Understanding Obama’s Financial Overhaul

Also published on the Atlantic Monthly’s Business Channel.

Joe Nocera has said his peace with respect to Obama’s proposed overhaul of the financial system. And in doing so, he expressed disappointment with several aspects of the proposal. In particular, he is displeased that the proposal “doesn’t attempt to diminish the use of … bespoke derivatives.” That certainly sounds ominous. But it’s also not true.

The proposal calls for increased capital charges on bespoke trades, which is a strong incentive away from them. But frankly, I’m sick of writing about the proposal. So rather than regurgitate and parse the administration’s plans for financial regulation, I’d like to take a moment to get familiar with some of the key concepts at play in the proposal, so that you can read it and come to your own conclusions. The two core areas I focus on here are derivatives and regulatory capital. With an understanding of these two areas, you should be able to get a grasp on what the administration is thinking and what effects the proposal will have in practice.

OTC Derivatives

I write about OTC derivatives pretty often, so rather than reinvent the wheel, I’ll shamelessly reuse a piece of introductory text I have handy:

A derivative is a contract that derives its value by reference to “something else.” That something else can be pretty much anything that can be objectively observed and measured. That said, when people talk about derivatives, the “something else” is usually an index, rate, or security. For example, an option to purchase common stock is a fairly well-known and ubiquitous derivative. So are futures for commodities such as pork belly and oil. However, these are not the kind of derivatives that [the proposal] is talking about. [The proposal] is talking about OTC derivatives, or “over the counter” derivatives. This category of derivatives includes the much maligned “credit default swap” market, as well as other larger but apparently less notorious markets, such as the interest rate and foreign exchange derivatives markets. The key defining characteristic of an OTC derivative is that it is entered into directly between the parties. This is in contrast to exchange-traded derivatives, such as options to purchase common stock. Highly bespoke OTC derivatives are often negotiated at length between the parties and involve a great deal of collaboration between bankers, lawyers, and other consultants. For other, more standardized OTC contracts, commonly referred to as “plain vanilla trades”, contracts can be entered into on a much more rapid and informal basis, e.g., via email.

For the limited purpose of wrapping your head around the world of derivatives, think of all derivatives as being in one of three broad categories: (1) exchange-traded derivatives (e.g., options on common stock and futures on pork belly); (2) standardized OTC contracts (e.g., your basic credit default swap); and (3) bespoke OTC contracts (transaction specific, often more complex instruments).

In fairness to Nocera, he’s not the only one weary of the third category of bespoke derivatives. But that doesn’t make his fears justified. So why do firms use custom made derivatives instead of just settling for an exchange traded derivative or a standardized swap? Despite uninformed opinions to the contrary, there are a lot of legitimate reasons for using custom derivatives. The most basic reason is what’s known as basis risk. The term refers to the risk that the difference between two rates will change. In the context of OTC derivatives, it usually refers to the risk that a hedge is imperfect. For example, a commodity user, like an airline, would like to lock in the price of jet fuel delivered to a terminal near an airport in northern California. However, the only exchange traded futures contracts available track the price of delivery to the Gulf Coast.  While we would expect these two rates – the price of delivery to CA and the price of delivery to the Gulf Coast – to be correlated, there are all kinds of events, e.g., supply disruptions, that can affect one price without affecting the other. As such, using an exchange traded future would expose the airline to basis risk. By using a customized product, the airline can more perfectly hedge its exposure to the price of local fuel.

At this point, most of the bozo pundits would say, “just move all the customized trades onto an exchange!” That’s a fine idea, but it has the unfortunate feature of being impossible. In order to have an exchange, you need a lot of liquidity, or simply put, a lot of people trading perfectly fungible assets. The reason you need perfectly fungible assets is that it allows buyers and sellers to be matched on a rapid basis without any communication between them.  Without a lot of people trading perfectly fungible assets, you don’t have a market where you can easily buy a new position or sell your current position, and therefore, you cannot have an exchange. Because bespoke derivatives are often one-off deals, hedging extremely specific risks, there is no market where they can be traded, for the simple reason that they are all unique and only useful to the parties to the original transaction. And so, bespoke derivatives are useful products that cannot always be substituted with exchange traded or standardized OTC products.

What Is Regulatory Capital?

There’s a lot of talk about regulatory capital in Obama’s proposal. So what is regulatory capital? In short, it has to do with how banks finance their operations. Banks are businesses. And like all businesses, they have investors that contribute money to the business. In the parlance of banking regulation, the money that investors contribute is called capital.  This capital can come in various forms, despite the fact that it’s all cash. The form of the capital is determined by what the investor expects in return for his capital contribution. For example, equity capital comes from investors who expect to share in the profits of the bank. That is, after all of the bank’s expenses and debts are paid, the equity investors get their share of what, if anything, is left over. Capital could also come in the form of debt. The bank’s debt investors, commonly referred to as creditors, expect regular payments in return for their investment, regardless of whether or not the bank generates a profit. As such, they get paid before any of the equity investors get paid. Because of this, we say that debt is higher in the capital structure of a bank than equity. But of course, life is a lot more complicated than simple debt and equity. And so, banks make use of a broad range of financing that falls in different places along a continuum from pure senior debt (the top of the capital structure) to pure subordinated equity. As money gets generated by the bank’s activities, that money gets pushed down the bank’s capital structure, paying investors off in order of seniority.

In the magical world of academia, capital structure isn’t supposed to matter much. But as Michael Milken reminds us, in the real world, capital structure matters, a lot. Firms that finance their activities with a lot of debt will have high fixed obligations, since creditors don’t care if you make a profit or not. They invested on terms that assured them payment, come hell or high water. And while they might not be as intimidating as the Goodfellas, creditors have a lot of power over firms that fail to pay their debts. These powers range from seizing assets pledged as collateral to forcing bankruptcy upon the firm. Obviously, these kinds of events are disruptive to a firm’s business activities. And as this crisis has taught us, the business activities of banks are pretty important. Fully aware of this, the world developed what are known as regulatory capital requirements. What these requirements do is place restrictions on the capital structure of banks based on the riskiness of the bank’s activities. As you would expect, the rules that implement these restrictions are very complicated. But the general idea is fairly intuitive: as the riskiness of the bank’s activities increases, the bulk of the bank’s financing should move down the capital structure, towards equity. This makes sense, since a bank that is running a high risk operation shouldn’t be promising too many people regular income, since by definition, their cash flows are unstable. As such, a high risk bank should make greater use of equity, since equity investors only expect their share of the profits, if and when they appear.

Most of the developed world has adopted some version of the bank capital regulations known as the Basel Accords, written by the Bank For International Settlements. Under the Basel rules, assets are assigned a weight, which is determined by the asset’s riskiness. “No risk” assets, such as short term U.S. Treasuries, are assigned a weight of 0%. High risk assets can have weights over 100%. The rules then look to the capital of the bank and break it up into three Tiers: Tier 1, Tier 2, and Tier 3. Tier 1 is comprised of pure equity and retained earnings, the absolute bottom of the capital structure; Tier 2 is comprised of financing that’s almost equity, or just above Tier 1 in the capital structure; and Tier 3 is comprised of short term subordinated debt, or the lowest part of the capital structure that can be fairly characterized as debt. Anything above Tier 3 doesn’t count as capital for the purposes of the rules.

When a bank buys an asset, they are generally required to assign a capital charge to that asset equal to 8% of the value of the asset multiplied by its risk weight. Half of the capital they set aside must come from Tier 1. So for a $100 loan with a risk weight of 50%, the bank that issued or bought the loan would need to set aside 8% x 50% x $100 = 8% x $50 = $4 worth of regulatory capital, at least half of which must come from Tier 1.

So regulatory capital requirements are a matching game between a firm’s assets and its capital structure. The more capital a firm has to set aside to purchase an asset, the fewer assets it can purchase. This means that heightened regulatory capital requirements will restrict a firm’s ability to generate returns on its capital. Well aware of this, Obama’s proposal uses regulatory capital as a tool to push firms away from certain practices. For example, as mentioned above, the proposal calls for increasing the capital charge for bespoke trades. It also threatens firms that are “too big to fail” with the spectre of overall heightened capital requirements. While Nocera thinks this is an empty threat, not everyone is so confident. But in any case, go read it yourself, at least the summary, and come to your own conclusions.

Could Government Intervention Help Markets Function Better

Also published on the Atlantic Monthly’s Business Channel.

If free markets never fail, there’s no inherent need for government intervention, though we might object to the resultant wealth distribution on moralistic grounds. But if markets do occasionally fail, then it’s possible that government intervention could be used to realign incentives, and “nudge” the market to a higher order equilibrium.

View From An Ivory Tower

Neoclassical economists believe that only a few types of market failures are possible, no matter how often reality disagrees. In particular, neoclassical economists reject the idea that coordination failures can occur. A coordination failure can be roughly described as a scenario where each individual in a group acts in a way that maximizes its own expected outcome, but by doing so fails to maximize the expected outcome of the group. You might ask, how is it possible for everyone to do their best and still reach an outcome that is inferior to some other outcome? The answer is: a failure to coordinate. That is, just because everyone does their best individually does not imply that the group as a whole will do its best collectively. This is a very simple concept with a lot of intuitive appeal. Yet, neoclassical economists reject coordination failures as a possibility, since they argue that if it is profitable for coordination to occur, it will. That also has a lot of intuitive appeal, which is why that theory stuck around for so long. But neoclassical theory doesn’t describe the world we live in, which is filled with crooks, liars, and idiots. It describes an idealized world where people can overcome their short-term expectations and desires, collaborating whenever it’s profitable, inadvertently advancing the greater, long-term common good.

About As Far As I Can Throw You

There are a variety of real world scenarios where a failure to coordinate can occur. The most basic example is when the parties simply don’t trust each other. For example, I would rather pay you to paint my house than paint it myself; and you would rather be paid cash for painting my house than sit around all day. But what I would prefer most of all is to have my house painted for free; and what you would prefer most of all is to get paid for doing nothing. That said, both of us could be better off than we currently are if I paid you to paint my house. However, one of us has to take the risk that the other won’t perform. That is, I pay you today and you take the money and run; or you paint my house today and I tell you to piss off when you’re done. If either of us expects that the other will not perform, we will not coordinate.

Free market zealots would argue that reputation alone is sufficient to solve this problem. That is, if either of us fails to perform, we will have a bad reputation, and in the future others will not trust us. That would probably work in a tiny village where everyone knows everyone else, travel is infrequent, and therefore reputations are easy to track. But in the developed world, it’s impractical and creates a fantastic opportunity for those willing to move around a lot pretending to be a painter. Moreover, even if it were practical, any system based on reputation alone would favor incumbents and make it very difficult for new entrants to compete, since no one wants to be the first to find out that their painter is actually a career swindler. So what’s the solution? Enforceable contracts. That is, the government, which has all kinds of power over its citizens, can force you to perform under your agreements. In this respect, the existence of government solves a basic coordination problem by supplanting bilateral trust. But this mechanism doesn’t completely eliminate the issue of trust, it just substitutes the mutual trust of the parties with their trust in the government. That is, I will trust that my contract is valid and enforceable insofar as I believe in the government’s ability and willingness to enforce it. This whole government substitution process can be viewed as a variation on the reputation game. But in the context of governments enforcing contracts, keeping track of reputation becomes practical, since it’s fairly easy to keep track of the enforcement records of a handful of governments. As such, enforcing contracts is, in my opinion, a necessary form of government intervention into otherwise free markets.

Better Than Worse

I am more than willing to concede that the market, when left to its own devices, could arrive at an equilibrium that is suboptimal. That is, the aggregate effect of market participants making (hopefully) rational decisions does not necessarily produce the best possible outcome. Again, neoclassical economists reject this since they view price as the only element required to properly coordinate market participants. But as I’ve argued in the past, and as recent events suggest, prices are also affected by coordination failures. So what’s the solution? Here’s the classic law school answer: it depends.

There are some obvious examples where the disparate bargaining power and levels of sophistication between parties warrant regulation to prevent unsophisticated parties from getting screwed or even physically injured by extremely sophisticated parties, even if the former are not technically mislead. That said, when sophisticated parties are dealing with other sophisticated parties, the case for regulation is much weaker. And it’s not because sophisticated parties know everything. It’s because they probably know more than the government, and have a lot more to lose, since governments have control over entities which they do not own (insert joke here), and therefore they can act upon those entities without bearing any direct financial consequences that spring from their actions. Moreover, there’s no reason to think that regulators and legislators aren’t subject to the same incentive quagmires that occur in markets.

Even if regulation is well intentioned, the risks of getting regulation wrong are enormous. Literal compliance with the letter of the law allows market participants to wash their hands of any other actions, and creates a false sense of security in their counterparties. For example, the popular wisdom seems to be that this crisis was caused in large part by the deregulation of the financial sector that occurred under the Clinton administration. That argument has one thing going for it that is impossible to refute: the crisis occurred after the Clinton administration left office. But this position ignores the possibility that this crisis wasn’t the product of an absence of regulation, but rather the omnipresence of poor regulation. For all the talk of systemic risk, very little emphasis is being placed on the fact that the regulatory regime in place prior to the crisis – and still in place now – gave rating agencies systemic influence. Because ratings were woven into almost every aspect of the regulatory regime, particularly those that determined whether a bank has adequate capital, any errors in those ratings would have systemic consequences. And it seems that they did. The Atlantic’s own Dr. Manhattan has already done a fine job exploring that subject, so I’ll spare the world my opinions on the matter.

So what’s the take-away? It depends. As a general matter, I’m opposed to the idea of governments having an active role in markets, particularly setting prices. But then again, if it weren’t for the FED, I’d be hunting deer on Park Avenue instead of writing this article. So like I said, it depends.