Unintended consequences of regulation, knee-jerk or Grand Plan?

The accumulation of risk in the buyside and its impact on economic growth

In this blog, I would like to set aside convention and start with a conclusion, which is as follows: “constraining any market’s ability to manage or mitigate risk means that there will be less economic growth. Where managing risk becomes too costly – whether that cost is justifiable or not – the tendency is to withdraw, or find an alternative route”.

We recently wrote about the inglorious race to the bottom in share value in the banking sector, and the need to control balance sheets by directly relating them to the xVA-adjusted price of each transaction[1]. Without this all-in cost, banks will never truly understand their break-even point. Without this, shareholder value in the banking sector will remain underperforming.

However, this is not a simple calculation. Moreover, it is difficult to compare and match this pre-trade price adjustment, with post-trade funding and capital costs over the lifetime of the transaction or portfolio. The cost of transaction across different routes to market is also far from obvious; intuitively, one would expect clearing to be cheaper, given the new rules on non-cleared OTC derivatives and the intention to encourage market participants to clearing. Additional margin costs, differences in MPoR and IM calculation, the increase in concentration risk and the fairly high number of CCPs, which naturally disallow netting of exposures, are discussed (and calculated) in a thoughtful paper issued by the Office of Financial Research in the US – with the conclusion that clearing is “not necessarily cheaper”[2].

The calculation of valuation adjustments is not clear cut either, and is dramatically impacted by new regulation, with the complexity and cost intensifying under FRTB. Meanwhile, the most advanced sell-side firms recognise the need to measure and manage these constraints, and create relative pricing methodologies on the way to market.

Understanding the true costs, and the nature of the risks of each transaction carry (we are after all looking forward and backward in determining likely and unlikely impacts through stress-testing and back-testing) under the new ‘standard model’ is one thing. Passing those costs back to the customer is another.

Buy-side institutions are already baulking at the cost of clearing OTC derivatives. Pension funds have declining returns for their pensioners on investments. Bond yields are down further - since we last spoke, and similarly to the BoJ, the ECB has ‘hoovered up’ much of the eligible government debt through quantitative easing (QE) - according to Credit Agricole. The impression we have is that in an environment of reduced returns and higher hedging costs, many buy-side firms are encouraged to absorb those risks on their own balance sheet, thereby limiting their ability to increase portfolios.

As well as break-even against inflated capital costs, banks are further restricted by leverage ratio - with the Chair of the US congressional financial services committee advocating that leverage ratio should be set even higher[3] - and a scaling up of Net Stable Funding Ratio in providing wholesale or retail liquidity to economies. Regulators that are striving to contain liquidity risk within their own jurisdictions reduce liquidity flows further.

Is this all really an unintended consequence of banking reform? And if so, what alternatives do buyside firms have in order to manage their risk?

The ‘futurisation’ of OTC derivatives is mooted as a possible alternative, with a driven response from some exchanges to deliver products that ‘look’ similar to bespoke derivatives. However, whilst there is some movement towards this, such an approach is counter to the reason why OTC derivatives were created in the first place. On the other hand, at a recent FIA conference, panellists intimated that recent moves to futurisation has been somewhat curtailed by the regulatory insistence on clearing for OTC, leaving a reduced necessity to create more ‘bespoke-style’ listed derivative products.

Futurisation it seems, at least for now, leaves buy-side companies with legs and tails of unhedged risk, or no appropriate hedge at all.

Larger buy-side institutions may see an opportunity to meet the demand by offering its peers alternative hedging strategies ahead of any further regulation into the non-bank financial institutions. This will be somewhat curtailed by their own requirements in risk management. This also raises further questions over a potential expansion of counterparty credit risk in this less well-regulated sector.

One would suggest that limiting a firm’s ability to (using an old-fashioned term) ‘lay off’ risk, means that they have to be self-reliant on managing those risks. The question is then, to what extent are they able to shape or understand those risk types and longevity, and does that mean the investment appetite for those buy-side firms’ changes? It is clear that now, more than ever, buy-side firms need to understand and measure their risk in the same way and is as much detail as their regulated sell-side counterparts.

We do however conclude, once again, that the investment appetite of firms will be reduced, either explicitly or implicitly. Greater credit risk will be curtailed, driving up the value of high value securities, and leaving small-to-medium enterprises and ‘start-ups’ less-well funded, or being forced to pay a higher premium for their investments or loans. The ‘value gap’ between large and cash-rich organisations (or cash printing in the case of central banks), and smaller growth-oriented companies may well be increasing further.

We pay a high price for a safer banking system, which in itself reduces growth and stifles opportunity. De facto. I’m afraid.

[1] See previous blog posting Banks whatever you're doing; it isn't funny and it isn't clever, and isn't working

[2] See paper from the Office of Financial Research “Central clearing of derivatives may not always have cost advantage over bilateral trading”

[3] The US has already imposed a supplementary leverage ratio of 5% on the bank holding companies of systemic banks, and 6% on their FDIC-insured depository subsidiaries. Jeb Hensarling, the Republican chairman of the congressional financial services committee, is now advocating a 10% leverage ratio.