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Admittedly, yesterday’s post over the Basel-III tier-one capitalisation ratio might have read as a long winded criticism over a bureaucratically defined metric for banking capitalisation.

Volatility Planes - How's that for charting! © Variancefutures.com

Volatility Planes - How's that for charting!
© Variancefutures.com

However, regardless of the actual ‘tier-one’ quantum decided on by the Basel committee, it would still suffer from one core flaw: it remains a discrete constant decided upon by a limited group of individuals under a specific set of circumstances.

This flaw need not be inescapable, indeed, a market-based pricing system aimed specifically at capitalisation ratios does exist: the CME SPAN margin calculation system.

This is not to say that the Basel committee members are neither experienced nor qualified to give assessments over banking policy. Indeed, they are probably the best in the industry to give such a setting at any particular point-in-time. The Basel committee is, after all, a financial industry and central bankers body, regrouping leading experts from both the financial services profession and those in charge of regulating their activities.

Technically, both set of participants are exempt from political influence, with most central banks having now acquired autonomy from their respective governments. However, even with such a group of people, experts as they may be, a core information asymmetry remains in the face of an ever changing and dynamic market: the group can only ever test its models with assumptions and scenarios based on historical knowledge and the limited statistical means at their disposal for any particular point in time. In other words, they are still only presenting the temporal view-points of a particular subset of economic agents.

The Case for a Market Priced Capitalisation Ratio

In comparison, futures and commodities exchanges worldwide have confronted the issue of capitalisation over their forward-delivery contracts for over a century and a half now (the CBOT began its margining requirements in 1865). These markets learned early on, but also through trial and error, that the margin on trades required to safeguard the integrity of their markets was not a ‘set-in-stone’ measure. Perhaps there was, on aggregate, an average figure that could be quoted for quick back-of-the-hand calculations but it was not, in any shape or form, a finite set metric that could be defined for all market conditions and for all situations.

Indeed, the margin requirements shift depending on the type of trader in the exchange, whether a hedger or a speculator, depending on the actual market conditions: high turnover but limited volatility and conversely (see some worked examples from the SFE here).

In other words, the capitalisation ratio is defined by the market and guided by market conditions. The capitalisation of each trade, ie the margin allocated on each transaction, is set out in a transparent and open manner and, furthermore, is secured from counter-party risk through the presence of an independent clearing house, usually one owned by the exchange and its participants.

This is a working example of mature, in large part self-regulated, markets and one which continues to prove itself, day-in and day-out. Indeed, when was the last time a government had to bail-out a commodity trading advisor? Or, for that matter, when was the last time the CME failed to clear end-of-day variation margins of one of its participants? The answer to both these questions: never.

Never has the CME/CBOT market failed over the capitalisation ratios of one of its members. This point alone demonstrates, better than any single-point-in-time analysis, the potential for an efficient market-cleared price of capitalisation ratios.

In its more than 100-year history, there has never been a failure by a clearing member to meet a performance bond call or its delivery obligations; nor has there been a failure of a clearing member firm resulting in a loss of customer funds.
CME Clearing

But What About the LIBOR/OIS Spikes?

So now I hear the critics rising stating that such a system was already in place prior to the recent financial crisis. That banks were already heavily, if not too heavily, reliant on short-term financing windows based on market cleared prices such as the LIBOR OIS (overnight interbank swap) market and it was this very market priced metric that actually proved highly volatile and ultimately damaging to the financial system.

To such critics I can only reply by saying this: review the facts. Yes, the LIBOR OIS spreads spiked over the course of 2007, but had we only properly confronted the issue back in 2007 then we might have had a much smoother 2008. Unfortunately, this focus was undermined by the regulatory requirements of a specific tier-one ratio and not the actual market-pricing mechanics that underpin capital flows. But returning to the price-spike: yes, markets can be volatile, and yes this volatility can impact the weakest links to push them aside. But this is actually a good thing: we want the smaller and more risky agents to move into the fold of larger and more prudent agents during periods of heightened volatility. What we do not want are the largest players, eg. Lehmann’s or AIG, suddenly falling off the face of the market when times get rough. Unfortunately, such larger players might well be lulled into a false sense of security through the imperfect solvency metric of tier-one capitalisation ratios (see past article:Retrospective Extremity: Insights from the FCIC hearings). Such an environment that systemically risks larger financial institutions is one simply too risky for any market to handle.

LIBOR OIS 2007-2010 Again, going back to 2007 and the operations of the over-the-counter LIBOR/OIS market, this period was marked by heightened risk-aversion by all parties: everyone knew that someone somewhere was going down but nobody knew who. This fear, in and of itself, should not be the cause for a market lock-up as was witnessed with the liquidity dry-up of 2007/08. As long as the market has a firm belief that their trades can be met and matched, ie that counter-party risk is minimised to a tolerable level, then the market has no reason not to trade in such periods.

As a matter of fact, capital and liquidity trades during the period should actually prove more profitable than the norm due to higher implied priced rates: increased demand for capital to shore-up write-downs over a, all other things being equal, equal amount of capital supply, should increase the price of lending, and therefore increase the profit-margin/incentive for any such liquidity-enabling activity to occur.

So how do we provide this confidence in the market that counter-party risk can be adequately managed? Listed exchanges have had the answer to this for some time now: offer an independent clearing house to enable the appropriate holding of required safety margins.

Rather than have a market price both the supply and demand and credit risk weighted factors of a capital trade, as is the case with LIBOR OIS trades where the funding rate combines with the credit-risk of the underlying posted-collateral in order to provide a market price, there can be an independent clearing body absorbing the collateral arrangements of the financing window offering a more secure price discovery mechanism to occur.

Such a clearing body can become self-sufficient too, providing a cost-amortisation mechanism for the inherent credit-risk in place during periods of heightened volatility.

I realise that Central Banks currently occupy such a position in our system, that they do provide an emergency back-stop window for financing in times of extreme duress. However, such a role should not be the core focus of central banks. Central banks are public authorities in charge of broader market mechanisms and with differing guiding interests from the private sector. There is an inherent moral hazard in transferring what is a private interest, that of secured counter-party guarantees, over to a public body. Furthermore, such a hazard can be minimised via adequate self-regulation.

So If This Works Why Isn’t It Already In Place?

Unfortunately, in this instance, self-regulation has not gained the appropriate momentum. But one must consider that the financial sector is confronted by the growing externality of regulatory pressures: they are therefore squeezed between two stones. On one side, they need to maintain margins in the face of growing ‘tier-one’ styled metrics and on the other they need to confront the potential loss of high-margin, internally cleared, over-the-counter trading practices. The result is somewhat of a suboptimal outcome for most economic agents. By agreeing to an external clearing mechanism they would risk losing a profitable margin from collateral management activities (remember, in times of heightened volatility, these interbank windows incur a higher upfront ‘haircut’ used to supplement a bank’s own capital). By operating under a Basel-III agreement, they are aware that their margins are going to be reduced due to external intervention.

This post is not stating that a move towards a reliable market-based capitalisation metric, as opposed to a regulator imposed tier-one measure, is an easy shift. Indeed, there are many facets to the operations of financial institutions that require adaption in order to fit within a CME styled clearing house solution. Furthermore, the potential trading turnover in such an inter-bank clearing house would be a significant operational and infrastructure challenge but, accordingly, also a tremendous opportunity for economies of scale in market-wide risk minimisation. But there remains one critical reason to support market-based capitalisation ratios: these metrics actually work. This positive assurance, however, is not as evident for regulator imposed metrics: historically, and taking the last two years as an example, externally set capitalisation ratios have not established an envious track-record.

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