Emotion Trumps Logic in the Rush to Regulate

After Lehman, Madoff or MF Global, the market is clearly focused on event risk. To listen to the regulatory constituency, the major risks lie in sub-custodian default, CSD (for which read ICSD) comingled banking and securities activities and the unstructured world of non-CCP cleared derivatives.

After Lehman, Madoff or MF Global, the market is clearly focused on event risk. To listen to the regulatory constituency, the major risks lie in sub-custodian default, CSD (for which read ICSD) comingled banking and securities activities and the unstructured world of non-CCP cleared derivatives. To resolve these problems, we have the AIFMD, CSDR and EMIR or Dodd-Frank. How simple it all seems!

Paradoxically, the concerns of the real world are linked, but fundamentally different. There is concern at the ability of CCPs to withstand extreme event risk. There is concern at the potential unintended consequences of the growing demand for capital resulting from regulatory action. And finally, there is trepidation that politics is driving structural and fiscal reform, which could cause Europe to devolve into a domestic backwater in world financial markets.

The CCP question raises more emotion than logical thinking. Complex structures are adopted to ensure that capital, margin money and contingent calls are available to meet the worst of all possible worlds. But they are all based on the assumption that any crisis will be benign and most major firms will survive. A CCP, such as LCH.Clearnet, not only clears U.K. and Euronext equities but is also expected to hold 50% of the $400 trillion global interest rate swap market, a major part of the U.K. bond and repo clearing and other instruments that regulation may push into the central clearing space. And for all of this, they will need a few hundred million of extra capital. That capital will cover new risks, more volatile markets with materially larger values at risk and a more distributed user base. And, at the same time, certain participants will be able to withdraw their collateral from the current mutual margin pool and place them in an apparently insolvency-proof area.

The reality is that CCPs are well structured except for the perfect storm. If we look at worst-case scenarios in my working lifetime, we have seen falls in bond markets of 10% and equities of 20% in a single day. We have seen derivative markets becoming almost totally illiquid. And we have had firms refusing to settle in the market for fear that the DVP process was not sufficiently robust.

Lehman is always cited as proof of the soundness of market structures. The Lehman crisis was incredibly well managed and extreme losses were avoided, but that is not proof that history will repeat itself, with or without the reduction, or elimination, of rehypothecation and other dangerous market practices. Lehman did not cause systemic collapse because of the M&A activity of certain major banks, but that intervention has proved painful for some of the acquirers.

The reality is that a future failure may have systemic implications even if it is not of the scale of a Lehman. Will there be hungry predators next time round? Will regulators step in and support the failing parties? Do central banks or governments have the ability to calm markets without showing the color of their money? And is the bailing out of the financial markets a viable proposition a second time around?

Some of the regulation coming out of Brussels and Washington appears to say no, although it is far from certain how effective their proposed solutions will be. The CCP EMIR or Dodd-Frank enhanced structures are deficient even if they may improve risk for 99.9% of all expected adverse events. The markets, including regulators, have to decide how to tackle the residual risk if ever the margin monies, contingent calls and capital of a CCP prove deficient. Who is the lender of last resort, or how is a levy placed on surviving market participants to compensate for any shortfall in that remote event?

Capital is definitely in short supply in the financial sector. It may well be that the market will recover enough to allow for a further round of capital raising from shareholders and investors. But the only alternative is deleveraging. Shrinking the asset base may not be in line with government policies around the world to unleash a bank loan-fueled economic recovery, but it appears the likely longer-term response to Basel III and other changes. Banks will need more capital for lending, changed capital support for trade receivables, likely capital for indemnified stock lending, and there must soon be a day when intraday risks are brought under the capital allocation umbrella. And we should note that the banking sector merely leads the way to what will occur in other financial institutions. Once again, matching capital to risk is sound; it is no alternative to solid risk management techniques. Unfortunately, though, the perhaps unintended consequences of the avalanche of change we are experiencing all over the world is the replacement of known risks with unknown, or perhaps untested, risks.

And, finally, we have the question of the future of the European offshore banking model. The one in Cyprus looks mortally wounded, if not dead. Other offshore financial centers will undoubtedly come under scrutiny. But Europe will have to decide if it wants a domestic financial market or support international financial centers. Neither the European Parliament nor the EU council of ministers will change the world. Europe is declining in importance relative to the rest of the world, and it is not just the pace of growth in the BRICs that is the driver. Bonus caps are the emotional manifestation of the European banking problem; paradoxically, they will lead to degradation in bank structural robustness as total compensation is unchecked but the bonus component is. The critical issue is not the narrow one of bonuses, but whether the EU operates in tandem with the global marketplace or seeks to be an outrider for change. FTT, short-selling directives and a push for stricter ring-fencing indicate a desire in Europe to lead the way in a financial market change agenda that may end up being quite unique to Europe. And some of the more tortuous and nationalistic reactions to capital support under Basel III suggest that stability may not always be the prime driver. In reality, Europe needs a coherent policy; London has to be part of it. Some countries may find this proposal unpalatable; the danger is that their stance may have unexpected adverse consequences for the cost of borrowing, the availability of funding and the robustness of the region’s savings industry.

Much of the regulation from Brussels and elsewhere is sound. But, it is important to understand the risks of the new world before emasculating the old. I fear we are rushing in with too much emotion and too little sound judgment.