resides with the clearing firm.  The clearing firm determines the risk capital requirement and, if necessary, the clearing firm will liquidate a portion of the account to ensure it remains within appropriate risk limits.

Who, might you ask, besides the unsophisticated retail investor would submit to such treatment?  How about every professional trader, market maker, hedge fund, investment and commercial bank on the planet?  Why?  Because by ensuring that no one participant can run unacceptable risk everyone can get on with their business and not have to waste time and energy worrying about the behavior, or for that matter the identity, of their counterparties. 

Whither Creativity?

We have heard much from portions of the current regulatory debate that further regulation would hinder innovation and, thus, it is reasonable to ask if futures exchanges and clearing firms have hindered creativity.  Allowing that “creativity” can be employed for good or for ill and given some of the spectacular headlines generated by both hedge funds and futures-trading groups in banks over the years, the answer would seem to be a resounding no.  Indeed, professional trading has evolved this risk-management system over time by learning from past experiences, like the 1987 crash, into something of, to date, remarkable stability.  This is due in part, we believe, to the unique perspective that exchanges and clearing firms have concerning firms they guarantee:  some of them will fail so let’s ensure that these failures are as minimally disruptive as possible.

From Here to There

So how much of a move from current bank regulatory practice is our proposed market solution?  Surprisingly, much of what we propose exists in some form in the banking industry already. 

First, a clear example of Lender of Last Resort is the FDIC who guarantees the performance of bank deposits.  The FDIC clearly needs a complete understanding of the balance sheet of any institution they assume, but waiting until a bank has failed to obtain this information is wasteful in both time and money:  time, because information gathering is rarely optimal in times of crisis, and money because there is a very real possibility that the FDIC, given it’s clear informational advantage over any single bank regarding risk, could have advised the bank to alter it’s course so as to avoid distress. 

Second, while the recent stress test were (rightly) heralded as a step in the right direction, the efficacy of this test was undermined by a lack of transparency and limited application across the industry.  By contrast, the Thrift Industry has been subject to regular balance sheet stress testing for some time using models that are completely transparent to all participants and a known scoring system for banks.  With this system a bank can assess it’s own risk and determine whether a proposed modification to its balance sheet would result in an acceptable increase in risk.  As recent events have, however, amply demonstrated, risk measurement is of limited effect in the absence of effective risk management, which brings us to our third point.

Third, while some regulators have been able to act on the information provided by the stress test, they have been, through the structure of their relationship with the banks and their limited stake in the consequences of bank failure, somewhat negatively incented to do so.  By contrast, an organization like the FDIC has skin in the game.  Their upside is that banks continue to pay their deposit insurance premiums and their downside is that they pay out deposit insurance claims:  they, unlike regulators, have a clear financial incentive in seeing that banks operate in a healthy manner.  This, together with their informational advantage puts them in a position very similar to that of a clearing firm and, we suggest, that they operate accordingly.

So how to get to there from here?  Given our existing financial institutions the simplest way would be (i) have the FDIC  extend the stress test currently used by the Office of Thrift Supervision to include both interest rate and credit risk, (ii) require that the risk of all depository institutions, not just Thrifts, be measured with this stress test on a monthly basis, (iii) have the premium for deposit insurance reflect the measured risk of each bank and change as that risk changes and (iv) empower to FDIC to liquidate portions of the balance sheet of banks that fail to comply with directives to reduced their risk. 

From a practical implementation perspective this is a simple and straightforward extension of existing risk measurement practice across the banking industry.  From a philosophical perspective we are recommending market-derived regulatory practice as everything proposed herein is common practice in the world of professional clearing and exchange risk measurement and risk management.

Futures exchanges and clearing firms are examples of market-developed solutions to the risk management challenge facing our banking system.  Indeed, it is perhaps amusing that banks themselves have, through their clearing divisions, revealed that their lender of last resort needs the transparency to see risk and the authority to act on it.  

This entry was posted on Thursday, April 1st, 2010 at 1:29 pm and is filed under Regulate Like An Exchange - April 2010. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.