Exchange Risk: MF Global, Morgan Stanley and Basel IV

It’s their money or the taxpayers’. A global battle.

Since the biggest banks remain Too Big To Fail, the only tool protecting taxpayers from bailout duty is bank capital.  Jamie Dimon believes this, too, and he runs the largest bank. Regulators frequently seem to be the last to know about problems. But capital is already in place.

If a bank suffers a major loss, its capital base should be sufficient to absorb that loss. And not only absorb the loss, but also sufficient to leave it with access to capital markets should it need to raise more capital. That’s how viable corporations operate. No access to debt or equity markets? It’s collapse, or a bailout if you’re a TBTF bank.

Global regulators have labored for over two decades with the monstrous task of assuring the global financial system that a robust and equitable bank capital regulatory regime is in place. Robust — it needs to work. Equitable — it needs to treat the major banks evenly so that they aren’t driven to more favorable regulatory climates to bask in the sun of higher profits, moving riskier business there, too.

This analyst in the loyal opposition respectfully suggests that the Basel Committee consider addressing exchange risk. Call it Basel IV. Dodd-Frank’s derivatives section uses moving over-the-counter (OTC) derivatives onto central exchanges as a major tool to address Too Big To Fail. Will it work to serve the intended function? A brief Basel overview follows. Then the point on exchange risk.

Bank capital is comprised primarily of cash raised through stock offerings or through retained profits. Its function is to absorb the downs in the cycle of ups and downs in capitalism. By absorbing losses, the corporation avoids bankruptcy and continues to manage its own fate.

Capital adequacy is presented as a ratio: capital as a percentage of total risk exposures. Capital in the numerator and risk exposures in the denominator. The denominator includes, among many things, loans and derivatives.

When a reader sees the word Basel with regard to banking, think Switzerland and the world’s central bankers. Think the generals in the battle between the biggest banks’ money and taxpayers’.

One huge difference between army generals and the world’s central bankers is the limited authority exercised by the central bankers. They battle the globe’s biggest banks and other affected parties to establish a regulatory regime, then go back to their countries and try to institute what was agreed. This takes years. After the 1980s financial crisis they launched their first Basel Accord (1988) to risk-adjust capital supporting loans. After Enron they added measures to capture trading risk and off-balance sheet risks in Basel II (2004). After the most recent, devastating financial crisis they strengthened several measures governing capital quality, the use of credit ratings and liquidity assessment. They call it Basel III (2011). It doesn’t go into effect for a few years. Frankly, Basel II hasn’t been fully implemented yet. But let’s move on.

In Annex 4, Section II, point 6 in Basel II, regulators allow banks to avoid posting any capital against OTC derivatives contracts with exchanges. “An exposure value of zero for counterparty credit risk can be attributed to derivative contracts … that are outstanding with a central counterparty (i.g. a clearing house).” Any number times zero equals zero. So no derivative contracts with exchanges need be included in the denominator of the regulatory capital ratio under Basel II.

The Basel II point goes on to nail two key requirements to remove exchange-traded derivatives from the denominator. First, the exchange needs to be the legal counterparty — the buyer for each sell contract and the seller for each buy contract. Second, margining must take place daily. Margining is the assessment of credit exposure followed by posting of collateral (preferably cash) to protect the bank if credit exposure to its counterparty increases.

MF Global’s bankruptcy demonstrates that exchange trading in a global economy isn’t risk-free. Trading crosses borders, meaning it is governed by differing legal interpretations of who has claim to assets. The legal jurisdiction of the U.K. versus the U.S., for example. In the frenzy of managing through financial turmoil, moving funds that need to travel through differing regulatory jurisdictions with varying operating rules may demand decisionmaking at a speed faster than a human brain can process. Trading is ultimately an aggregation of millions of human decisions. Add the Long-Term Capital Management fiasco risk — the influence of an expert, politically-connected executive (like Mr. Corzine) — and one has a situation that is anything but risk-free.

The clearing houses describe themselves as risky. An examination of the annual reports of three major clearing houses reveals that they compete intensely with each other and the many other exchanges around the globe. They face substantial counterparty risk. They have significant dealings with commercial and investment banks and with hedge funds around the globe. They hold sovereign debt as collateral for protection when the value of that debt has been declining. Operating a clearing house involves substantial operational risk and technology risk. One of the three served as clearing house for MF Global. (The three I examined are LCH.Clearnet in the U.K., IntercontinentalExchange Inc. and CME Group Inc., both headquartered in the U.S.

This analyst observed that Morgan Stanley seemed to be using this aspect of Dodd-Frank to reduce its regulatory capital requirements. (See a related post.) After I noticed the sudden and significant decline in Morgan Stanley’s derivatives exposure in their regulatory capital calculation and called attention to it to both the company and the Fed, Morgan Stanley restated its regulatory capital calculation in the third quarter of 2011. The bank added an additional $44.4 billion in risk-weighted assets to the denominator of the regulatory capital calculation.

These days folks describe these amounts as small change for such a big bank. But according to the American Banker Association, each dollar of bank capital supports 7.6 dollars of credit. (Find a link to the ABA 2008 letter in this Bloomberg article.) Each billion dollars of  capital could support $7.6 billion in loans in the hands of a bank making loans to the smaller businesses that create new jobs.

An observer of the history of financial engineering over recent decades could credibly view the Dodd-Frank focus on moving derivatives onto exchanges as yet another strategy by the biggest banks to avoid the most effective means to minimize taxpayer bailouts — breaking up the big derivatives-trading banks. Let’s call the separation of the FDIC federal guarantee of deposits from the bulk of derivatives trading a modern market Glass-Steagall. When Congress finally realizes that this must be a goal, the debate could finally shift to how to do that incredibly challenging task. Having global regulators recognize the limitations of exchanges is a good start.