Mirabile Dictu! Regulators Using Trading Scandals to Push for Tougher Capital Requirements

Most news reports on financial regulatory reform hew to a few storylines: banks pushing back in private and winning on diluting regulatory reform; banks attributing lousy profits to new regulations (with a notable lack of proof of this convenient blame-shifting); bank regulators demonstrating capture, corruption and incompetence (which even though true to a fair degree is played up by industry incumbents to support the notion that regulation is futile).

So it’s refreshing to see a contrasting storyline: Regulators threatening to get tough. Whether they will or not is an entirely different matter, but even noising up that they might do something is more pushback than we’ve seen in a while (with Mervyn King and Andrew Haldane of the Bank of England, and Adair Turner of the FSA as notable exceptions; they pushed for a version of Glass Steagall in the UK). And the newest reason is that the recent (more accurately, ongoing) spate of trading scandals had led the authorities to fret that current capital levels don’t make sufficient allowance for operational risk.

The Financial Times article on this new show of regulatory resolve cited the recently-tried UBS trading scandal and the JP Morgan London Whale fiascos as the proximate causes. It’s curious not to see the recent poster child of operational failures, MF Global, included. Admittedly, it’s wasn’t a too-big-to-fail concern, but it had operational breakdown on multiple fronts, including lack of proper controls over cash movements and inadequate intra-day reporting.

I nevertheless found parts of this piece surprising, and not in a good way. For instance:

Regulators are particularly concerned that banks may not have enough capital to cover losses from operational risk and may not be doing enough to tackle potential problems when many are slashing back-office staff and technology expenditure….

Technology and infrastructure issues are critical, including business continuity, outsourcing and data protection, people and conduct problems as well as mis-selling and other product-related problems.

As a rule of thumb, roughly 50 to 75 per cent of a big bank’s capital requirements stem from credit risk, 10 to 20 per cent from operational risk and the rest from trading. Regulators are already rethinking the capital rules for credit and trading, and operational risk is next on the agenda.

Aiee. Whatever confidence I had in this effort was seriously diminished with this attempt to quantify various aspects of capital requirements. Were it not for the tender ministrations of Timothy Geithner, Bank of America would be dead from legal liability on mortgage backed securities. Yet you see the sources for the FT article studiously avoiding even acknowledging legal issues as a potential bank-killer, particularly fraud. Instead, it’s at most “mis-selling” as opposed to behavior located somewhere on the spectrum of “lousy controls” to “outright, orchestrated predatory practices”.

And where is interest rate risk? Oh, it’s not an immediate risk, but given the tendency of generals to fight the last war, the fixation with credit risk looks to be leaving the other bank nemesis, credit risk, by the wayside. Calling it “trading risk” is wrongheaded. The banking industry is structurally long; there’re aren’t enough credible counterparties for them to flatten their positions or go net short when interest rates start to rise (ex government bailouts, of course, but the new regime is supposed to make those a thing of the past). Remember, an unexpected quarter point increase in the Fed funds rate in 1994 created a bigger destruction of value than the 1987 crash. Among other things, necessitated a stealth bailout of US firms via a rescue of the Mexican government (interest rate moves lead to currency adjustments, and the FX price change whacked Mexican banks, see Frank Partnoy’s book Fiasco for a great explanation of what transpired).

One bit of hope here is the current approach to operational risk is apparently so bad that any change is likely to be an improvement:

Tim Thompson, a Deloitte partner, said the industry could benefit. The existing approach to calculating operational risk “has the twin drawbacks of being complex while providing few incentives for better risk management and stronger controls.

“This review provides the Basel committee with a real opportunity to improve on the status quo,” he said.

Sadly, this closing bit reads as if regulators are unwilling to make assessments and intervene, and are instead going to use metrics, which lend themselves to gaming. As we’ve said before, the solution is ultimately to require backstopped firms to be much simpler so that (among other things) they can be properly supervised. But things will likely have to get worse before anyone in a position of power is willing to demand a banking regime change.