.
August 26, 2012 7:10 pm
We need much simpler rules to rein in the banks
Congress, lobbyists and editorial writers have been engaged in an intense debate over how to provide effective governance for the US banking system in the wake of the 2008 financial crisis and, more recently, JPMorgan Chase’s billion-dollar derivatives losses. It is a complex subject and, not surprisingly, the language has been at times as opaque as the derivatives themselves – and the inability of the public to understand the system is contributing to a decline in trust and confidence. I believe the real solution lies in formulating a simpler, not a more complex, set of regulations.
Begin with the reality that banks’ operations are vastly different now than they were even 10 years ago. The days when a large multinational bank could borrow money from depositors – backed by a government insurance guarantee – and then lend it out to customers at a reasonable spread are gone, at least as their main source of revenues. With net margins squeezed, banks have had to reach for profits in increasingly esoteric areas, such as derivatives trading, which rely on complicated computer models and mathematical algorithms few people understand.
Most of these activities boost profits by cranking up leverage, which the banks feel comfortable using because of confidence in their computer models. As this is a highly complex process, in turn, the regulatory oversight must grow in complexity simultaneously.
.
Consider that despite more than a year of effort the standards for implementing the so-called Volcker rule, intended simply to prevent banks from engaging in proprietary trading, have become exceedingly complex and have yet to be finalised. (Paul Volcker’s original idea is a prudent step that I support.)
This computer modelling is impressive stuff. However, while these models create the appearance of mathematical certainty about the relationships between markets and the way world events will affect prices, it is essential to recognise that, at their root, these models rely on man-made assumptions about human behaviour – not iron-bound laws of nature.
.
In addition, the behaviour of derivative markets can be episodic and illiquid at precisely the times we most need greater liquidity and confidence. No matter how sophisticated the maths or how large the data base supporting a model, no one can predict behaviour – human or market – with certainty. Inevitably, this means the formulas break down at the most critical times.
.
I have no reason to doubt the managerial capabilities at JPMorgan Chase, but given the nature of the bank’s recent trades, and the models on which they relied, we should understand that those same highly leveraged, highly complex positions might, with some shift in the assumptions embedded within them, have produced no loss, or one even larger than the $5.8bn recently reported, or even a big profit. None of those results would have threatened the bank’s viability, but stepping back and looking at these divergent possibilities, should the public be asked to understand and give its seal of approval to such a complex system? After all, these multibillion-dollar transactions encoded in high statistical theory are a distant science to most of us.
.
Certainly, the complexity of the models behind the trading makes it exceptionally difficult for the regulators to have benchmarks that allow them to make their own independent – and different – assessments of the risks. The regulators themselves may have an alternative view of the underlying assumptions in the derivatives.
.
This is why regulation should shift to simplicity, not add more complexity. We took this approach when I was Treasury secretary confronting the Latin American debt crisis, by adopting a flat rule: the solution to too much debt is not more debt. We forced ourselves to think only of ways to reduce leverage, not increase it, and the so-called Brady plan brought about an actual reduction in debt and interest rates. Today, we need to reduce the complexity of the regulations rather than add more layers.
.
Regulators need a clear “bright line” that they can apply to bank activities. The aim should be to permit innovation, and prudent risk taking, while also creating less varied and complex boundaries that banks cannot cross and that everyone can understand. The new simplicity should establish a clear ability to determine when to say yes, and when to say no; and the meaning of “no” should be unambiguous.
The debate should shift to focus on the total leverage permitted in the bank’s books – that is the “bright line”. Banks should be permitted to devise their own strategies and use trading as they see fit, but they should be restricted from taking positions that use leverage of more than “X-to-1”. That may limit the upside of their operations, but at the same time it will limit the downside for taxpayers. It also puts responsibility for operational decisions where they belong, in the hands of the bankers themselves. What should be the boundary? Will it take additional time to design? Yes, but it will be worth it. For a change the public will both understand and agree with it.
.
The writer, a former US Treasury secretary, is chairman of Darby Overseas Investments and a principal of Holowesko Partners
.
Begin with the reality that banks’ operations are vastly different now than they were even 10 years ago. The days when a large multinational bank could borrow money from depositors – backed by a government insurance guarantee – and then lend it out to customers at a reasonable spread are gone, at least as their main source of revenues. With net margins squeezed, banks have had to reach for profits in increasingly esoteric areas, such as derivatives trading, which rely on complicated computer models and mathematical algorithms few people understand.
Most of these activities boost profits by cranking up leverage, which the banks feel comfortable using because of confidence in their computer models. As this is a highly complex process, in turn, the regulatory oversight must grow in complexity simultaneously.
.
Consider that despite more than a year of effort the standards for implementing the so-called Volcker rule, intended simply to prevent banks from engaging in proprietary trading, have become exceedingly complex and have yet to be finalised. (Paul Volcker’s original idea is a prudent step that I support.)
This computer modelling is impressive stuff. However, while these models create the appearance of mathematical certainty about the relationships between markets and the way world events will affect prices, it is essential to recognise that, at their root, these models rely on man-made assumptions about human behaviour – not iron-bound laws of nature.
.
In addition, the behaviour of derivative markets can be episodic and illiquid at precisely the times we most need greater liquidity and confidence. No matter how sophisticated the maths or how large the data base supporting a model, no one can predict behaviour – human or market – with certainty. Inevitably, this means the formulas break down at the most critical times.
.
I have no reason to doubt the managerial capabilities at JPMorgan Chase, but given the nature of the bank’s recent trades, and the models on which they relied, we should understand that those same highly leveraged, highly complex positions might, with some shift in the assumptions embedded within them, have produced no loss, or one even larger than the $5.8bn recently reported, or even a big profit. None of those results would have threatened the bank’s viability, but stepping back and looking at these divergent possibilities, should the public be asked to understand and give its seal of approval to such a complex system? After all, these multibillion-dollar transactions encoded in high statistical theory are a distant science to most of us.
.
Certainly, the complexity of the models behind the trading makes it exceptionally difficult for the regulators to have benchmarks that allow them to make their own independent – and different – assessments of the risks. The regulators themselves may have an alternative view of the underlying assumptions in the derivatives.
.
This is why regulation should shift to simplicity, not add more complexity. We took this approach when I was Treasury secretary confronting the Latin American debt crisis, by adopting a flat rule: the solution to too much debt is not more debt. We forced ourselves to think only of ways to reduce leverage, not increase it, and the so-called Brady plan brought about an actual reduction in debt and interest rates. Today, we need to reduce the complexity of the regulations rather than add more layers.
.
Regulators need a clear “bright line” that they can apply to bank activities. The aim should be to permit innovation, and prudent risk taking, while also creating less varied and complex boundaries that banks cannot cross and that everyone can understand. The new simplicity should establish a clear ability to determine when to say yes, and when to say no; and the meaning of “no” should be unambiguous.
The debate should shift to focus on the total leverage permitted in the bank’s books – that is the “bright line”. Banks should be permitted to devise their own strategies and use trading as they see fit, but they should be restricted from taking positions that use leverage of more than “X-to-1”. That may limit the upside of their operations, but at the same time it will limit the downside for taxpayers. It also puts responsibility for operational decisions where they belong, in the hands of the bankers themselves. What should be the boundary? Will it take additional time to design? Yes, but it will be worth it. For a change the public will both understand and agree with it.
.
The writer, a former US Treasury secretary, is chairman of Darby Overseas Investments and a principal of Holowesko Partners
.
Copyright The Financial Times Limited 2012.
0 comments:
Publicar un comentario