Why the Basel 3 Leverage Rule is ridiculous

Once upon a time there was a financial crisis. This caused much havoc in the world and it was agreed it would be advantageous not to have one again. So a bunch of people dissected the causes of the crisis and decided that these evil institutions called banks had been doing lots of terrible things. One of the things they had been doing was buying lots of assets and writing lots of derivative contracts which exposed them to potential future losses without having sufficient equity so that if losses occurred the banks wouldn’t go bankrupt. This was actually unexpected. 30 years earlier regulators had written a bunch of of complex rules to protect against exactly this eventuality. What had gone wrong? Banks found lots of clever ways to circumvent these rules.

So after the financial crisis, regulators came up with a solution – we’ll not just have a new and improved update of the complex rule-set from before, we’ll also have a really simple simultaneous leverage rule. This way, even if banks try to be naughty, they will always have enough equity to stay safe. We even know what the leverage ratio should be: it’s 3%!

And herein the problems start.

Problem 1. Why 3%? Why not 2%? Or 4%? Or even 5%? Usually when assessing the right amount of insurance someone needs, people talk about insuring against a 1 in a something year event. Buildings in San Francisco designed to withstand in a 1 in a 1000 year earthquake, flood defenses designed to withstand a 1 in 500 year flood. What event is a “3%” leverage ratio designed to defend against? A 1 in 500 year banking failure? A 1 in 100 year event? A 1 in 10 year crisis?

This leads me on to my second big issue. Regulators decided what the prudent leverage ratio is before they had even defined leverage. When banks used to do simple stuff like loan businesses money to buy machines, and loan people money to buy houses this was a simple calculation. You took the bank’s equity, totted up all the loans the bank had made to get its assets, divided the former by the latter and hey presto! You have a leverage ratio. Unfortunately, banks don’t operate like that anymore, because this thing called the repo market and the these other things called derivatives appeared and really messed up the whole totting up of assets bit.

So problem 2.  Netting of matched repos, and netting of market-to-market paid for derivatives. To better explain, a bit of technical description is necessary. Imagine Bank A owes Bank B $100 for contract 1 and Bank B owes Bank A $80 for contract 2. Bank B says to Bank A you owe me $100 and I owe you $80 so lets say that net you owe me $20. All is fine until Bank A goes bankrupt. Bank A’s administrator now says to Bank B “you know that agreement you had with Bank A about netting money you owed each other? It’s not legally binding. I will collect your $100 and you can get some small percentage of your $80 some years down the line after a bunch of messy bankruptcy proceedings”. Bank A, instead of losing the $20 he was expecting, is now $100 dollars down.  What does this mean for the leverage ratio? Bank B should recognise the full $100 Bank A owes it as an asset.

Except it’s not that clear. Banks recognised this issue and think they have a solution. They went away with their lawyers and drew up a whole bunch of new fancy contracts that mean that this time they really well be able to net the $80 from the $100. So in the future, at default, administrators will only be able to claim for $20. So whether or not you should allow netting of contracts is actually quite a complicated question.  Your favoured treatment depending on how much you believe lawyer’s opinions today will stand up in the bankruptcy courts of tomorrow.*

Going back to the question at hand – what does this mean for the calculation of the leverage ratio? Well, a lot actually. Just looking at derivatives contracts, if you didn’t allow netting of the sums Banks owe to each other for gains and losses, JP Morgan’s reported balance sheet would be $3.7tn rather than $2.4tn – or a whopping 50% bigger**!

But that’s not even the point. The point is, at the start, you go around and you agree with all the banks how to calculate leverage ratios and what to do about repo and derivative netting etc AND THEN you say OK then the leverage ratio will be X. This way if you decide netting is fine maybe you have your leverage ratio at 4 or 5%. On the contrary if everyone decides netting isn’t fine than you have a lower leverage ratio of 3%. What you DON’T DO is declare what your leverage ratio is, give everyone an idea of how you are going calculate it and then spend the next year watching banks, lawyers and everyone else pick holes in your methodology.

The final issue I have with the leverage ratio*** is with the assumption ‘it can’t be gamed’. Again a little more explanation is needed. The problem with derivatives from a “let’s try and make simple regulatory rules” point of view is that they are what as known as ‘unfunded’. This means that I can enter into a derivative with someone else today and it costs me nothing****. So the new balance sheet entry is nothing. However, tomorrow that derivative can lose you $100. But if you lose $100 where do you get the money from to cover those losses?

Regulators have realised this is an issue. Losing $100 dollars and not setting aside a nice lump of equity to cover those potential losses is clearly not acceptable. The question is how much equity should you set aside? You could go and create a really fancy model of potential losses that factor in the volatility of the contract, the creditworthiness of the counterparty and a whole bunch of other stuff, but derivatives are complex and that would pretty much be relying on doing the same kind of things we’re trying to avoid in the first place. Alternatively you could have a nice simple model that says your derivative is of this type and you will therefore need to set this amount of equity aside. This has the benefit that everyone can understand it***** and it can’t be gamed. Except it can. The problem with simple models is that banks can look at your model and say, how can we design the riskiest thing possible that your model says is safe? 

So a substantial part of your total asset base******, the denominator in your leverage ratio calculation, can be gamed! The thing you were trying not to do in the first place.

So what’s the morale of this long and winding story?
Firstly, if you’re deciding how much insurance you need, ask yourself first, what am I insuring against?
Secondly, if you’re deciding how much to pay for that insurance, first of all agree with the insurance covers.
And thirdly, if someone says they have a method for calculating capital requirements that is simple and can’t be gamed – they are a liar!

*Accountants also disagree on this question. American US GAAP thinks assets should be reported on a ‘Gross’ basis, whereas in Europe IFRS looks at derivative mark-to-market net.

** Source: http://www.fdic.gov/about/learn/board/hoenig/capitalizationratios.pdf Also basel actually calculates leverage in a slightly different way than accountants but the underlying change is likely to be of the correct magnitude. Banks also

*** I have others but they are less important.

**** This isn’t completely true since I may have to post collateral or margin etc but for some derivative counterparties trading OTC derivatives, particularly before the financial crisis this was the case.

***** If you are fairly technical person and have a decent understanding of derivatives pricing.

******This is exactly what happened pre financial crisis. Loans and bonds and other financial assets were put into buckets depending on how risky rating agencies thought they were. Banks were then told to set aside a fixed amount of equity for that loan / bond / financial asset depending on the bucket it was in. So what did banks do? They bought all the riskiest loans that just about managed to fit in the non risky bucket.

******* Barclays estimates around 20%. Look under PFE add-ons. Any estimates are currently subject to change. Not least because the entire standardised model used to calculate derivative exposures is being changed, and the new one is currently going through Basel’s rigorous testing and consultation program. http://group.barclays.com/Satellite?blobcol=urldata&blobheader=application%2Fpdf&blobheadername1=Content-Disposition&blobheadername2=MDT-Type&blobheadervalue1=inline%3B+filename%3DBarclays-PLC-Announces-Leverage-Plan-PDF.pdf&blobheadervalue2=abinary%3B+charset%3DUTF-8&blobkey=id&blobtable=MungoBlobs&blobwhere=1330701423014&ssbinary=true
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Gold. Just another financial house of cards.

                No other asset holds the same magical allure as gold. The yellow metal is seen as the ultimate in last resort insurance, the go- to guy in times of financial uncertainty, the saviour of the investor bedevilled by fears of inflation. Yet what makes gold valuable is no different to what gave the Zimbabwean dollar value in the years before hyperinflation; confidence.

                Gold, unlike many other financial assets does not provide a yield. The only return available from holding gold is that in the future someone else is willing to purchase gold from you at a higher price than you paid for it. There can be no change in the ‘fundamental value’ of gold. You cannot build a model that says: the fundamental price of gold is X. You cannot take the view (like you could with other commodities) that demand for the use of gold will be higher in the future that is today, or that the supply of gold is likely to diminish. All you can do is take a view on an expectation that the price of gold in the future will be higher than it is today.

Gold is a bet on the possibility that fiat currency will lose its ability to continue to fulfil the functions of money. Gold has a number of characteristics that enhance its attractiveness as an agent for making this bet. Firstly, Gold is scarce. It is unlikely that in the future discoveries of copious new reserves are going to flood the world with abundant quantities of the precious metal. Secondly, historically, before the invention of fiat currency, people used gold as money, so if fiat currency failed, it seems an obvious candidate to replace it. Thirdly, related to these two prior beliefs, an investment in Gold relies on the belief that it will hold its value relative to other real goods and services (or hold its value better than alternative assets). Above all, your investment in gold relies on a confidence that the rest of the market will continue to see gold in the same way. If fears over the continued of scarcity of gold led investors to turn to say platinum as the new reserve asset, the price of gold may drop precipitously and your confidence in gold may have been misplaced.   

                This is not to say gold is a poor investment, or that I expect it to relinquish its place at the zenith of every doomsday merchant’s favourite asset. Just that in my opinion gold does not deserve the semi-religious fervour it seems to hold for many of its investors. Gold is susceptible to the same dangers, the same bubbles, the same black swans as any other asset class. 

A little explanation

Flittering through the financial blogosphere, watching the news, listening to comments I am always struck at the strength of opinion people have with regards to their view on economics. From academics, to economic journalists to the casual observer the one common theme they have about their views on economics is most seem to believe they are absolutely right. They present their opinions as indelible fact and dismiss criticism of their views as the stupidity of ignoramuses or, for the high brow economic commentator, the unwavering rants of an ideologue. Yet by their very nature many of the theories are contradictory or mutually exclusive and as the old saying goes “they can’t all be right”. 

Surely as a profession Economists should be able to agree on the impact of austerity on the performance of economies, or whether or not QE is inflationary or even whether QE is even ‘money printing’. After all, the arguments (and their theoretical basis) are the same arguments that have existed for decades. Discussions of fiscal vs monetary policy as the most effective lever for improving economic growth was rife in the aftermath of the Great Depressions 80 years ago. Yet despite all this time, after all the academic careers, data points collected and analysis conducted we still seem to be no closer on reaching a true consensus on some of the most fundamental questions about macro economics. No matter your view point there will be some academic somewhere (though probably a whole school of academics) who can write you out a complex thesis about why your view is correct, and can cite a vast body of empirical literature that will no doubt provide the experimental evidence to substantiate your claims.

I admit that inertia to change can be strong, the world is full of ideologues – history is littered with people railing against the wall of institutional indifference only to be proven right. It could be the case that one of these world views is absolutely right, and the rest of us are just in denial unwittingly counting down the days until the undeniable, unquestionable evidence of the truth comes forth to sweep away our prejudices. However, I doubt this is the case. 

Economics has pretensions as a science. Like Physics or Chemistry or Biology it is an endeavour in trying to understand and explain the world around us and for the most part, like the physical sciences or Biology, it starts with observations about our environment. Then based on these observations people come up with theories that try to explain these observations. Finally, people go away and carry out experiments that hopefully disprove some of these theories leaving one left that so accurately describes the evidence it is generally considered to be fact. One thousand years ago people observed the sun appeared in the sky every  morning, and watched it disappear in the evening. They came up with a theory to explain this – that the sun moved around the earth. A little while later some other chap named Galileo came up with an alternative theory that the earth actually moved around the sun. Both theories explained the observation of the sun moving around the earth, however it was only after experimentation was Galileo able to come up with the proof beyond reasonable doubt that his theory was in fact correct.

Economics as a profession is very good at the first two parts of science. There are large numbers of theories that are used to explain a vast array of observations, and yet a dearth of conclusive evidence that establishes the dominance of one theory of another. If all these empirical papers are so convincing in proving the supremacy of a theory, why has the body of economic science not rallied around it?

So what’s the point of all this waffle? That as much as people would like to argue that they are right and that the failure of others to understand their point is a failure to recognise the truth – they are wrong. Their is no absolute truth in Economics. Just theories and opinions. That is not to say that we won’t be able to (largely) disprove a few of the more extreme theories along the way, the separation of North and South Korea is about a good as you’re going to get as an experiment that established the failure of an economic paradigm (communism) as a successful way to organise economic activities, but it does mean that the day when we can accurately forecast the performance of, even a small economy, or that we can be certain that the outcome of any one economic policy decision will be the right one, is still a very long way off. So maybe people writing on your message board, or disagreeing with your view, are ideologues, but if you deny their view and blindly dismiss their opinion, than so, my friend, are you.