Known Unknowns

[Edward Ferrars and Elinor Dashwood are baiting Margaret Dashwood, who is hiding]

Edward: “Oh... Miss Dashwood. Forgive me. Do you by any chance have such a thing as a reliable atlas?”
Elinor: “I believe so.”
Edward: “Excellent. I wish to check the position of the Nile. My sister tells me it is in South America.”
Margaret: [out of sight; laughs]
Elinor: “Oh. No. No, um... she’s quite wrong. Um... for I believe it is in Belgium.”
Edward: “Belgium? Surely not. I... I think you must be thinking of the Volga.”
Margaret: [still out of sight; appalled] “The Volga?!”
Elinor: “Of course, the Volga. Which, as you know, starts in...”
Edward: “Vladivostock, and ends in...”
Elinor: “Wimbledon.”
Edward: “Precisely. Where the coffee beans come from.”
Margaret: [revealing herself] “Ah! The source of the Nile is in Abyssinia!”
Edward: “Is it? How interesting.”

— Sense and Sensibility (1995)

It is a heartening feature of the internet that one can often determine the truth about a subject by asking for the input and advice of experts, who upon application will usually contribute their knowledge freely. In my experience, it is an even more effective method to adopt a strong and firmly argued position upon a topic you know very little about. This will flush out even more experts, who will dismantle your faulty reasoning and expose your flimsy command of the facts with fierce glee or kind patience, depending on how charitably they view your ignorance and presumption.

My recent post on the current state of counterparty credit risk in the global financial system has already elicited two excellent reponses, and I am reliably assured that more are coming. The first of these was submitted to me by email, by a mysterious personage (let us call him or her “X”) who appears to be even more skittish about his or her real identity than Yours Truly, which is saying something. X’s first messages to me assumed a higher level of knowledge on my part than I possess, and X declined to let me disseminate his or her thoughts for reasons of security. Fortunately, after X read my babbling here and discovered exactly how ignorant I am about the day-to-day finance and operations of large trading banks, he or she took pity on me and sent new material fit for publication.

I now quote M/Mme/Mlle X at length, for your education as well:

Let’s look at the example of Bank A hedging some exposure by trading with Bank B. Let’s say

(1) Bank A has bought $100mm of CDS from Bank B,
(2) The CDS is currently worth 65 points (i.e. the $100mm notional contract is worth $65mm),
(3) Bank B has posted $60mm of collateral to Bank A.

What is Bank A’s direct exposure to Bank B? I would argue that the correct number is $5mm. If Bank B were to default and have 0 recovery, Bank A would post an immediate loss of $5mm, since Bank A already has the $60mm in collateral.

The point is that direct counterparty risk only exists on the uncollateralized portion of any exposure. One term for this is “gap risk.” This is relevant because in your example, Bank A would not try to hedge out its exposure to Bank B by buying protection on Bank B from Bank C. Almost all of Bank A’s exposure to Bank B is already covered by collateral. As for the remaining part, generally the amount of uncollateralized exposure that Bank A has to Bank B is not correlated to Bank B’s credit rating, especially if there are a large number of trades in multiple asset classes between the two banks. Bank A can’t know a priori what the uncollateralized amount will be if Bank B defaults; it’s just as likely that the CDS in the above example has moved from 60 points to 55 points and Bank A actually owes Bank B collateral. Also note that since this is essentially portfolio risk, doubling the number of trades with Bank B doesn’t actually double the exposure, especially if (as is common) many of the new trades are offsetting in risk. There’s no gross buildup of residual risk; this just boils down to net risk against the counterparty.

Why was AIG different? The above is a fairly accurate stylized approximation of what happens for relatively liquid CDS (which do increasingly go through central clearinghouses anyway). Something like a corporate or sovereign CDS is a distinct product that trades and has an observable market price. In the AIG case, most of AIG’s CDS exposure came from much more bespoke deals on structured products. A typical AIG CDS contract might be on some particular complex mortgage product, for which the only CDS trade was the one in which AIG wrote the protection. It has no observable market price and has to be priced using model assumptions on the underlying. This contrasts with e.g. sovereign CDS, where a price can be observed in the market and multiple trades happen on the same CDS; i.e. where there does in fact exist an observable market price.

Why is this relevant? In the above example, we assume that banks A and B agree on the contract’s valuation. If instead Bank A believes the contract is worth $65mm but Bank B only believes the contract is worth $30mm and has only posted that much collateral, then Bank A has $35mm of exposure to Bank B, which it will need to hedge accordingly. But the point is that this is a valuation issue; if the two banks actually agreed on the value of the contract, but Bank B simply refused to post collateral, then Bank B would be defaulting outright on its obligations, and would have its positions closed out accordingly, rather than have the counterparty risk just continue to exist.

The above discusses direct counterparty exposure in the sense of “losing money if my counterparty defaults.” There is of course further risk; if Bank B defaults, Bank A is left with that $100mm of risk that it previously didn’t have. But the risk here is actually a function of Bank B’s net exposure, not Bank A’s gross exposure. If, for example, Bank B had an offsetting contract for $90mm notional with Bank C, then after a default by Bank B, you would expect that Bank A and Bank C would offset their newly acquired risk against each other, such that e.g. Bank A only ends up with a $10mm change in risk, and Bank C ends up with no change in risk. This is pretty much what happened after Lehman defaulted. In fact there was a special trading session arranged for just that purpose, though most of the risk rebalancing actually happened in normal trading after the default.

I believe points (2) and (3) in your blog post boil down to concerns regarding net risk. I agree that large concentrations of net exposure would be a cause for concern, more so in illiquid positions but even to some extent in liquid ones. One way to get more comfortable with this in CDS space is just to look at the DTCC net notional numbers. By definition no entity’s net position can exceed the total net position. This ends up giving you a cap on how bad things can be; of course not ideal, but maybe less bad than you would initially think.

* *One more thing—and you can share this too as long as it’s not attributed.

The “margin call contagion” scenario you propose is not representative of how banks operate. Just about everything in a bank’s portfolio will already be contributing to its funding. Bonds will be repoed out (i.e. for cash equal to the bond’s value, less a haircut), stock will be lent out, and collateral posted on derivative contracts will be rehypothecated.

It’s possible that e.g. repo haircuts will exceed the bid-offer on some instruments and selling a security might give me slightly more cash than repoing it, but the extra amount is small. In general the notion of “liquidating a valuable position for cash” doesn’t make sense for a bank. Of course this may be different for a buy-side firm, but it doesn’t make sense for a bank to sell a security for liquidity purposes when it’s already used to secure some cash. This is also less true for illiquid things that can’t be financed; it is however true for any collateralized derivative position due to rehypothecation.

Alles klar?

* * *

So, at the risk of having my mysterious interlocutor correct me once again, I will take the liberty of drawing a few conclusions.

First, I think X has substantially diminished my fears about investment banks being piles of counterparty credit kindling just one counterparty default away from causing massive systemic conflagration. The daily zero-limit, two-way settlement of collateral calls between large investment banks (now current practice among most large market participants, according to this BIS study) means that, except in very fast moving markets, one should expect that changes in net margin requirements triggered by changes in the value of underlying investment contracts should be reasonably well-reflected in the risk books of most major banks. Second, the fact that big trading banks settle margin exposure on a net portfolio basis—which, Harry Markowitz assures me, should net out to less than the simple addition of each individual exposure across large, multi-market and multi-instrument portfolios—gives me some comfort that whatever residual risks accumulate on bank balance sheets should not be extreme. Third, X’s assurance that investment banks prefer to use asset positions to fund their operations rather than sell them for cash in a market meltdown leads me to discount the risk of cross-market contagion and “death spirals” triggered by collapses in unrelated markets. All these points directly address the second concern I cited in my previous post.

However, if my concerns about the risk of market collapse inherent in the structure and operations of large trading banks have been partially assuaged, I remain less confident about systemic risk in general. In particular, I worry more about investment banks’ exposure to substantial net risks created by large hedge funds, other originating banks (e.g., Dexia), and non-bank participants (e.g., AIG Financial Products). If one is to believe X, this is where the major risks are created and packaged. If Bank A trades with Hedge Fund 1, which cannot meet its financial obligations and has no counterparty assets of its own to net against A, Bank A could still be seriously fucked if Hedge Fund 1 defaults. Especially if Hedge Fund 1’s default coincides, as it well might, with a substantial gapping out of risk exposure on the underlying trade with Bank A.

Assume, as I would certainly hope we can in today’s markets, that most investment banks aspire to pretty close to zero-net present value risk books across the firm. (This is the fundamental philosophical tenet of the Volcker Rule.) Then risks to the system will be created not by the banks at the center of the markets, but rather by the risk-takers (investors, hedge funds, etc.) at the edges. And, should you need reminding, risk-takers don’t hedge all their risks to zero. Duh.

I also worry that investment banks remain seriously exposed in illiquid, hard-to-value markets now and in the future. X him- or herself hints strongly that the nifty daisy chain of traditional bank risk mitigation can get dangerously frayed under such circumstances. Sovereign CDSs may be relatively transparent, given the monitoring and data publication of the DTCC, but this is not true in every market. In particular, I worry that the next dangerous net risk exposure will be created in one of those opaque, highly-illiquid, obscenely profitable new markets which Wall Street is so fond of creating. And if there is no central repositary of trade data in a particular security or derivative market, no standardization and reporting of net and gross positions, what is to prevent the rise of yet another bunch of idiots like AIGFP to create a huge net risk position of which their multiple, competing investment bank counterparties remain blissfully unaware?

Last, I retain a nagging worry about the sheer complexity of the balance sheets, risk books, and insanely complicated credit and financing plumbing upon which modern day investment banks rely. Long-time Readers will know I am no fan of complexity, because it introduces fragility and vulnerability into any system. X and his peers may have designed a beautifully functional risk transmission system for their employers, but what happens if one of the pipes clogs or breaks, due to human error or unforseen complications? (How likely are those, I ask you? Yeah.) I have every faith that the clever gnomes of Wall Street can figure almost anything out, if you give them enough time. The problem is, that when the shit hits the fan at an investment bank, your clients are sucking funds out at a blistering pace, and the ratings agencies and your shareholders are in a desperate race to write you off forever, you have almost no time at all.


© 2011 The Epicurean Dealmaker. All rights reserved.

Methinks Thou Dost Protest Too Much

Any sufficiently advanced technology is indistinguishable from magic.

— Arthur C. Clarke

Attentive Readers will realize that I have used my durable and insightful epigraph before, specifically in a post which defended my industry against accusations of malfeasance arising from the common tendency of merchants in any economy reliant upon buying and selling to conceal the true costs and profits embedded in their activities. It was my contention then and is now that no law, human or otherwise, compels a vendor to offer buyers of its wares the “best price”—whatever that may be—or, indeed, prevents it from doing what profit-maximizing enterprises are commonly presumed to do: maximize profits. As long as said vendor is not selling faulty merchandise to inappropriate customers in a fraudulent manner, we should not expect to know nor require it to reveal all of its secrets.

This, however, is not that post.

For those of you with half a brain will (or should) realize that my idyllic little précis of laissez-faire capitalism skips lightly over two critical assumptions: that 1) all this happy buying and selling take place in reasonably competitive markets, where other vendors compete to offer the same good or reasonable substitutes therefor, and 2) the manufacture and sale of these goods does not impose intolerably noxious externalities on the society in which they are sold. The first of these can be seen as simply a special case of the latter, in which the externality which society should naturally seek to limit is economic rent-seeking in all its forms: monopoly, oligopoly, producer or factor cartels, preferential government regulation, etc. Of course, this tends to assume that the economy should be servant to society, rather than vice versa, which belief seems unhappily out of fashion nowadays.¹ Go ahead, call me a dreamer.²

A cynic might say that politics is nothing more than a neverending argument over the size and distribution of economic rents in society. But let us set that question aside for now. Instead, I would like to focus on other kinds of externalities: those corrosive and destructive injuries to society which are generated as ineluctable byproducts of the activity of certain unsavory economic actors, like arms dealers, child pornographers, and television reality show producers.

And investment banks.

* * *First, some history.

One of the principal functions of investment banks is the distribution of economic risk in society, from those who wish to sell it (and its associated productive return) to those who wish to buy. In the past, investment banks generally worked pretty well as conduits for risk, passing it from natural seller to natural buyer pretty effectively while skimming a small percentage off the top as recompense for their services. On the wholesale securities side of the house, they acted as large, temporary warehouses, buying and selling securities and derivatives on behalf of clients and maintaining minimal stocks in inventory to satisfy unforseen demand. It was a model which required little equity capital to support it, so investment banks levered up with short-term financing of their short-term assets and earned a nice return on the shareholder or partner equity they employed. Operating with so little equity entailed substantial risk, as a simple mistake or unexpected market shock could send the entire house of cards tumbling down. But because they tended to deal in liquid, easily marketed instruments, failed investment banks could be liquidated with relatively little disruption to their counterparties or the financial markets. Of course, the shareholders or equity partners got wiped out, but that was understood as part of the game. Live by the sword, die by the sword.

But then came the Great Moderation, and the industry changed. Investment banks merged and converted into universal banks, with commercial lending, mortgage businesses, and retail depositors, and they began swelling like mutant ticks on a hemophiliac dog. They began to warehouse more and more securities and derivatives to accommodate increased trading volumes on the market-making side. They began to warehouse more and more financial instruments for their own proprietary trading efforts. And they began to manufacture securities and derivatives, like mortgage-backed securities, credit default swaps, and other “structured products,” to meet investors’ insatiable demand for adequate returns in a seemingly riskless world. But as their balance sheets ballooned, these banks stuck with the tried and true risk management philosophy they had developed over decades as pure investment banks: mark your assets to market in real time, get out of losing positions early, and never hold risky assets in inventory without hedging them. Unfortunately, this is a strategy which depends at its core on operating in liquid, transparent markets, where prices are well known, trading volumes are robust, and hedging instruments are effective and liquid themselves. It also depends on a key principle which every trader knows: it doesn’t matter whether the markets are liquid or not if your position has become so large that you effectively are the market.

In addition, investment banks began to take on more and more counterparty risk as they waded deeper and deeper into such activities as leveraged lending, prime brokerage (lending and clearing for hedge fund clients), and derivatives and other structured products. And this was not the simple counterparty trading risk of old, where your primary worry was whether the party you traded with would deliver a security. It was counterparty credit risk, incurred as part of a trade in which your ultimate profit depended on your counterparty’s ability to satisfy its financial obligations, like repaying a loan, delivering an unencumbered security, or paying off a derivative. And let’s face it: investment banks have historically been lousy at credit analysis. Oh, sure, they’re fine when it’s short-term, secured lending, like a margin loan collateralized by liquid, easily-marketable securities with transparent market values. But lending money (or, what is the same thing, contracting for delivery of future economic value under certain circumstances) to counterparties subject to multiple financial risks and multiple financial obligations over a longer period of time? Not so much. And this is a big problem, because it seems that investment banks as a group have become their own biggest credit counterparties in many markets, particularly derivatives.

* * *

The problem is neatly illustrated by a recent Bloomberg article on the European sovereign credit default swap market:

Five banks—JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. (BAC) and Citigroup Inc. (C)—write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. The five firms had total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy, according to disclosures the companies made at the end of the third quarter. Spokesmen for the five banks declined to comment for this story.

While the lenders say in their public disclosures they have so-called master netting agreements with counterparties on the CDS they buy and sell, they don’t identify those counterparties. About 74 percent of CDS trading takes place among 20 dealer- banks worldwide, including the five U.S. lenders, according to data from Depository Trust & Clearing Corp., which runs a central registry for over-the-counter derivatives.

Gross exposures are many multiples higher, of course, but the banks like to advertise their net exposures instead. The problem is that net exposures are not the clean, unassuming things a layperson might think they are. Take the following scenario: Bank A sells a $100 million credit default swap on Underlying Company or Country X to Hedge Fund 1. Then, in order to hedge itself, it buys an identical $100 million CDS on X from Bank B. Bank A has completely eliminated its exposure to X and can sail off into the sunset, happily counting the money it made in spread between the two transactions, right? Wrong. Bank A has not eliminated its risk exposure at all, it has merely introduced a credit risk exposure to Bank B, which is now on the hook to pay off the CDS if X craters. But what if B craters? Bank A is still on the hook, and now it is completely naked short a $100 million CDS. Now Bank A could try to protect itself against Bank B’s default by buying a CDS on Bank B from Bank C or Hedge Fund 2, but I think you must begin to see that that merely introduces a credit exposure to Bank C or Fund 2. Of course in real life all these counterparties try to ameliorate this exposure by requiring frequently refreshed margin collateral on these trades, with the objective that any party’s true risk exposure at any point in time is simply the difference between the value of the collateral held (usually cash) and the net cost to replace the instrument in question.

The challenge to global financial stability posed by investment banks conducting these activities is threefold, in my humble opinion. First, the daisy chain of trades illustrated above clearly demonstrates that investment banks never completely eliminate the residual risk involved in buying and selling investment contracts like CDSs and other derivatives. There will always be some risk attendant on any transaction which has not been completely immunized (like, e.g., Bank A buying an offsetting CDS from Hedge Fund 1, which would have the effect of cancelling the original trade), whether this is direct credit exposure to your counterparty or basis risk introduced by trying to hedge counterparty credit risk indirectly, like via short-selling its stock. Each such trade adds residual risk to the bank’s balance sheet and, given the tremendous aggregate volume of gross derivative trades investment banks do, these residual risks can accumulate to a very large and scary extent.

Second, because most big banks have overall margin agreements (Credit Support Annexes) in place with each other that aggregate offsetting daily margin requirements across all trades outstanding between the firms, the collateral protection mechanism itself can trigger contagion both within and across tightly linked firms. A bank or large hedge fund faced with a substantial margin call in one market or security might liquidate positions in other, more liquid securities in order to meet its obligations. If substantial enough, this can cascade through the markets and the trading books of interlinked investment banks, causing broader market sell-offs and further associated margin calls. This sensitivity is exacerbated by the highly leveraged financial profiles of most major financial market participants, especially the large trading banks and derivatives dealers.

Third, the ineluctably bilateral nature of many of these structured products and derivatives means that, no matter how careful and conservative any one investment bank is in structuring and managing its risk profile, nobody can be assured they are not transacting with another AIG Financial Products or, less dramatically, that systemically dangerous net exposures are not accumulating in disturbing quarters. The chief reasons that AIGFP’s collapse exacerbated the financial crisis were because it did not post collateral (due to its AAA credit rating), it transacted in difficult-to-value, illiquid markets, and it accumulated huge net exposure to mortgage-backed securities. And yet investment banks and others gleefully piled into counterparty credit exposure with AIGFP (the “dumb money”) until it cried uncle. Wall Street piled into copycat trades and lending relationships with Long-Term Capital Management, too, in a 1998 dress rehearsal for 2008’s systemic collapse. The very nature of secretive, cutthroat competition in my industry means that none of us want to share information that might reveal the existence of unsafe concentrations of credit risk in the system.³ How else can one explain why French-Belgian bank Dexia was able to write so many interest rate swaps that it required a government margin call bailout to the tune of $22 billion? Last month.

* * *

The practice of counterparty risk management on Wall Street has improved mightily since the Panic of 2008. Given that disaster, it damn well better have. But given the nature of massively connected, highly leveraged investment banks acting as conduits and collectors of the risk of the financial system, and their historical blindness to risks like counterparty exposure and risk concentration which were the very risks which nearly killed them (and us), I am loathe to take them entirely at their word that everything is hunky-dory now. Short of requiring all derivatives and structured products to be cleared through global exchanges (with associated net position limits and centralized margin posting) and sharply limiting overall financial leverage at trading banks, I do not see a failsafe solution to this conundrum. Investment banks are bred in the bone to be highly competitive and take substantial risks. Their competitive risk taking added materially to the accumulation of dangerous stresses and vulnerabilities preceding the crisis, and there is no reason to believe it will not do so again.

I would be delighted to be proved wrong about this by those who know much more about the plumbing of the financial system than I do.⁴ What is to prevent the occurrence of another AIG Financial Products? How can existing system controls prevent or dampen the cascade of credit failures through the system? Are potential leverage-induced death spirals limited to markets with illiquid, opaquely valued securities? If so, what prevents them from spilling over via contagion into other markets? What is to prevent a major securities or derivatives market meltdown from forcing another massive government bailout?

And if you are brave, knowledgeable, and/or foolish enough to try to answer these questions, please keep in mind the admonition of another very clever man whom few now trust:

There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don't know we don't know.

A wise man learns to plan for all three.

Related reading:
Committee on the Global Financial System, The role of margin requirements and haircuts in procyclicality (BIS CGFS Papers No. 36, March 2010)
Selling More CDS on Europe Debt Raises Risk for U.S. Banks (Bloomberg, November 1, 2011)

An early response:
Brandon Adams, Response for @Epicurean Deal (November 5, 2011)


¹ An economy is simply the set of organizing principles and rules which a society establishes to allocate and employ resources for the benefit of its members. How these rules are established and maintained is politics. To assert otherwise, or claim as some do that society and politics have no proper claim on the organization or maintenance of economic activity (e.g., via regulation or taxation), is the height of folly or disingenuousness.
² Those among you who cannot comprehend this concept and who would prefer to call me much less flattering names than “dreamer” are welcome to stock up on canned peaches and armor-piercing ammunition and join your fellow nutcases in Galt’s Gulch. The rest of us will come annihilate you when we can spare a moment. (Or just let you starve to death.)
³ For example, my best and most comprehensive source to-date for understanding the intricacies of the issues under discussion would not allow me to share them directly, in part because (s)he believed some of the generic information (s)he provided could provide a competitive advantage. And you people think I’m secretive.
⁴ All reasonable, informed, and specific responses are heartily welcome. I may publish or link to the most informative and interesting of these here. Please direct your responses to the email address found on this site, or notify me on Twitter (@EpicureanDeal) or by email if you have published it on another site. Please indicate if you would prefer no attribution.


© 2011 The Epicurean Dealmaker. All rights reserved.

Tort Reform

Overheard this morning at breakfast:

Lawyer #1: “Being a litigator is like cleaning the Augean Stables: it’s not particularly pleasant work, but you know you’ll always have a job.”

Lawyer #2: “That’s nothing. You should try representing investment bankers. It’s like being a streetsweeper in the Rose Parade: you have to deal with a neverending parade of horses’ asses, and you’re always cleaning up their shit.”

I love lawyer jokes. Especially when they’re told by lawyers.

Happy Friday.


© 2011 The Epicurean Dealmaker. All rights reserved.

She Blinded Me with Science

Science has not changed the laws of social growth or betterment. Science has not changed the nature of society, has not made history a whit easier to understand, or human nature a whit easier to reform. It has won for us a great liberty in the physical world, a liberty from superstitious fear and from disease, a freedom to use nature as a familiar servant; but it has not freed us from ourselves. It has not purged us of passion or disposed us to virtue. It has not made us less covetous or less ambitious or less self-indulgent. On the contrary, it may be suspected of having enhanced our passions by making wealth so quick to come, and so fickle to stay.

— Woodrow Wilson, A Commemorative Address, October 21, 1896

No matter what technology and science bring us, the dystopias of our future will always be of our very own, all-too-human design.


© 2011 The Epicurean Dealmaker. All rights reserved.

You’re Doing It Wrong

And he sampled the time-winds, sensing the turmoil, the storm nexus that now focused on this moment place. Even the faint gaps were closed now. Here was the unborn jihad, he knew. Here was the race consciousness that he had known once as his own terrible purpose. Here was reason enough for a Kwisatz Haderach or a Lisan al-Gaib or even the halting schemes of the Bene Gesserit. The race of humans had felt its own dormancy, sensed itself grown stale and knew now only the need to experience turmoil in which the genes would mingle and the strong new mixtures survive. All humans were alive as an unconscious single organism in this moment, experiencing a kind of sexual heat that could override any barrier.

— Frank Herbert, Dune

There is something deeply wrong with this country, O Dearly Beloved.

We seem to have painted ourselves into a corner from which we cannot escape. Grass roots movements as diverse as the Tea Party and Occupy Wall Street implicitly recognize this fact and have sprung up in response to it. People from a broad spectrum of Americans less committed, strident, and/or crazy than these activists have shown themselves to be largely sympathetic to their discontent. Depending on where you stand, and which hobby horse you happen to be riding at the moment, our predicament can appear in any number of guises: corrupt crony capitalism, grossly overbearing and inefficient government, a broken financial system deeply riddled with self-interest, or a society-wide breakdown of personal responsibility and uprightness.¹ Our so-called leaders—the very men and women we elected to get us out of this mess—cannot seem to tie their own shoes, much less offer a solution or even a direction in which to begin marching. Politicians are the only group of individuals more despised and less respected than investment bankers nowadays. Believe you me, as one of the latter, I can attest that that is a pretty damning indictment.

A common feature of many of our ills is the unmanageable size and complexity of our institutions and practices. This is certainly true of the government itself, our regulatory and tax systems, and our financial system. Part of this problem—size—may be an ineluctable outgrowth of the sheer mass of our nation and economy. One can certainly argue that size itself can lead to myriad ills. One can credibly entertain the notion that perhaps governing over 300 million people and managing a $14 trillion economy may be beyond the collective ability of any group of people, however intelligent or dedicated. Size certainly seems to have flummoxed the captains of my industry and their regulators in the most recent crisis.

But the bigger culprit, in my opinion, is complexity. Complexity makes things more difficult to manage. Complexity imposes substantial extrinsic costs, which must be expended simply to deal with complexity itself, apart from any underlying issues at hand. Complexity increases uncertainty, introduces distortions, and encourages mistakes. Want examples? Just think of the tax code, or the current state of the global financial system.

And yet we cannot seem to hit the rewind button on complexity. The latest example of this is the appalling complexification that the Volcker Rule—which was included in the Dodd-Frank financial reform act in order to prevent risky proprietary trading by government-backed depositary institutions—has undergone at the hands of those drafting the final regulations. The Beltway rulemaking sausage factory has turned what was a three-page initial proposal and a ten-page section in Dodd-Frank into a 300-page monster. A monster which, by all accounts, nobody loves.

Now, without a doubt a substantial portion of blame for this complexification can be laid squarely at the feet of industry lobbyists and banks themselves. They were the ones who lobbied so expensively and extensively for exemptions and extensions. They were the ones who no doubt insisted that the simple premise of the Volcker Rule was too simplistic to impose on a complex, interconnected industry without causing unacceptably expensive and potentially dangerous disruptions to established business practices.² I’m sure they offered all sorts of eminently reasonable objections to straightforward implementation of a separation between proprietary trading and depositary lending, while simultaneously missing or pretending not to understand that THAT IS THE VOLCKER RULE’S ENTIRE FUCKING POINT. That these dickwads and their hired guns were able to impose their will to neuter this piece of legislation you may credit to another virulent contagion in our polity: the pervasive and poisonous influence of corporate and individual money on politics and regulation.^{3, 4}

* * *

But the more general contributor to this legislative abortion is a structural one. Too many (all?) of the people writing these rules—both on the regulatory side and the industry itself—are lawyers. And lawyers have strong professional and cognitive biases against simplicity when drafting rules, laws, contracts, or indeed any sort of document designed to govern behavior. In all such situations, it is lawyers’ job, objective, and desire to minimize interpretation. They do this because they want to forestall future disputes and potentially expensive litigation by exhaustively codifying behavioral rules and spelling them out under every conceivable circumstance. Since when have you not seen a lawyer sorely tempted to insert a “provided, however” phrase into the simplest contract? Yeah, me neither.

A charitable reader like yourself might understand this impulse as a natural outgrowth of the pervasively litigious culture in the United States. For whatever reason, this tendency to sue first and ask questions later has led to a preponderance of rule-based, as opposed to principle-based regulation in this country. Nevertheless, codifying a principle as clear and straightforward as the Volcker Rule into a 300-page cookbook of recipes for what is and is not allowed in the financial sector is a wrongheaded exercise in futility. For one thing, exactly no-one can possibly anticipate how the financial markets and their constituent banks will change over the forseeable future. The global financial system is just too dynamic, and the likelihood that a piece of regulation penned in 2011 will be able to effectively anticipate and regulate financial market developments over the next several years is simply ludicrous. Investment banks themselves don’t know what kind of opportunities and threats they will face—and hence what they’re actually going to be doing—next quarter, much less in 2012 or 2015. How can we expect a static document drafted by a bunch of underpaid, cover-your-ass government lawyers who couldn’t recognize a proprietary trading desk if they were sitting at it to do so?

Because of this, regulators must have the ability to flexibly interpret and respond to changing conditions in the financial markets and the businesses of their regulatees.⁵ The relentless, rapid evolution of finance requires that financial regulation be principle-based, not rule-based. Reformed quant Emanuel Derman makes the case persuasively that we cannot understand financial markets using rigidly codified models. If that is true, how, then, can we ever hope to regulate them with a framework based on rigid, over-codified rules?

No points for guessing: we can’t.

* * *

So what does that mean for the Volcker Rule and financial reform in general? Well, one might argue that the best solution is to scrap that overlawyered piece of toilet paper and go back to the author of the eponymous rule’s own suggestion:

“I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

Of course, this would be principle-based regulation. As Mr. Volcker points out, such a regulatory regime would require strong and well-informed regulators. I have made the same point, too many times to link to here, over and over in the past. Professor Derman is with me too. You would want ex-bankers, experienced in sales, trading, structured finance, and derivatives, who would work closely with regulated banks to monitor, understand, and control the changing nature of risks, activities, and opportunities in the markets. You would create performance incentives which completely insulate them from the results of their regulatees, and you would impose strict prohibitions on them returning to the industry before their active market and industry knowledge has gone stale.

Such regulation would demand close, realtime cooperation and consultation between regulators and industry participants. But if it is done properly, it should work out to everyone’s benefit. Regulators would get realtime information on risk exposures and market practices from their regulatees, and regulatees would receive realtime feedback and guidance from regulators on overall market developments and trends in risk management. Done properly, this model would not stifle innovation or profit-making. It would enhance it, while simultaneously reducing systemic risk and giving regulators early warning of developing threats to global financial security.

* * *

The Dodd-Frank legislation at over 2,000 pages is an abortion. The Volcker Rule at 300 pages is an abortion. They cannot succeed. If we cannot empower intelligent, experienced regulators to monitor and control the wholesale financial system using heuristic principles, we are fucked. Under the current financial regulatory system, and its proposed rules, we are all fucked. I will leave it to my Loyal and Long-Suffering Readers to decide whether that is a state of affairs which can be corrected. I suspect these pearls will be trampled like all the others into the muck of the pig wallow. Only time will tell.

In the meantime, we need to reinvent our rulemaking processes. Currently we make laws and regulations like oysters make pearls, except instead of starting with a tiny grain of sand and covering it with precious nacre, we start with a tiny pearl of sensible principles and cover it with layer upon layer of sand, grit, and detritus. This makes for ugly pearls, and lousy legislation.

When are we going to wake up?

Related reading:
Paul Kingsnorth, This economic collapse is a ‘crisis of bigness’ (The Guardian, September 25, 2011)
Grains of Sand (August 10, 2007)
James Stewart, Volcker Rule, Once Simple, Now Boggles (The New York Times, October 21, 2011)
Emanuel Derman, Maybe markets need more principles and less regulation (Reuters, October 21, 2011)


¹ For the avoidance of doubt, just in case you do care, I believe all of these things to be true. In my opinion, we are in deep doo-doo, and I see no-one on the horizon with a shovel.
² The premise behind these shenanigans is faulty. It is not the obligation of regulators to adapt, weaken, and modify regulations to minimize disruption to regulatees’ current business practices. It is the obligation of regulatees to modify their fucking business practices to comply with regulation. Jesus.
³ There is a part of me that hopes the Volcker Rule is implemented in its currently bastardized form so mega-banks will be forced to expend ridiculous amounts of shareholder money and management attention complying with the Frankenstein’s monster they have helped create. Karma can be a bitch.
⁴ As an aside, SCOTUS’s decision in Citizens United was an abortion of American jurisprudence. Just sayin’.
⁵ My focus throughout this piece is on regulation of the wholesale financial sector; that is, investment banks, commercial banks, and other entities which provide services to corporations, institutional investors, hedge funds, and other such non-retail customers. I have nothing to say about retail financial regulation, since that is neither my area of expertise nor my day-to-day concern. Perhaps more rule-based regulation makes sense for consumer finance, since I suspect that field is less changeable and dynamic than the wholesale sector. But I defer to others with better knowledge on that topic.

© 2011 The Epicurean Dealmaker. All rights reserved.