The Costs (If Any) of Derivatives Reforms

The question of the impact of derivatives rules on ‘end users’ — real economy companies who use derivatives to hedge production risks — has been a constant refrain in derivatives debates.  The claim is that basic requirements to back up derivatives with cash collateral (such as clearing and margin requirements) will impose large costs on end users. These arguments about a supposed burden on real economy companies have already led to a broad exemption from derivatives clearing requirements for non-financial end users. But opponents of new derivatives rules are continuing to push the idea that any kind of margin requirements (including for uncleared derivatives) would create significant economic costs.

Now John Parsons of the Massachusetts Institute of Technology has written the definitive paper on just how small – or possibly non-existent – the costs of new margin requirements will be. The major point of the paper is that the costs of derivatives exposures are inherent in the risks being taken in the derivative. Requirements to temporarily reserve money in margin or collateral accounts against possible future exposures don’t affect those costs, they simply change the form in which they are recognized. Unmargined derivatives are in effect a loan to the company. Reserving money up front means that the company recognizes its risk earlier, and in a more transparent fashion.  These are simply good risk management practices, not new costs. They do change cash flows and the timing of payments. But these changes in the timing of cash flows should have at most a small effect on true costs.

Federal Reserve Reform And The Federal Reserve Independence Act

In the wake of the multibillion dollar losses at JP Morgan there have been increasing calls for Jamie Dimon to resign from the board of directors of the New York Federal Reserve (see this petition, for example).  We agree that he should resign.

But we also think that he shouldn’t have been there in the first place. His presence on the board is evidence of a broader problem with conflicts of interest in the governance of the Federal Reserve, particularly the regional banks. The regional banks are important public regulatory institutions and they should not be managed by the  financial institutions they are charged  with regulating.

The Board of Governors of the Federal Reserve is chosen by the President and subject to Senate confirmation. But two-thirds of the directors in each of the 12 regional banks that make up the Federal Reserve system are elected by the local banks in that region. These directors may hold stock in or invest in regulated banks. Up to one-third of the board of directors for each regional bank (so-called ‘Class A Directors’) may also be current employees of the regulated banks in that region. And typically they are.

The financial crisis and its aftermath have made clearer than ever before the central role the Federal Reserve plays in our financial system. During the crisis of 2008 and 2009 the Federal Reserve granted trillions of dollars of direct lending assistance to individual banks through special credit programs. The Fed’s role in setting interest rates through the Open Market Committee is enormously important in good times and bad – and regional directors elect the regional bank presidents on that committee. But the Fed’s role in the everyday supervision and oversight of banks and bank holding companies also influences the allocation of trillions of dollars in our economy.   Much of this supervision is actually performed by  the regional banks, which means the boards for these regional banks are in a position to impact  it. This issue is particularly acute at the New York Federal Reserve, which supervises the largest Wall Street banks. We now know, for example, that lenient supervision at the New York Federal Reserve played  a crucial role in the massive risk management failures at Citibank that helped lead directly to the crisis.

In the fight over the Dodd Frank act AFR advocated changes to increase the Federal Reserve Board’s accountability to the public, and remove the undue influence of Wall Street banks. But in the end the Dodd-Frank Act made only very limited changes in this area. The law mandated that Class A directors could not participate in the selection of the bank president. In addition, the Federal Reserve Bank of New York has changed its bylaws to limit the role of Class A directors in oversight of bank supervision.  More dramatic change is needed.

New legislation introduced by Senators Sanders, Boxer, and Begich — the Federal Reserve Independence Act — would make that change. Their proposal would not only require the removal of Jamie Dimon from the New York Fed, but would fix the structural problem that put him there in the first place. The bill mandates that the directors of regional Federal Reserve banks be appointed by the democratically selected Board of Governors, rather than elected by the banks they supervise. It also bans directors or employees of the Federal Reserve from holding stock in the banks they supervise. These are straightforward, common-sense solutions to the conflict of interest problem that should become law.

JP Morgan And The Volcker Rule: It's Not About Banning Risk

Opponents of new financial regulations are starting to claim that JP Morgan losses don’t show us much about the need for new restrictions on bank activities. First, they say, risk is inherent in banking, and no restriction can eliminate it. Second, there’s no benefit in restricting the types of risks that are taken — traditional lending risk permitted under the Volcker Rule is the core problem in financial oversight. An anonymous banker summarized the argument in a statement to Politico’s “Morning Money” last week:

“The inconvenient truth is that ‘plain vanilla’ lending is far and away the riskiest activity any financial institution can engage in. Virtually every financial crisis in history – including the most recent one – was caused principally by lending-related losses. The value of mortgage-backed securities plummeted in 2008 not because those securities were traded, but because too many of the mortgages… backing those securities were poorly underwritten … The notion that we can legislate or regulate risk out of banks is absurd.”

First, the banker is dead wrong about the relationship between trading risk and the 2008 crisis.  The loans packaged into mortgage-backed securities were indeed poorly underwritten. (One reason is exactly that the loans were sold off into traded securities –underwriting practices can become lax if the lender does not plan to keep the loan). But the losses from those loans, while severe, would not by themselves have created the financial crisis we saw in 2008. As Ben Bernanke stated in a recent speech, aggregate subprime loan losses amounted to several hundred billion dollars, not in itself enough to take down the global economy.  Problems in the mortgage market triggered the collapse because of a vast structure of financial market trades based indirectly on the value of those mortgages. That structure included trillions of dollars in synthetic derivatives bets (synthetic CDOs), as well as trillions of dollars in short-term (overnight) funding tied directly to traded valuations. That was the structure that collapsed and took the economy down with it.

Second, no one is trying to – or could – ban risk from banking. The goal of the Volcker Rule is instead to change the form and location of risk. The rule moves one particular type of risk –proprietary speculation in the financial market ‘casino’ – out of the giant banks at the center of the economy and into smaller hedge funds and other speculators who can fail without threatening the system.  The Volcker Rule permits banks to continue risk taking in the form of lending and investment, as well as low risk forms of market making.

That’s because risks created by financial market gambling differ in important ways from those created by long term investment and lending. Financial markets are inherently unstable and volatile, vulnerable to bubbles and crashes. At the extreme, markets can fail completely during periods of panic and trading can become impossible. When institutions central to the economy are gambling their money in these markets, the entire system becomes more vulnerable. Supervisors can require banks to reserve capital against this risk, but today’s speculative instruments can create enormous financial exposures that are very difficult to predict. Determining those exposures relies on complex and uncertain mathematical models that have a history of spectacular failures (and just failed JP at Morgan yet again).

That’s the risk part of the problem. There’s also the connection to the real economy to think about. Speculating in secondary trading markets occurs at several layers of remove from real economy capital provision. Much of the volume in today’s financial markets is just derivatives bets on future prices, with no actual lending or investment involved. There are some risk management benefits for hedgers. But the real economy benefits of, for example, the exotic credit derivatives JP Morgan was speculating in appear limited at best. And paper speculation can actually suck money away from the real economy.

In contrast to financial market speculation, lending and long-term investment have a direct real economy connection and the risks are easier to understand. Exposures are more straightforward and underwriting is less dependent on complex mathematical assumptions and more on assessing basic creditworthiness. In addition, when lending goes wrong the banker often has time to ride out the problem and restructure the debt. Speculative market exposure forces loss recognition immediately and makes banks vulnerable to contagious market panic.

So the Volcker Rule builds a firewall between speculative trading and basic credit intermediation. Banks can take risks in traditional, longer-term lending and investment, but their financial market activities should be limited to low-risk market making and hedging. Banks are resisting this shift, since their business models have mixed market trading and basic banking functions in so many ways. But it’s strange that anyone should find the basic idea outrageous, since it’s the same distinction made in one of the most famous and long-lasting regulations in American history, namely the Glass-Steagall division between depository and investment banking.

Cost Benefit Analysis and Financial Reform

There are three fronts in the battle over financial regulation — Congress, the regulators, and the courts. The third gets perhaps the least attention, but legal challenges to new regulations are a major issue that could undermine the entire process of implementing the Dodd-Frank Act. The DC Circuit Court has already overturned SEC proxy access rules on cost-benefit grounds in the ‘Business Roundtable’ decision. Lawsuits have also been filed against rules for commodity market speculation limits and derivatives oversight rules, and future suits are threatened against a wide range of major rules. This legal threat is creating a serious chilling effect on regulators’ implementation of new Dodd-Frank rules.

The challenges are all grounded in judicial review of agency rules on the basis of cost-benefit analysis. While controversial, such cost-benefit analysis has long been a fixture in other areas of regulation such as safety and health this is part of the role of a pricing analyst, by the way. But the scope of the challenge to Dodd-Frank on cost-benefit grounds is something new in the area of financial regulation. Americans for Financial Reform recently held a half-day conference to examine both the legal and economic aspects of applying cost-benefit analysis to financial regulations. Some of the presentations included a keynote address by CFTC Commissioner Bart Chilton, an overview of the scope and nature of cost-benefit challenges by Dennis Kelleher of Better Markets, a critical analysis of the DC Circuit’s recent Business Roundtable decision by Jay Brown of the University of Denver Law School, a presentation by AFR Policy Director Dr. Marcus Stanley on the issues raised by applying formal cost-benefit analysis to financial regulation, and more. See all the presentations here.

The JP Morgan Debacle: Synthetic 'Hedges', Real Banking, and the Dodd-Frank Act

JP Morgan CEO Jamie Dimon has been a leading voice in the call to roll back the Volcker Rule and other provisions of the Dodd-Frank Act. His anti-regulatory message just lost a lot of credibility.

So far, the unforseen losses on JP Morgan’s London trades are around $2 billion (although more may be coming). That’s a level that the bank can probably absorb. But this story is so compelling because it highlights two deep problems in our banking and regulatory system. The first is the capture of the banking system by a culture of speculation that fails to serve the real economy. The second is the willingness of regulators – and bank risk managers themselves — to believe claims that this speculation is low risk or ‘hedged’ when in fact it poses great risks. The Dodd Frank Act includes tools to take on these problems, but regulators have to get tough and truly use those tools in order for them to work.  And Congress has to resist Wall Street pressure to roll them back.

We don’t know exactly what JP Morgan’s trade was. But from their statements and what the press has found, JP Morgan appears to have hedged securities holdings with an arbitrage trade on a credit default swap index. The transaction would work like this:

1)      Cash holdings from bank deposits were invested in what the bank calls ‘very high grade securities’. The highest grade securities would be some form of US Treasuries.

2)      These securities were then hedged by buying credit protection on an index of investment-grade securities. Such protection could theoretically reduce risk, but it costs money.

3)      The costs of buying credit protection were then offset by selling protection on another closely correlated credit default swap index – most likely a different maturity point of the same index.

This last step was probably sold as making the initial ‘hedge’ more efficient – but in fact it converts that ‘hedge’ into a speculative arbitrage or spread trade. If the spread between the instruments JP Morgan bought and sold is positive, then the bank makes a profit and increases the return on its securities. Even if the spread is low or zero, the trade can still be portrayed to regulators or risk managers as a hedge. The problem comes when the speculative trade goes sharply negative. Mathematical models say this risk is low for correlated trades, but these models have been proven wrong over and over again, going back to Long Term Capital Management in the 1990s.

Even before questions of risk and regulation, the first issue is just how far removed from traditional banking and the real economy this is. Rather lending deposits to businesses, JP Morgan placed the assets in low-return Treasury bills or perhaps blue chip corporates (the same large corporations who are currently sitting on over $2 trillion in cash). At current interest rates, the return on such instruments is very low. So the bank sought out higher returns. But instead of trying to raise returns by seeking out real economy lending opportunities, JP Morgan instead tried to increase its return by trading derivatives on synthetic credit default swap indexes – pure paper speculation.

To make things worse, because it was hoodwinked by its own mathematical models (JP Morgan now admits its VAR model was ‘inadequate’) the bank apparently did not even understand that this speculation involved risks at least as great as it would have incurred had it made real economy investments.

The replacement of real banking by purely speculative, synthetic banking is at the heart of the problems with our bloated and inefficient financial system. The Dodd-Frank Act contains multiple tools designed to address this problem. The foremost among these is the Volcker Rule, which is designed to get banks out of the business of financial market speculation and back into supporting the real economy. But many other sections of the Act address the problem too. These include the ‘swaps push out’ provision that would separate derivatives trading from core banking functions, new rules on derivatives that increase the collateral and margin that must be set aside against speculative trades, and even new prudential capital requirements that should force better recognition of speculative trading risks.

But the effectiveness of these rules depends on how regulators implement them – and unless regulators change their lenient attitude toward the culture of Wall Street trading, that implementation will not be effective. The clearest example is the definition of ‘hedging’. Most Dodd-Frank rules have exceptions of some sort for hedging operations that are truly risk reducing. This is true for the Volcker Rule and for many of the derivatives rules, including the swaps push out provision. The problem is that in the culture of speculative trading, hedging does not simply mean risk reduction. It means something closer to ‘a trade that will reduce my risks if markets behave as I expect, while giving me the chance to increase my profits’. Basic economic theory says that you cannot reduce risks without sacrificing opportunities for higher returns. Hedge trades should lower risks, not increase profits, and ‘hedging’ operations – such as JP Morgan’s Chief Investment Office – should never be profit centers. In fact, it clearly was a profit center (until it became a loss center) and not in the hedging business.

The implementation of the hedge exemption in the Volcker Rule does not take this principle into account. It also allows vague and ill-defined ‘portfolio hedging’ that would be a perfect refuge for these types of arbitrage trades, along with dynamic rebalancing of hedges that is necessary for sophisticated arbitrage. To make things worse, the rule would not scrutinize trading positions held longer than two months. Many spread trades are held for relatively long periods. Indeed, as the AFR Volcker Rule comment letter argues, the combination of a broad hedge exemption and little scrutiny of long-term positions makes the current Volcker Rule proposal extremely vulnerable to arbitrage trading.

The Volcker Rule is not the only area where this episode reveals vulnerabilities. For example, in its implementation of new capital rules the Federal Reserve appears to have accepted the inadequate base levels of capital required in the new Basel III accord. It will apparently rely on model-based ‘stress testing’ to determine when additional capital is needed. Yet these stress tests rely on the same type of VAR model that failed in this case. Other areas of derivatives regulation, such as the ‘swaps push out’ requirement and dealer oversight have hedge exemptions that raise similar issues to those in the Volcker Rule. And basic derivatives protections like clearing and margining that would help make these types of trades safer are under attack in Congress – as well as by industry lobbyists putting pressure on regulators.

Regulators and Congress need to learn from this episode. We need to put tough restrictions in place to reorient banks on serving the real economy, and we can’t rely on Wall Street assurances that their speculative trading is safe.  Strong versions of already enacted Dodd-Frank laws are a necessity, but Congress also needs to seriously consider measures to break up the big banks, such as Senator Brown’s SAFE Act.

The Volcker Rule is Already Principles Based

(Guest Post By Wally Turbeville of Demos)

The same message is repeated day after day by opponents of the proposed regulations implementing the Volcker Rule, and sometimes by those who should be sympathetic with its purpose.  They say that the proposal is too prescriptive and complex and should be pared down to a statement of principles.  The proposed regulations are by no means perfect, a fact that is not surprising given the scope of the Volcker Rule.  But these imperfections in no way justify abandonment of the work done by the regulatory agencies to implement Section 619 of the Dodd-Frank Act.

The statute sets out a fundamental redirection of financial services industry.  Banks that are insured by the FDIC and have access to the Fed window are prohibited from proprietary trading and investment in hedge funds, business lines that had grown dramatically in recent years.   The purpose is to eliminate risky trading market activity by institutions that enjoy the Federal safety net and are therefore far more likely to be too-big-to fail.  The rule would also go a long way toward breaking up the oligopoly of banks that dominate many markets because of their massive and subsidized capital bases.

The rule affects many of the largest participants in the securities and derivatives markets.  This is because of the distorted structure of the industry that was the result of the financial crisis.  The surviving investment banks were either absorbed by insured institutions or were converted to banks.  The Volcker Rule will mean that independent investment banks and other institutions not supported by the Federal safety net will absorb the prohibited business, assuming that it is profitable without the subsidy of the safety net.

The proposed rule release document setting out the proposed regulations is indeed a daunting read.  The Federal Register release itself is about 127 pages, though the rules are no more than 13 pages long with an additional 12 pages of appendices on detailed metrics, descriptions of processes and similar matters.  Even those who are sympathetic to the concept ask why the rules cannot be expressed as a simple statement that proprietary trading is forbidden.  We will all know proprietary trading when we see it, the logic goes.

In reality, the basic ban on proprietary trading is not too far from that.  It describes the activity in relatively simple and familiar terms (relying on the familiar concept of trading accounts) and then establishes a “rebuttable presumption” that positions turned over within 60 days are held for a proprietary purpose, basically the purpose of profiting from short-term price movements.  All this means is that the banks need to explain why positions that turned over in less than 60 days were not held for short swing profit reasons.

However, the statute does not stop there.  It excludes “market making” and underwriting, so as not to be too restrictive on banks.  Most of the complexity flows from these exceptions.  The reason is that over the period that banks traded in more and more reckless ways, generating massive profits and even more massive risks to their very survival, these relatively stable and low-risk business lines were contorted into vehicles for proprietary risk-taking.  The regulatory agencies were compelled to craft monitoring regimes to detect the potential drift toward camouflaged proprietary trading by the market making and underwriting desks.

Much of the attention is directed at market making, a function that traditionally involved customer service by facilitating access to trading markets.  The essential element is the existence of a market that provides reasonable assurance that the bank can cover the newly acquired position at a foreseeable price.  This function had been perverted by the banks into a customer sourced risk business providing access to positions for which no market existed.  These positions were taken on and held as bets that the exotic risks would pay off.  Underwriting, principally the facilitation of large offerings into the market for a customer, was similarly re-tooled into a means of marketing financially engineered securities and derivatives on behalf of the bank itself.

Hedging of otherwise permitted proprietary trading was also excluded from the prohibition.  Again, the regulatory agencies had to confront bank practices that involved the fabrication of exotic risks by offsetting positions with other positions that effectively created a new risk.  The excess risk embedded in the purported hedge remaining after the offset would be an altogether new risk position on the bank’s book.  Using this technique, a bank could take on a proprietary position properly as part of its market making.  The risk reducing “hedge” could offset the market making position, but also include excess risks that were even more dangerous that the underlying, market making position. This technique has commonly been used by traders to avoid internal rules against proprietary trading.  Again, the regulatory agencies were compelled address this practice of camouflaged proprietary trading.

The vast majority of provisions of the proposed regulations deal with these concerns by providing guidelines and monitoring techniques to detect a drift toward proprietary risk taking.  These are not hard and fast rules, but general characteristics that might arise if the Volcker Rule exceptions are being exploited improperly.  And the vast majority the text in the release is a discussion of the principles and a large number of questions designed to give the public, including the banks, ample opportunity to provide input.

The proposed regulations are simply not a draconian set of rigid and prescriptive rules.  They establish the principle of the prohibitions and the exceptions and then provide guidance so that the regulated institutions can discern the contours of compliance.  There are some clear issues relating to the proposed regulations that are worthy of debate.  However, the general complaint that the rules are too prescriptive and create intrusive and overbearing requirements is simply a straw man that opponents have propped up merely to knock down.

This is a clever tactic, since the subject matter is arcane and unfamiliar to those not in the trading businesses.  However, it should be seen for what it is: even more cynical than it is clever.  The industry lobbying effort using this tactic is merely reinforcing the reputation, so well earned in the financial crisis, that the banks cannot be trusted.

Not Just Technical — The War on Derivatives Reform

Unregulated derivatives markets have been at the center of almost every major financial crisis of the past two decades, from the 1998 bailout of Long Term Capital Management to Enron to the catastrophic financial collapse of 2008. (A fuller list would include the implosion of Banker’s Trust and Barings Bank, the bankruptcies of Orange County and Jefferson County, and numerous more ‘minor’ scandals). Derivatives can allow almost unlimited exposure to speculative risks, and no financial regulatory regime can be secure as long as they remain unregulated.

But derivatives regulation is highly vulnerable to attack by industry lobbyists. The technical details can be complex, and are understood by few outside the industry. So it’s easy to disguise major loopholes as ‘technical amendments’ or ‘clarifications’, even if the changes would seriously weaken or even destroy the capacity to regulate derivatives. Adding to the problem, the agencies responsible for derivatives reforms – the tiny Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) — are comparatively small and, unlike the banking regulators, depend on Congress for funding.

Industry lobbyists are trying to capitalize on this vulnerability through a coordinated assault on derivatives reform. One element of this attack is the so far successful effort to deny adequate funding to the CFTC, a key derivatives regulator. Another is a set of bills currently working their way through the House.

This legislation is usually presented as minor technical or clarifying changes, but that’s far from the truth. For example, the “Swaps Jurisdiction Certainty Act” (HR 3283) would make a huge range of derivatives reforms almost impossible to enforce by allowing big banks to evade derivatives regulations any time they deal through their foreign subsidiaries. Major banks have hundreds and sometimes thousands of foreign subsidiaries, and currently do more than half of their derivatives business through foreign affiliates. So such evasion would not be difficult. HR 2586, also being presented as a minor clarification, would make it almost impossible to achieve a significant goal of derivatives reform — ensuring fair price competition and full customer transparency in derivatives dealing. Under HR 2586 regulators would be banned from enforcing basic price transparency requirements at new derivatives exchanges. These bills have passed the House Financial Services Committee with some bipartisan support.

Another bill, HR 3336, has already passed the house by a 312-111 vote. Sold as a technical amendment that would assist small business, it would in fact eliminate key oversight rules for banks doing up to $200 billion in interest rate derivatives, global oil companies who do swaps trading, and other big financial players. Two other bills – HR 2779 and HR 2682 – are somewhat less sweeping but still have the potential to create real weaknesses in derivatives oversight. That’s particularly true in the case of HR 2779, which bans any regulation of swaps between affiliated companies.  This legislation has already passed the House with large majorities.

It’s striking that a number of these bills include such sweeping language that as originally drafted  they would have made it difficult to enforce not just new reforms but even pre-2008 prudential regulations on bank activities. This made someone nervous enough that sponsors added ‘reservations of authority’ language stating that key banking regulators such as the Federal Reserve would not be bound by the legislation when enforcing longstanding banking laws. It’s possible that this made some regulators less worried. But of course it leaves in place the damage to new derivatives reforms. If pre-crisis regulation had been sufficient we wouldn’t have needed reform at all.

Opponents of reform hope to pass off these major loopholes as unimportant technical amendments and potentially win large bipartisan majorities in the House. Although House bills passed on a partisan basis receive little attention, the hope is that a bipartisan majority would force attention to these bills in the Senate. But even amended versions of some of these measures would represent a significant setback. Consideration of these bills is also intended to intimidate the regulators as they work to complete derivatives rules. The experts at the regulatory agencies are supposed to work in a non-political environment, but they are now under fierce pressure from industry lobbyists. We’ve already seen cases where industry lobbying severely weakened regulations between the initial proposal and the final rule. A show of force in Congress increases the political pressure.

Fortunately, this is a battle we can win. All that’s necessary to stop this assault in its tracks is for Congressional supporters of reform – as well as the Administration — to hold firm and speak out in support of the common-sense derivatives oversight regime passed in law, and give regulators time to implement it. A bill that passes by a relatively narrow or partisan majority in the House is likely to die unnoticed in the Senate. It’s disturbing to see legislators of both parties, even some who in the past have supported reform, signing on to some of these bills or indicating their willingness to support them with amendments that could leave dangerous provisions still in place. We need legislators to stand up for the public interest, defend the derivatives reforms in Dodd Frank, and to let regulators do their job of implementing them. Join AFR’s mailing list or contact us at info@ourfinancialsecurity.org to learn how you can help.