Do Regulators Want To Run Their Supervised Banks?

A big story this week has been the Fed's current hobby horse, "Comprehensive Capital Analysis and Review ("CCAR") for the 18 largest Bank Holding Companies ("BHC") with assets of over $50 billion.  The Fed's March 2013 publication set the stage by redoing the stress tests done by each of the BHCs with an "interdisciplinary team" of Fed staffers who sound just like most corporate staffs, with the exception of not having bank auditors on the corporate teams.

In August, the Fed published "Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice."  The large bank holding companies, as we've said before, have become too complex to manage, especially if we are looking to eliminate any possibility of a failure like the system wide crises of confidence and then liquidity which brought the global system into paralysis.

This document reads like a rehash of many reports on risk management, internal control, and corporate governance.  Have a look at the Report of the Committee of Sponsoring Organizations of the Treadway Commission from 2009, and the reader will see language, themes and recommendations which are reprised in the Fed's August volume.

Basically, the agenda seems to come down to this: the Fed doesn't want banks to consider returning capital to shareholders through dividends and buybacks without redoing their stress tests and then changing their return of capital plans to add a second significant digit (after the decimal) improvement to some capital ratios.

Here's a stirring sentence from the report's conclusion,

"The fundamental insight governing the Federal Reserve’s
expectations about capital planning is the importance
of having a forward-looking perspective on the risks
to a BHC’s capital resources under severely stressful
conditions."

We also learn, "These elements represent substantial conceptual and operational improvements in capital planning that go well beyond simple consideration of current and expected future capital ratios."  It's never clear at all what lies at the end of having gone "beyond."  A new set of indicators?  A digital dashboard of minute-by-minute risk indicators for every business, financial product, trading desk, currency, and country?  What would it all mean anyway?

We've often made reference to Andy Haldane's speech at the Kansas City Fed's Jackson Hole Meeting, "The Dog and The Frisbee."  In it he notes,

"It is close to impossible to determine with complete precision the size of the parameter space for a large  international bank’s banking book. That, by itself, is revealing. But a rough guess would put it at thousands, perhaps tens of thousands, of estimated and calibrated parameters. That is three, perhaps four, orders of magnitude greater than Basel I.   

If that sounds large, the parameter set for the trading book is almost certainly larger still. To give some  sense of scale, consider model-based estimates of portfolio Value at Risk (VaR), a commonly-used  technique for measuring risk and regulatory capital in the trading book. A large firm would typically have  several thousand risk factors in its VaR model. Estimating the covariance matrix for all of the risk factors means estimating several million individual risk parameters. Multiple pricing models are then typically used to map from these risk factors to the valuation of individual instruments, each with several estimated pricing parameters."

We haven't yet implemented Basel III, and now we are layering Dodd-Frank's evolving regulatory creosote on top of other complex, costly and ineffective frameworks.

The stories about traders dealing with marks on their trading books should tell a dispassionate observer the reality about how global international banks work, as opposed to the bureaucratic schema envisioned in the schemes of European, American, and other regulators. There is no single, infallible, scientifically correct number for the marked to market value of a trading book full of instruments with few buyers and sellers that trade by appointment.

So, some traders walked away from the midpoint of a spread convention.  A regulator would have acted differently.  So what?

Let's also not forget about the boards of directors of the largest bank holding companies. With all due respect, the membership of these corporate boards would never be willing or able to, for example, challenge management on the specifics of their scenario designs or on their methodologies for estimating credit loan losses.  Yet, the Fed report talks about these issues in bureaucratic abstraction as if their schemes can be actually implemented. They can't and they won't.  And, even if it were possible, there would probably be no net marginal benefit to shareholders.

By quoting Haldane's example, I am certainly not advocating the continuing or exclusive use of VaR models, but at least everyone has had some experience with these, for good and ill.

People who are really fluent with complex financial modelling, like Emanuel Derman know their limitations too. He writes,

"Derman, a professor at Columbia University and former head quant for Goldman Sachs, is outspoken on the limitations of modeling and the need for risk managers, along with CEOs, CFOs, financial engineers and traders, to keep their enthusiasm for modeling in check. “There isn’t a short cut or mechanical formula that will help you figure out the right price for a financial product,” said Derman in an interview, adding that, “these financial models are only trying to capture human emotions and instinctual feelings that we use to help us determine prices in financial markets. They are not absolute things like the distance from here to there or here to the sun, where everyone agrees on the distance.”

The managements of many of the largest bank holding companies have failed to exercise a degree of care, diligence and commitment over their sprawling organizations, and JP Morgan has been one recent example, among many.  Their businesses, which each have distinct portfolios with different risk profiles, have been stitched together by acquisition and by evolution.  Trading desks have cowboy cultures that are polar opposite to consistently profitable, high net worth wealth management businesses. Their compensation metrics, conventions and attitudes towards regulation and oversight are polar opposites: yet, they exist under one corporate roof, as in JP Morgan, Bank of America and Wells Fargo, for example.

When things have gone wrong, they have gone wrong in trading businesses, often by the action of rogue individuals who are allowed to buck the oversight.  These are not complex, multidisciplinary, quant issues.  The heads of profit centers, their supervisors, everybody in the C-suites, the board, internal and external auditors, analysts, shareholders, creditors, rating agencies, bank regulators, securities regulators and the courts all have responsibility for making sure that the inevitable issues that arise in complex businesses don't become systemic issues.  We already have plenty of infrastructure aimed at the problems, and we don't need more regulatory complexity.