Risk Management, PRMIA

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October 13, 2008

Exotic Options turn Chaotic

Life will never be the same again in the financial world where the staunch private market arguers turned to the State Treasury and Central Banks for the crises bail-out. Risk Analysts of repute at CREDITSIGHTS said amidst the crisis that "the growth of the Credit Default Swaps (CDS) market over the past decade has outpaced development of settlement systems and trading infrastructure. " CDS are just instruments that provide a form of insurance on fixed-income assets. The protection given to Fannie Mae and Freddie Mac necessitated the International Swaps and Derivatives Association to launch a protocol to facilitate settlement of credit derivative trades involving these two firms. The take over of Fannie Mae and Freddie Mac, collapse of Bear Stearns in March 2008 and the systemic crisis that followed triggered a default on credit default swaps - instruments that provide a form of insurance on fixed-income assets. While the Dealers in the market are working to settle these contracts, after deep threats, the $700bn bail-out has been voted favorably by the US Congress. All the rules and regulations of Basel II could not rescue either the European Banks from near collapse and four UK banks were nationalized in a matter of just seven months. The villain of the piece is the exotic options and credit derivatives. The chaos they brought in seems to be unending. Is Capital an adequate measure when greed perpetuates and gilt-edged guarantees and securitization have the potential to increase the moral hazard? How can we safeguard the global financial system and provide architecture sturdier than the present? This paper would like to look at the current regulations under Basel II in such backdrop.

Harder lessons had to come by. I recall an Occasional Paper of the IMF (124 of 1995) that had put down the impacts of financial liberalization on asset markets of Japan in the later half of 1980s. The increased lending to property markets that fuelled the boom in the prices of both residential and commercial properties boosting the value of collaterals of the SMEs followed by a sharp economic downturn adversely impacted on the financial sector profitability. The lessons of the Asian meltdown of the 1990s, again due to the real estate markets, erratic behaviour pepped up by the greed of the financial institutions were also forgotten. The same Citi, Susan Credit, Merril Lynch, Lehman Brothers, the un-repenting Credit Rating Agencies forgot the scratches and screaming quickly and entered the sub-prime mortgage markets without demur. Even the US Savings-Loan debacle of the 1980s has been a forgotten history in that country,s financial circles.

The US crisis proved that even strong fundamentals flounder against weak regulation. "Lax oversight did indeed allow financial firms to borrow far more than was prudent (a leverage ratio of 30 or 40:1) to make bets that have gone sour. Tougher regulations might have prevented this. (Economist 20th Sep 2008) Alan Greenspan, extolled as the best US Fed Regulator for more than two decades has neither to regret nor explain. It is Prof Bernanke,s unenviable task to alter this legacy. Now the Investment Banks winding up in US are entering the virgin Indian Financial Markets. Unless safeguard measures of the global financial system are revisited and put in place, there could be a burn-out of the emerging economies, ere long. The time is more opportune now than ever and there are enough lessons to learn.

The much-abused and most-extolled market-led reforms are now strongly positioned against each other with the US Fed rescuing Bear Sterns, nationalizing the tainted Fannie Mae and Freddie Mac, the two giant mortgage guaranteeing institutions, infusing capital of the order of $700bn to rescue the AIG Insurance to prevent the global contagion effect after throwing Lehman Brothers to fend for themselves. When the Asian meltdown occurred, the Council of Foreign Relations had set up a Task Force with Carla A. Hills and Peter G. Peterson as Co-Chair persons to suggest measures for safeguarding the global financial system - The Future International Financial Architecture. Some of its recommendations are worthy of a revisit at this juncture as the content of that Report seemed to have been put in archives, notwithstanding its pitch for market-related financial sector reforms that would "create greater incentives for borrowing countries to strengthen their crisis prevention efforts and for their private creditors to assume their fair share of the burden associated with resolving the crisis."

Good house-keeping had its first ticket. Its advice to IMF: crisis-lending - less will do more. For country crises, the IMF should abandon huge rescue packages. In this hour of crises in the US, Washington trio is observing golden silence as its role has been taken by the US Treasury Secretary. Task Force is tougher in the measures it proposes to reduce moral hazard and to induce private creditors to accept their fair share of the burden of crisis resolution. Triple ,B, rated mortgages were assigned triple ,A, ratings at counterparty derivative instruments by all the leading Rating Agencies like the Fitch, Standard and Poor, Moodys etc., with absolute impunity. Securities Industries and Financial Markets Association,s Task Force recommended wide ranging reforms of the Credit Rating agencies and transparency in rating methodologies. It is not yet known whether such reforms would be part of the global financial architecture. In the context of implementation of Basel II tri-pilloried Risk Management heavily depending on external credit ratings, it is but essential that the Credit Rating Agencies globally should conform to the new reforms suggested by SIFMA in August 2008. It is time to cry halt to the paymaster calling shots on ratings.

Briefly, the lessons:
•Development of speculative real estate markets and lax standards of credit appraisal are sure to bring economic catastrophe.
•Rating instrumentality is no substitute for independent due diligence by the Financing Institutions. Instead of external ratings, depend upon internal ratings and scorings resting on the native culture of the clientele bases demonstrated over the decades
•Derivatives and Hedging instruments have severe sensitivities
•Higher capital allocation, with or without Basel 1, 2 and the prospective 3, is no insurance for bank failures triggered by neglect of systems, peoples, and processes
•You will be better served to rely on native intelligence and conservatism that guided the
•It is good to fall back on smaller banks and well networked financial institutions instead of running after the big banks and volatile markets.
•US has to keep a close watch on China as it holds key to its Treasury Bond Markets.
•Sophisticated mathematical models, inconsequential of back testing and stress testing, hardly forebode collapses. It is better that the modeling soothsayers exit the markets.
•Like millions of private investors across the globe, Germany holds gold as a form of savings impervious to currency depreciation, systemic failure and geographical instability. By its example, it has delivered an important message. Average Indian investor too typically has a lesson or two to offer to the world in this hour of global distress.
•Current state of macro prudential analysis (MPA) requires a revisit.
•Efforts to develop better indicators of FIs, exposure to the household and real estate sector should be stepped up, notably in the direction of more transparent information on credit outstanding to these sectors at shorter intervals.
•High degree of flexibility is required in the use of benchmarks, as they are often country specific and change over time.
•GAAP is not enough.
•Moving towards a sound and robust financial system is arduous task, it would appear.
•Appetite for Mergers and Acquisitions will move in a new direction - distinct from the present market driven to customer and shareholder-value driven.
•Currencies throughout the world weakened against the downturn of all the world,s stock markets in terms of US$. Several Central Banks injecting liquidity to help calming the nerves of the financial markets could at best be temporary palliatives.
•Strengthening manufacturing sector -particularly, the SMEs, through right type of financial instruments holds the key for sustaining annual growth rate of above 8percent.

Let me now look at what Basel II has to say on the derivatives. Basel II requires valuation and analysis of exotic options, over-the-counter (OTC) exotic derivatives, and credit derivatives. Section 112 says: ,The comprehensive approach for the treatment of collateral will also be applied to calculate the counterparty risk charges for OTC derivatives and repo-style transactions booked in the trading book., ,Where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and supervisors are satisfied that banks fulfill certain minimum operational conditions relating to risk management processes they may allow banks to take account of such credit protection in calculating credit requirements., (Sec140) Basel II also expects that the maturity of the underlying exposure and the maturity of the hedge should both be defined conservatively.. For the hedge, embedded options which may reduce the term of the hedge should be taken into account so that the shortest possible effective maturity is use. But the US Banks did not choose to adopt Basel II and the European counterparts were mauled and the disaster that followed is everywhere in print and the global contagion as a result of indiscreetly rated exotic options continues unhalted. Now that the Investment Banks are getting subsumed or merged or bought over by the commercial banks, it is important to recognize the compulsions for the Banks as well in respect of counterparty risk: Banks will be required to calculate counterparty credit risk charge for OTC derivatives, repo-style transactions booked in the trading book, separate from the capital charge for general market risk and specific risk. The risk weights to be used in this calculation must be consistent with those used for calculating the capital requirements in the banking book.

Exotic options are used in a variety of settings in a bank, including the applications of general risk hedging and credit risk hedging. Banks should have methodologies that enable them to assess the credit risk involved in exposures to individual borrowers or counterparties as well as at the portfolio level. (Sec733) The credit review assessment of capital adequacy, at a minimum, should cover: 1.Risk rating systems; 2. Portfolio analysis/aggregation ; 3. Securitization/complex derivatives ; and 4. Large exposures and risk concentrations.

Pre-deal checks should be netted accurately in regard to portfolio-based exposures. Portfolio Analysis is not just a pre-requisite under Basel II Accord. It actually makes sense for a bank to manage its investments/loans portfolios: an optimal portfolio can generate added profits and lower expenses and required economic capital for the bank.

Exposure at default (EAD) is only secondary to primary risk assessment. Dimensions of risk should guide risk managers to set timelines and their management. Pre-deal limit checks should be performed via real-time interface the dedicated credit limits system and the front office. Cost of credit that includes both the expected and unexpected losses should be held to the minimum and separate to limit checking.
Banks that retain or acquire positions in securitization, or have an off-balance-sheet exposure in a securitization, have to hold capital with respect to these interests. When combining derivatives (counterparty) exposures with the lending exposures, the current Mark-to-market (MTM) exposures is the most appropriate measure. The ability to set limits to control the maximum exposures to an issuer is the most important aspect. The monitoring of any concentration risk in certain aspects of securities is the next most important aspect while reviewing issuer exposures with the credit limit exposures. Measurement model for issuer holdings or security holdings should take into account a combination of notional value, market value and historical cost . The global limits system should monitor compliance with all the terms and conditions of Banking book facilities like credit limits, LCs, Guarantees etc.

The financial architecture developed under the shadow of US Banking, where the investment banks, broking institution, mutual funds, retail banking, asset reconstruction companies, commercial banking, housing finance arms, insurance companies, re-insurance companies, and advisories are under one roof of a Holding Company under the garb of efficient customer service, is fraught with severe risk. In India, where 70 percent of banking is under the public sector fold, which effectively means that they are insulated from any misdemeanors of the nature that such combined operations could upset in the long run, we should not move closer to bail-outs by the exchequer. It is perhaps worthwhile for the super regulator in India to rethink the strategies for combating the operational risks more effectively than now with higher capital allocation than now instead of allocating higher risk capital for credit risk default.

Posted by rajubehara at October 13, 2008 04:44 PM

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