What may be Coming Next in the FX Benchmark Story?

The big news in November was the settlement between a number of banks and regulators. However, not all of the large FX banks have reached settlements and not all of the major regulators were involved either.

Some recent related events:

1) Last week, New York's Superintendent of Financial Services was reported by Bloomberg to have evidence that Deutsche and Barclays had used algorithms on each of their single dealer platforms to manipulate FX rates. No details are known, but we assume that whether manipulation is involved will be as complex an issue as algorithms are themselves. Such charges go well beyond the fix, which to date has only been determined to have been manipulated by a few traders, occurring only due to poor oversight and management on the part of the banks. Last month's settlement did not include this New York regulator, as apparently the regulator was seeking tougher sanctions, including the installation of monitors on the fx desk of certain banks. What they uncover in this newly reported line of investigation will certainly be interesting and have potentially even larger ramifications for the banks.

2) As a result of their FX investigations, both the DOJ and the UK's FCA are expected to bring criminal charges against both banks and individuals, the DOJ as soon as early next year. The DOJ has already been interviewing traders in London. As far as civil litigation, so far there have been 2 antitrust class action lawsuits filed in the US.

3) WM Reuters, the company that manages the fix process planned to make changes (primarily widening the window to 5 minutes and adding Thomson Reuters rates for major currencies) to the fix as of December 15, but has now delayed implementation until at least February 2015. The company says that the delay is at the request of some customers who need more time to prepare.

From SCOTUS Blog: LIBOR Litigation

For those of you following the LIBOR litigation appeal in front of SCOTUS, here's an excellent write-up from the good folks at SCOTUS blog.   

Fixing Banking

(Adapted from Fixing Banks - Part I Industry Commentary of the Global Association of Risk Professionals)

Banks are junk credits.  Such is one conclusion of our previous post Junk Banks?!  A government’s guarantee of its banks is expensive precisely because the underlying banks are junk.  One way or another, the taxpayers and citizens bear the large expense of the government guarantee for banks.  Yet it would be disastrous for a country to lose its payment system through the near-simultaneous failure of several large banks.

Though not a “solution” to this quandary of whether and how a government should support its banks, the obvious premise for a solution is that banks should have much lower dependence on the government guarantee.  That is, underlying bank risk should not be “junk.”  To the extent that banks have very low risk of failure on a stand-alone basis, they would have low risk of government bailout.

We divide proposals for “fixing banking” into three categories:  “Nibble the Edges;” “Dramatic Change Inside the Box;” and “Banking Re-Boot into Safe Mode.”  All three have advantages and disadvantages.  The first option is easiest to implement and is the current course of global governments and regulators.  Unlike this first option, the second proposal would be highly effective.  While straightforward to implement, this option #2 is controversial and requires an old-fashioned political battle that could go either way.  Finally, we consider the third option to be the “best answer.”  But being right and winning arguments are not the same thing.  Convincing a majority to adopt this option #3 will be challenging.  In this Part I, we discuss only the “Nibble the Edges” alternative.

Option #1:  Nibble the Edges

When human organizations confront failure and must take remedial action, the prevailing attitude is often to make as few changes as possible.  The failure demonstrates the imperative for change.  Yet all organizations have vested interests that abhor change.  The result is that such institutions grudgingly concede only the incremental modifications that will supposedly eradicate future failures.

Global governments, bank regulators, and bankers constitute the large “human organization” that must address the failure of government policy, bank regulation, and banking of 2008 to the present.  True to form, this organization has enacted and proposed minimal change to banking operation.  Beyond the small number of significant banks (such as IndyMac, Washington Mutual, Lehman Brothers, and Laiki Bank) that governments permitted to fail without bailouts for all creditors, almost all players remain the same.  Leading politicians, regulatory heads and staff, bank executives – they’re all the same people.  Banks and governments still retain their political bargain as we described in Banks and Political Bargains.  It is not an exaggeration to say that the only reactions to the Credit Crisis are moderately higher capital requirements, the possibility of improved bank liquidity, a potential loose and discretionary limit on simple balance sheet leverage, and central banks’ administration of “stress tests.”  (As support, the Basel Committee on Banking Supervision proposes nominally constructive bank liquidity requirements at Basel III:  The Liquidity Coverage Ratio and liquidity risk monitoring tools, January 2013.  The article M. Auer and G. von Pfoestl, “Basel III Handbook,” Accenture, 2012, shows the increased capital requirements from Basel II and so-called Basel 2.5 to Basel III in figures 2 and 3.  Though there are many “moving parts,” we quote just one aspect here:  minimum Tier 1 capital increases from 4% to 6% of risk-weighted assets.)

The great advantage of “nibbling the edges” in this manner is that the changes are politically achievable.  Political leaders can show that “they did something.”  Regulators get more apparent control over banks, larger budgets, and a longer checklist of activities.  Bankers retain their lucrative careers in exchange for following a modified set of rules.  It stands to reason that increasing capital requirements will lead to some beneficial reduction of bank default risk.  Thus, this edge nibbling should have a positive near-term impact if one ignores the increased and incalculable inefficiencies of the new regulation.

The glaring disadvantage of this approach is simply that there is no real change.  With the eraser at the end of the pencil, regulators are removing old capital requirement values and writing in some new and higher values.  The direction is right, but there’s no rhyme or reason to the old or new numbers other than what emerges from a global political agreement.  As a further criticism of the solution, there is not even a cogent statement of the problem.  That is, regulators and politicians do not state a goal of a target bank stand-alone default probability or expected loss to taxpayers.  Without a clear problem statement, there can be no solution and no intelligent discussion of a solution.

In Parts II and III of this series we will describe the “Dramatic Change Inside the Box” and “Safe Mode” alternatives to “Nibble the Edges.”  Part II will focus on the proposal of Admati and Hellwig to require multiples of additional equity capital.  Part III will explain the calls of Kotlikoff, Wolf, Kay, and many others for stark reinvention of “fractional reserve banking.”

All Announced on One Day: Five Banks Fined for FX, One for Precious Metals and BOE Chief FX Dealer Fired

As had been rumored for a few weeks, FX settlements between multiple regulators and several FX banks were announced on the same day, today. The banks prefer not to be singled out for misconduct but just to be one of many, so that this is viewed as more of a market problem. The banks were not found to have attempted to manipulate FX rates but instead found to have had ineffective controls allowing traders to engage in manipulative behavior. However, the DOJ is still looking into criminal charges, the New York regulator would not sign on to this agreement as it was felt to be too weak and penalties against many other banks by these same and other regulators will be forthcoming.

The Swiss regulator FINMA also fined UBS for precious metals misconduct, finding "clear attempt to manipulate precious metals benchmarks", particularly in the silver market. As FINMA also fined UBS for FX market violations, UBS would certainly have wanted both announcements at once.

Then the Bank of England hopped onto the bad news train today as well. They have been quiet for several months after announcing that an unnamed employee had been suspended for misconduct regarding FX. Today they announced that the chief FX dealer had been fired yesterday, but still provided little information, other than misconduct was discovered as part of the FX manipulation probe but the behavior itself was not related to the probe.

A Bank Bailout Plan to INCREASE Systemic Risk ?!

Eighteen global banks agree not to terminate derivative contracts when regulators seize their failing bank counterparty.  Is that a bad idea?

(Adapted from A Bailout Plan that Could Actually Increase Systemic Risk, a Quant Perspectives column published by the Global Association of Risk Professionals)

ISDA (the International Swaps and Derivatives Association) reports that eighteen large global banks have agreed not to terminate derivatives transactions when regulators seize the bank counterparty with the goal of “resolving” the failing institution.  Both the ISDA announcement and another news article claim that this agreement will “reduce systemic risk.”  The FSB (Financial Stability Board) had requested this accommodation in the September Consultative Document “Cross-border recognition of resolution action.”

What about the healthy banks?

But what about derivatives risk management for the healthy banks that are counterparties to the failing bank?!  Termination of derivative trades before failure has been a standard tenet of risk management for decades.  See, for example, this BIS (Bank for International Settlements) 1994 document “Risk management guidelines for derivatives” that explicitly discusses early termination.  On its face, this new FSB-ISDA opposition to early termination drastically increases risk to the healthy banks in the name of assisting resolution of the failing bank.

The risk to a healthy bank in a derivative trade with the failing bank is that the former cannot know if the latter will ultimately perform on the derivative hedge or not.  If the failing bank does default on the trade, the healthy bank will have an unhedged risk position and will lose some or all of the positive value of the trade.  The healthy bank cannot hedge its risk with another derivative counterparty as long as the original trade remains in place.  Given the critical importance of hedging to bank operations and stability, this hedge uncertainty to a large global counterparty is a huge threat to safety and soundness.  Systemic risk increases due to this hobbling of risk management at healthy banks.

One may sympathize with the dilemma of the regulators

If one believes that a proper role of regulators and governments is to control the resolution or liquidation of large financial institutions, then the FSB-ISDA initiative has its merits.  It would likely be easier to “save” a failing bank if it has all hedge (derivative) agreements in place.  Just as we noted above for healthy banks, evaporation of derivative trades would leave the failing bank with ruinous open risk positions.

The FSB resolution plan appears to be to transfer some debt, some assets, and all derivatives to a “good bank” and leave distressed assets, shareholders, and bailed-in creditors in the “bad bank.”  In this positive scenario, the healthy bank derivative counterparties would find themselves facing the “good bank” such that, in the end, they would have suffered no harm.  But there are too many assumptions here.  First, the bank resolution may fail.  Second, it is unreasonable to project that all derivative trades should go to the “good bank.”  Since some assets and debt will remain in the “bad bank,” there should certainly be “bad bank” derivatives as well.

Perhaps the goal is to guarantee the derivative trades?

The FSB and ISDA do not state or hint that governments will guarantee the performance of the derivative trades as the quid pro quo for the agreement of the healthy banks not to terminate upon regulator seizure.  But this is our conjecture.  Otherwise, it is all too clear that the FSB-ISDA removal of early termination merely aids one weak bank – which likely deserves to fail – at the risk to and expense of the entire banking system.  Surely the FSB would be averse to increasing systemic risk.  Thus, our ansatz that governments will guarantee derivative performance rings true.  Perhaps the regulators will simply squeeze bailed-in creditors to whatever degree is necessary to honor derivative contracts.

The irony splashes all around us!  Once again, we find ourselves witnesses to governments bailing out and protecting the banks!  The plan appears to be that regulators will protect the bank counterparties.  At risk of raising a past controversy without room to dissect the details, this is AIG all over again!  AIG the insurance company would have withstood the failure of AIG FP (the “financial products” affiliated entity).  The true AIG FP bailout beneficiaries were the bank counterparties.

Returning to more sober considerations, our conjecture implies that the FSB-ISDA plan gives higher priority of repayment to derivative liabilities than to senior debt liabilities.  Derivatives and senior debt are currently pari passu.  We remain unconvinced that derivatives merit such super-priority.

What about CCPs?

We wonder how the FSB-ISDA gutting of early termination impacts CCPs (central counterparty clearing facilities).  The failing bank subject to regulatory resolution might be a counterparty to the CCP or a member of the CCP or even the CCP itself.  In any of these cases, forcing a prolonged period of hedge uncertainty on all other presumably healthy parties would be chaotic.

(The author acknowledges numerous helpful conversations with Ce Shi, a graduate of the Quantitative Finance and Risk Analytics Master’s program at the Lally School of Management of the Rensselaer Polytechnic Institute.  Mr. Shi is now a candidate for a Master’s in Applied Mathematics at Rensselaer.)

Not Edgar Too! Do High Frequency Traders Have an Advantage?

Bloomberg reports that a study highlights another way that high frequency traders appear to be taking advantage of slower market players.  The SEC's EDGAR system receives companies' required  filings electronically.  There are some participants that pay to receive this service directly while most can access it for free online.

The study indicates that the documents are received between 0 seconds and up to one minute earlier by those who pay compared to when the documents are made available online to all others, 10 seconds earlier on average. The study also shows that in cases where the filing availability was made earlier to paying market participants, abnormal volume and price moves began on average 30 seconds before availability to the general public.  The study does not tie the early availability to these moves, stating that the cause is unknown.

While there are many reasons that some are concerned about high frequency traders making money at the expense of slower moving investors, this has not been heard of before by us.  While the article states that this is most likely unintentional, as high frequency traders did not exist when the system was initiated in the 1990s, it does seem to highlight another way that certain market players keep ahead of the regulators and the rest of the market.  Ironically the system replaced a much longer availability time discrepancy when reports were not available electronically at all.  The SEC has been reviewing the situation at least since June.

We will need to await the SEC's review to assess market impacts and the potential for a new set of "market rigging" lawsuits.

Estimate of Regulator Fines on Banks for FX Fix Misconduct - $41 Billion

Bloomberg reported that Citibank analysts' estimate of fines relating to the FX fix could total over $40 billion between US, UK and European regulators, spread among money center banks.  The analysis excludes fine reductions or waivers for those banks cooperating with investigations.  As many banks are cooperating (some required to do so by their agreements with regulators in the LIBOR scandal) this might substantially reduce the actual fines.

As most banks have been reserving for these investigations, which started in the middle of last year, there may not be a big hit to the earnings of the banks as a whole from the eventual fines.  As to reputational hits, the fact that so many banks will be included may, in effect,  protect all of them.

Number26: the future of banking? Or just banking the way it ought to be?

From TechCrunch is a piece about the new European online bank Number26. I had no idea how difficult it is to open a bank account in Europe. Americans complain about our banking system but wow, needing to go to the post office to mail copies of your passport to prove your identity, that's something else.  I like the sound of Number26, which is currently in private Beta testing. Those readers in Europe, you should apply now. 

Outline of FX Fix Reforms is Clearer

The recommendations of the Financial Stability Board last week regarding changes to the WM Reuters fix will be presented at the G20 meeting in November.  These include extending the fix window (they support a move from from 1 minute to 5, but want the WM Reuters company to set the period), making prices transparent and appropriate for the risk borne (meaning that banks should be paid for fix trades, unlike past practice) and codes of conduct and internal guidelines should be more explicit.

While fully agreeing with all of the above, we see the two remaining major recommendation as problematic.  First is the recommendation that "banks establish ... separate processes for handling such orders".  Handling fix trades separately from other fx trades will be costly, probably causing some smaller players to eliminate their participation in the fix.  An article from FX Week (subscription or free trial) refers to banks considering the possibility of creating sealed trading rooms, away from other fx traders and order flow.   While it is unclear how seriously this is being looked at, such a possibility appears a bit absurd to us, as enforcing more explicit codes of conduct and internal guidelines as already suggested, should improve the outcome without the costs or need for quarantined traders.

The other problematic recommendation of the FSB is "the development of industry-led initiatives to create independent netting and execution facilities for transacting fix orders". While a longer term recommendation, this continues on the path of much higher cost and uncertain outcome.  Just to mention one issue, commonsense dictates that the largest incentive for manipulating rates is when there is a large discrepancy between buy and sell orders for a currency pair.  At such times, the only way to clear these separate trades is to trade with the rest of the market, the same traders that this recommendation is trying to avoid.

All in all, we approve of the recommendations as promoting that which Financial PESTs stands for - ethics, simplicity and transparency, albeit with the two exceptions discussed which require additional scrutiny before any implementation.

Peer-to-peer enters its growth phase

Peer-to-peer (P2P) lending is the latest business sector that has captured the attention of both the Internet economy (tech startups, disruption, transformation) and the old economy (Wall Street, flow of capital).

SoFi, a P2P student loan lender, has recently closed two securitizations that were heavily oversubscribed.

Lending Club, one of the pioneers of P2P lending, has filed to go public.

At the recent ABS East Conference dedicated to securitization held by IMN, a separate sub-conference focusing specifically on P2P was standing room only. According to attendees, a majority of the booths at the ABS conference were P2P businesses looking for capital.  Mind you, all this interest on P2P securitizations is based off of only a handful of rated deals.

ABS East was not the only conference to address P2P, as the Lend Academy provides a list for those interested.

Everyone from Nasdaq to institutional investors are voicing their belief and support for the P2P model. Charles Moldow, a partner of Foundation Capital and an investor in a number of P2P business has some interesting takes in Tech Crunch on the P2P sector and how he sees its growth. Another interesting aspect of P2P businesses is the attraction that institutional investors have to the business model and how they have provided both debt and equity capital to P2P originators.

Banks, as everyone knows, continues to retreat from certain areas of traditional lending, shadow banking has stepped in providing capital. The application of the P2P model to all areas of finance has only started. If the marriage between securitization and P2P is successful, then this will become a fast growing segment of the economy.

Bitcoin crashes already?

Yesterday's TechCruch post points out that Bitcoin is trading around the $300 mark down from its peak of $1,150 last year, with Paul Krugman, Dealbook and others questioning whether this is the crash. If this is indeed the crash then it's come awfully fast. In today's world where news headlines finish their cycle in 24 hours, perhaps it's only fitting that speculation and crashes run through ever shorter lives as well. 

How to Build DISASTROUSLY WRONG Financial Models

Here’s the secret:  begin with the wrong goal.

(Adapted from How to Build Disastrous Financial Models, a Quant Perspectives column published by the Global Association of Risk Professionals)

Perhaps the greatest weakness we quantitative financial people have is that we assume at the outset of our careers that all colleagues and competitors share the philosophy that the goal of model development is to seek truth.  That is, imagine the current model task is to estimate the value of a loan or derivative trade, or the risk of a portfolio, or the proper credit rating of a bond, or the likelihood of repayment of a residential mortgage.  Clearly, we assume, everybody would prefer that the model have good accuracy (i.e., truth) in estimating value, or risk, or credit rating, or repayment likelihood.

Unfortunately, real life is different.  Many, though not all, actors in the financial world – business heads, traders, rating analysts, executives, regulators, consultants, auditors, politicians – desire models that describe and promote their reality.  As an example, the head of a trading desk wants models for derivative pricing that permit her group to win an adequate number of trades in competition with other firms.  (The direct experience of a friend of mine is that the tranche correlation desk of a first-tier investment bank rejected the quant team’s improved pricing model because it made the desk lose trades!)  In this case, rather than accuracy, the “reality” of the trading desk is that a good model will help win trades.

Another example is the difficulty of the CEBS (Committee of European Banking Supervisors) and EBA (European Banking Authority) in implementing stress tests for European banks beginning in 2009.  Stress tests are models.  For the CEBS and then the EBA, the “reality” of the stress test model is that it must be credible to the public and build confidence that the banks are adequately capitalized.  (See Kevin Dowd’s penetrating and entertaining “Math Gone Mad,” CATO Institute 754, 1-64, September 3, 2014.)  Needless to say, the goals of credibility and confidence are not synonymous with truth and accuracy.

Yet another, albeit indirect, example of a manipulated model is the U.S. Consumer Financial Protection Bureau (CFPB) determination that bank lenders enjoy a presumption of prudent mortgage lending practices under “Ability-to-Repay and Qualified Mortgage Standards.”  This “QM” standard specifically does not require the lender to impose or consider the loan-to-value (LTV) ratio of the mortgage loan.  Yet, if the goal of mandated underwriting standards is to reduce loan defaults, which harm both lender and borrower, then omission of LTV consideration from the “model” for a qualified mortgage is a huge oversight.  (See, for example, “Housing Industry Awaits Down-Payment Rule for Mortgages,” Bloomberg News, January 18, 2013.)  Unfortunately, the “reality” for the CFPB and self-appointed advocates is wide access to mortgage loans rather than low default risk of the loans.

There are numerous further examples of both high and low public notoriety in which practitioners create or adjust models in “helpful” directions only.  Lehman Brothers in 2007-8 (see page 180 of the Examiner’s Report) and J.P. Morgan in 2012, for example, tweaked their internal models to reduce apparent risk.

The focus on reaching desired end results rather than true and accurate results is certainly a misuse of financial models, but there’s a nuance to consider.  To judge truth and accuracy, one must inspect the model results and determine somehow whether the results “seem right.”  It could well be that the loan underwriter who watches competing lenders make loans that he had rejected will legitimately question the accuracy of his own bank’s model.  But how does one distinguish legitimate questioning of the model result from abusive adjustment of the model?

There is no simple answer other than to rely on the expert judgment of the quantitative model developer and for all analysts, users, and management to adhere to a principle of good faith.  This good-faith standard is the commitment to truth and accuracy.  Senior executives of the institution must understand that models are, by nature, malleable given their numerous judgments and assumptions.  With this understanding, the executives must then set, proclaim, and maintain a culture of good-faith, unbiased model construction and use.

The best uses of quantitative models are:  (i) the learning, intuition, and judgment one develops while building the model and (ii) the testing for completeness and quality of the firm’s data that exercising the model provides.  By virtue of assumptions and insufficient information, many financial models are less useful as generators of precise numerical results (e.g., for bank capital, loan default probability, et cetera).  When it’s imperative to have such numerical model results, then the principle of good-faith model construction is critical.

Settlements Approaching on FX Benchmark Rate Investigations

Reports are becoming more frequent that a settlement is in the works between the UK Financial Conduct Authority and money center banks regarding the FX benchmark pricing scandal.  These discussions are supposed to involve a total fine of about $3 billion (at the low end of expectations) and importantly, only charge the banks with maintaining insufficient compliance procedures to catch individual traders.  It is the traders who would be seen as the true purveyors of misconduct.

UBS today reported that it is in talks with an unnamed regulator that could result in material fines for not having sufficient controls to prevent misconduct of their employees.

There is a belief that the regulators of many countries are working multilaterly, even if not exactly together.  If they all pursue a line of reasoning as discussed above, this would indicate a much lighter hit for the banks.  The fines may be less than assumed, and importantly, the banks may not have to plead guilty to criminal behavior.  With settlement talks ongoing, some are now expecting settlements before year end.

From AVC Blog: The Bitcoin Hype Cycle

Fred Wilson of AVC blog has a great piece about the Gartner Hype Cycle, which lines up rather nicely with the price history of Bitcoins.  Bitcoin enthusiasts should definitely check it out. 

Trade stocks with zero commission

Great article over at techcrunch about Robinhood the stock trading app that lets users trade stock for $0.  They're only in friends and family beta testing right now but have raised $13mm in Series A funding. The idea is amazing and has the potential to disrupt current trading system while bringing in more retail money.  Wonder though how the business itself plans to make money.  Ads?

No More Junk Banks !!

Now Available:  Banking on Failure – Fixing the Fiasco of Junk Banks, Government Bailouts, and Fiat Money !  The authors propose simple but drastic changes to banking and bank regulation.  Banking on Failure explains how banks will be safer and have far less impact on economies and governments if and when they do fail.  No more bailouts!

I became fascinated with the challenge of “fixing banking” while spending a year as a lead investigator for the Bankruptcy Court to determine why Lehman Brothers failed in September 2008.  With additional consulting experience and independent study, I believe Laurel and I have found a comprehensive and pragmatic solution.  But it’s a big change!

Please see this link for the (short) Introduction.  I paste the Table of Contents below.  The Kindle E-Book version is best since it has more than 200 live links to news articles and other references that support our discussions.

Table of Contents:

1.    Introduction

2.   Business Failure

3.   Banking Business

4.   Banks Versus Non-Banks

5.    Analysis of Banking Risk

6.   History of Banking

7.   History of Money and Gold

8.   Central Banks

9.    Regulation of Banks

10.   Money, Lending, and Inflation

11.    Junk Banks

12.    Fixing Banking

13.    Summary

Regulators/Prosecutors Moving Forward in UK and US FX Benchmark Investigations

Reuters sources  indicate that in the UK there is a push being made by the banks to come to a joint settlement with the FCA regarding the benchmark FX investigation.  A joint settlement reduces the reputational risk for each bank and would allow for the FCA to wrap up the investigation more quickly than pursuing each bank individually.  Indications are that such a settlement, if it occurs, could come as early as year end.

In the US there is a report that the DOJ has informants still working on the fx desks at several US banks. The DOJ is looking to charge individuals with crimes as an additional deterrent to the fines on the banks.  Perhaps it may also avoid a repeat of the criticism of the regulators following the LIBOR investigation that fines alone are merely a cost of doing business for the banks.

Report CFTC Finds Criminal Behavior in ISDAFIX Investigation

As we reported last week, the first lawsuit was filed in the ISDAFIX controversy.  This week Bloomberg states that the CFTC, which is limited to bringing civil cases, reported evidence of criminal behavior to the DOJ. The DOJ can then determine whether to pursue a criminal investigation.  Bloomberg bases the article on a person familiar with this matter.

The report alleges that ICAP, a broker with a central role in setting ISDAFIX through January 2014, accepted large numbers of trades from banks at the close, attempting to influence the fix.  This "banging the close" is similarly charged in FX benchmark cases.  In addition to these actual trades, banks also submitted rate quotes as part of the process of setting ISDAFIX.  The lawsuit last week alleged that identical quotes were submitted by multiple banks on most days, down to the thousandth of a basis point.

The ISDAFIX cases may have a better chance of reaching antitrust status, unlike the LIBOR case, due to the actual trades involved and the lack of reasons other than profit for banks entering into these ISDAFIX trades.

Another Shoe Drops: Pension Sues Banks Alleging Manipulation of ISDAfix

Hot off the presses, Bloomberg reports that the Alaska Electrical Pension Fund yesterday filed suit against the banks responsible for contributing to the ISDAfix rates. Those of you who want more about this brewing controversy can read my report here.  This comes on the heels of lawsuits alleging manipulation in gold, FX rates and LIBOR.  I'm sure there will be more to come as additional information comes to light. 

Political Origins of Banking Crises

(Adapted from Banks and Political Bargains, a Quant Perspectives column published by the Global Association of Risk Professionals)

We recently read, appreciated, and enjoyed the analysis and proposal of Charles Calomiris and Stephen Haber in Fragile by Design – The Political Origins of Banking Crises and Scarce Credit (Princeton University Press, 2014).  Calomiris and Haber analyze banking structure and operations over the past centuries and across varying countries and types of government.  These authors argue that “political bargains” in all cases determine banking structure and operations.  The bargains differ substantially depending on whether the form of government is authoritarian or democratic.  Within democratic societies, the degree of populism (majority rule) versus liberalism (protection of individual, corporate, and property rights from majority rule) also plays a large role in the bargain that underlies the banking system.

In the landscape of Calomiris and Haber, governments need banks as agents for state borrowing.  Thus, governments charter banks to enable and expand such borrowing and also to accomplish political tasks of providing loans to favored sectors and individuals.  In return, governments confer limited “charters” such that banks with charters have reduced competition and therefore enjoy higher returns than they would receive in an open market.  Direct and indirect government support activities, including deposit insurance, lending, and bailouts, are just additional features of the “bargain.”

Fragile by Design profiles the histories of banking in the United Kingdom, Canada, the United States, Mexico, and Brazil.  The authors’ theory explains, for example, why “the United States has had 12 major banking crises [since 1840] while Canada has had none.”  More specifically, the “political bargain” among government, banks, and regulators in the U.S. prohibited or strongly discouraged branch banking until 1980!  Unlike the Canadian banks with sizable branch networks, stand-alone (“unit”) banks have no risk diversification.  Calomiris and Haber describe the creation of deposit insurance by Federal legislation in 1933 as a government prop to unit banks.  Deposit insurance schemes at the state level had already failed by that point due to moral hazard and excessive taxpayer losses.

Calomiris and Haber argue that, since 1980, the political bargain detrimental to safety and soundness of U.S. banks is the government “encouragement” of residential mortgage lending.  Rather than wade through this contentious question of recent history here, we note that Morgenson and Rosner’s Reckless Endangerment (Times Books, 2011) shares the Calomiris-Haber view.  In the (majority) Financial Crisis Inquiry Report of 2011, however, the government commission disagrees that either government housing policy or the government-sponsored enterprises contributed significantly to the degradation of mortgage underwriting standards.

What does the financial risk manager gain from studying Fragile by Design?  The best answer may be simply that one interprets current events in a new light.  Consider, for example, the role of the (U.S. government’s) Consumer Protection Financial Bureau (CPFB).  The CPFB defines “qualified mortgage” (QM) and “ability to repay” (ATR) rules for mortgage origination.  When banks lend within the QM/ATR guidelines, they are far less likely to suffer future government penalties.  This is certainly a “bargain.”

Yet the CPFB’s mission is also to prod banks to lend rather than simply protect consumers from bank malfeasance and high fees.  One might call the CPFB-Bank relationship a “balancing act” or a “partnership” (in the words of Calomiris and Haber).  Further, the CPFB arguably encouraged the private firm FICO to change its credit score model in a manner that will boost apparent creditworthiness.  (See the credulous “FICO’s new scoring model to help lenders better assess risk,” Reuters, August 8, 2014.)

The quantitative analyst has a tremendous challenge!  How is it possible to incorporate bargains with government into default and valuation models?!

Peer-to-peer currency exchange startup

Saw this pitch from WeSwap which is a peer-to-peer (p2p) fx exchange startup. Its success will depend heavily on adopters and volume of transactions that take place. But it's an interesting and ambitious attempt to apply the p2p business model to yet another aspect of the banking business model. 

Comments Published Regarding FSB's FX Benchmark Recommendations

The Financial Stability Board had issued general recommendations for changing foreign currency benchmark fixes, open to comments through August 12.  This week the FSB released the comments from 36 interested players, including asset managers, banks and others.  A page with the links to these comments is included here.

Two areas that may be considered controversial seemed to have a lot of support.  The first concerns paying the banks for taking fix orders and charging a bid/offer spread or specified fee (discussed in a prior post here).  Comments included the logic of paying for this service to reduce the incentive for banks to look for ways to make profits in ways that hurt their customers.  Comments acknowledged that any such charge will not eliminate this possibility, and thus the need for a better process / monitoring the market makers will remain.

The second involves widening the period of the fix.  The current WM Reuters fix window is one minute for major currencies.  While there was much support for this, there seemed to be concern that the period not be widened to much, perhaps beyond a half hour, as this could add difficulty to managing trading risk and could add volatility from exogenous factors such as market news impacting the fix rates.

The FSB is scheduled to issue final recommendations in early November.

Who Likes the Financial Stability Board's Recommendation of a Fee for FX Benchmark Trades?

The Financial Stability Board released a consultative study on FX benchmark rates that includes several items for the industry to consider as well as a couple of recommendations.  One recommendation was to widen the period of the window for calculating rates.  Another was that the banks should charge for the service of filling fix orders.

As it currently stands, the WM Reuters rate, the London Close benchmark which is the fix with by far the largest daily volume, includes a bid, mid-rate and offer rate for each currency pair.  Most large and many small users of the fix are filled at the mid-rate, and thus do not pay any fee or bid offer spread to their bank for filling their order.

Why does this occur?  Banks allow it as the cost of doing business with large customers.  If others are doing it, you need to do it as well - it became a market practice in effect.

Bank customers, of course, would like all trades executed for free, so how did fix trades become the only trade type executed routinely without spread or fee? This occurred as many funds use the WM Reuters FX rates to translate their local currency asset values into base currency values each day.  The investment managers then wanted to execute any trades for that day at the same rate to avoid FX tracking error for their funds.  Many managers also saw these rates as a means to achieve market rates without going through the work of negotiating rates with their banks. Others such as corporates began using the mid rate for execution purposes while hedge funds and others did so for speculative purposes.

While this seemed to be a win for the customers, it was not for the banks.  When the fix began in the early 1990s FX spreads were quite wide compared to today and perhaps the banks could more easily tolerate these "free trades".  Apparently as pressure increased on traders to perform in an environment of reducing spreads, some misconduct occurred, including collusion, as a means to generate profits on these trades.

The FSB's suggestion seems quite sensible to us.  Expecting free services does not. In effect, the actions that traders took in recent years reinforces the adage regarding no free lunches.  Using bid offer spreads or a small commission should reduce this tension between bank and customer.

While not the only change required to benchmark trading, this change is reasonable and should go along way in making this a more rational part of the FX business.

Asset managers and other fix users may not like the concept initially, but its inherent reasonableness and the need to increase market participants' faith in benchmark rates should see customers agreeing.  The devil being in the details, however, the size of any commission or spread (tracking error to many) may be much more controversial.

Junk Banks?!

(Adapted from Are Systemically Important Banks Junk Credits? Industry Commentary of the Global Association of Risk Professionals)

A great challenge for bank credit analysts is the degree to which banks rely on “extraordinary support” (a euphemism for “bailout”) from their governments.  A bond investor may build a brilliant quantitative model to understand how a bank’s leverage, asset volatility, and other financial, operational, and economic characteristics impact the bank’s estimated default likelihood.  But there’s a final overlay that is vexing:  what is the probability that a government will step in to make creditors whole if the bank fails?

As with almost all such investment analysis questions, there is no definite, unambiguous answer.  But recent research of FitchRatings provides a fascinating observation.  (See the Fitch Special Report “The Evolving Dynamics of Support for Banks,” September 11, 2013.)  For the period 1990-2012, Fitch assessed both the default rate and the failure rate for “senior creditors of systemically important” global banks with Fitch ratings.  The five-year cumulative default rate in the period (1.15%) is six times lower than the failure rate (6.95%).  Fitch defines failure as “defaulted or would … have defaulted without extraordinary support.”

A quantitative model builder might be pleased with this historical data point.  She will use her financials-based risk model to estimate failure rate and then multiply by a new “no-bailout” parameter of one-sixth (the Fitch result) to get the model’s estimated default probability.  This approach is feasible, but we’re struck by a different observation.

Stepping outside the model-building exercise, the five-year failure rate of 6.95% (call it 7%) is striking.  Referencing Fitch’s Default Study of 2012, the Global Corporate Finance Average Cumulative Default Rate for double-B rated entities is 6.91% (call that 7% also).  (See the table on page 9 of the Fitch Special Report “Fitch Ratings Global Corporate Finance 2012 Transition and Default Study,” March 2013.)  Thus, in the absence of “extraordinary support,” the world’s systemically important banks behave like junk credits.  At least, this is the blended effect of the Fitch universe for the period 1990-2012.  Neither qualification, though, is disquieting.  The universe is large and the 23-year time period is long and indicative of recent history.

To our knowledge, the dominant rating agencies do not assign underlying bank ratings (such as “bank financial strength ratings”) that are non-investment grade.  For example, Fitch itself shows a list of 28 global systemically important banks in Appendix 4 of “The Evolving Dynamics of Support for Banks” and gives a junk "viability rating” to the Bank of China only.  Hence, the rating agencies likely disagree with the characterization that “systemically important global banks are junk” absent government support.  But we appreciate the Fitch study precisely because it shows observed data rather than just potentially optimistic models and judgment.  We’re not aware of any alternative historical studies of this sort.  (If such studies exist, please tell us!)

Of course, this question matters greatly to bank regulators, investors, and taxpayers as well as to rating agencies.  The world is now tightening prudential regulation by elevating capital requirements, pondering liquidity enhancements, considering a maximum leverage ratio (absent risk weighting), forcing central clearing of derivatives, et cetera.  Do regulators and the broader community agree that the “starting point” of systemically important global bank credit quality is junk?  Or, as I suspect, is this point contentious?  We need discussion and debate!  Our view is that the Fitch study is critically important.  It deserves much wider attention and acclaim.  Like a published scientific result, the world needs other rating agencies, bank regulators, and academics to perform similar studies with other data sources to validate or dispute the finding that “banks are junk” without government support.

Regulatory Investigations of the FX Markets are Progressing

Bloomberg reports that the U.K.'s FCA is trying to speed up settlement talks with the banks by keeping the settlement narrowly focused.  The FCA is hoping for a settlement before year end, much earlier than previous reports.  The SFO in the UK has recently begun a criminal investigation and the director said that charges could come next year.  It is reported that the DOJ's investigation could bring charges and impose fines as early as this year.

The WSJ also reports that a number of banks are negotiating with the UK's FCA that any settlement will be announced at the same time for all of the banks.  This is an attempt to avoid the LIBOR scenario where each bank settlement was announced separately, bringing considerable bad publicity to each.  Perhaps a cross bank settlement would spread such publicity around and also draw attention to the misconduct being more of a market-wide problem rather than any bank being a bad apple.

New York's bank regulator, the Department of Financial Services, is negotiating with Barclay's and Deutsche Bank to install monitors at the two banks to investigate whether trades manipulated FX currency benchmark rates.  This was reported by the Wall Street Journal , but both banks declined comment.

All in all it sounds as if the regulators are attempting to fast track the investigations.  Earlier this year the FCA had mentioned 2015 as a goal and BAFIN in Germany had mentioned completion in 2018, hopefully. Speed will be helpful for all involved - the banks, regulators, and oh yes, market participants.  The discussions on changes to benchmarks is ongoing publicly, but no solution is perfect - longer windows of trading which seems to be a favorite, mitigates but does not eliminate the possibility of misconduct and a benchmark that is more of an average rate for the day is not what all market participants are looking for.