Risk Must Be Sensibly Priced

Many observers feared that when the UK and US governments caved in to bankers' cries that regulation and legal action would stifle investment, the result would be an increase in risk rather than a chastened acknowledgement that some things had to change. The truculent opposition of the financial institutions to any move to reduce their potential profits has confirmed those fears. Francesco Guerrero explains in the Financial Times why some new regulation is necessary and why the bankers are being short-sighted:

“Let’s trade!”

Jeffrey Skilling’s primordial cry in Enron The Musical, about the rise and fall of the Texas energy group, sets off a cacophony as each actor sings to a different tune. The noise, according to the stage directions, should build to “an atonal bubble of commodity prices and bids”, a metaphor for the chaos of derivatives trading and the reckless greed that sank the company.

The curtain has long fallen on Enron but its themes are very much alive.
This month the US authorities, which had a silent part in Enron’s drama, got in on the act with proposed rules for the large and lightly regulated derivatives market.

No sooner had the plans been unveiled than an atonal chorus of banks, companies and lobbyists arose to attack them.

At the centre of the dispute is a requirement for “non-financial end users” – airlines, oil groups, manufacturers and other companies that hedge their risks with derivatives – to post margin, or collateral, to the banks they deal with. Blue chips such as Caterpillar, Ford and Boeing do not put up margin on many over-the-counter derivatives.

The idea is that forcing banks to collect cash and liquid securities from corporate counterparties in the $583,000bn derivatives market will boost their defences in case of a crisis. As AIG and Lehman Brothers showed in 2008, a severe dislocation in such a diffused and opaque area can have ruinous ripple effects on the rest of the system.

The proposed rules do not impose automatic margin requirements but simply demand that, for each trade, banks set a “risk threshold” above which collateral would be required.

This seemingly logical approach – if a trade gets too risky, pay up – did not go down well with end users. The Washington corporate crowd thundered that the rules would divert billions of dollars from investments to idle margins, impairing economic growth and endangering 100,000 jobs.

The big groups say the plans are unpatriotic (leading to overseas migration of the derivatives market), misguided (none of the companies would destroy the system if they failed) and unnecessary (derivatives were not a significant cause of the crisis).

The last argument is the only indisputable one. It is also beside the point.

Policy actions should guard against the next crisis, not the one just gone.
The proposals remind me of what a golfer friend said when I asked him whether being dull was a requirement in his sport (full disclosure: I hate golf).

“It’s not indispensable but it helps,” he replied.

Maybe derivatives are not the “financial weapons of mass destruction” Warren Buffett warned against (a big derivative user like him should know, though). But in the post-crisis world, ensuring that risk is appropriately priced is a sensible approach.

The most puzzling aspect of the companies’ furious reaction – and inevitable lobbying onslaught before the June 24 deadline for comments – is that the proposals would not change the status quo much. Some OTC derivatives already require collateral. But even for those that do not, banks adjust the cost based on the credit profile of the buyer. The riskier the company, the higher the derivative’s price.

As finance professors John Parsons and Antonio Mello have argued in their blog Betting the Business, the rules would make transparent a cost that is baked into the securities’ price.

A glance at the big profits earned by banks such as JPMorgan Chase on derivatives proves that they do not dole out risk-free lunches to companies. Corporate treasurers may prefer the certainty of regular payments to the vagaries of margin requirements, but that hardly justifies predictions of Armageddon.

The claims that corporate end users are “non-systemic” are also suspect. It is true that most of the 30,000-plus companies that trade derivatives are too small to threaten the global financial system, but economic contagion works in mysterious ways.

When the Baltimore utility Constellation Energy was teetering on the brink after the Lehman collapse, local electricity supply was in jeopardy. Oil markets shuddered in 1994 when Germany’s Metallgesellschaft lost $1.6bn on “hedges”.

Those last quotation marks are the crux. The bespoke nature of most derivatives, coupled with regulators’ chronic failure to oversee the market, makes it almost impossible to distinguish between genuine hedging and Enron-style speculation.

In such a secretive environment, collateral seems like a small price to pay to ensure that banks have enough funds to survive wildly turbulent times.

“Let’s trade!” But sensibly