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Friday, September 2, 2011

BOE’s Paul Fisher Examines Tail Risks and Contract Design


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

In a September 1, 2011 speech at Clare College in Cambridge, Paul Fisher, Executive Director for Markets of the Bank of England, outlined his thoughts on ways risk taking is executed and how contracts between parties assuming these risks can have “a profound impact on systematic stability beyond the normal consideration of formal regulations.” 

We focus on one aspect of market structure: contracts where, because of a failure to take into account how the financial system as a whole operates, the true value of the contract is different from what it was intended to be – by at least one of the counterparties who struck the contract. This can arise either because in states of the world in which a particular contract is designed to have value there is high correlation with other events or where, in that state of the world, full adherence to the legal structure would cause large unintended consequences in terms of signaling or reputational damage.

Applying lessons learned from the financial crisis, Fisher recommends that parties should structure their transactions with a critical evaluation of contingent exposures, and take into account stress correlations with an eye on capturing tail events properly.  In addition, Fisher also advises that implications of a contract should be clear and the structures should be as transparent as possible. 

To illustrate his recommendations, Fisher looks at two areas where the value of contracts did not match market realities.

“Wrong Way Risk”

Fisher begins with an examination of “wrong way” risk in tail events, where contracts entered into for the purpose of providing insurance ended up adversely correlated with the credit quality of the counterparty providing the “insurance.”  Mr. Fischer addresses a fundamental question of why the correlation problems of these transactions were not apparent before default events occurred. 

If such an insurance contract is worth having, one must be able to envision the tail event happening and what the circumstances might be. Why was it so hard to anticipate what would happen if there were losses on large numbers of bonds insured by monoline insurers which had relatively small amounts of capital?

The primary reason seems to be that the parties involved measured the risk of default events using antiquated, or inappropriately local metrics like VAR and other correlations based on historical averages rather than actual stress tests for different sets of potential market conditions. 

A lot of the surprise seemed to come from the fact that virtually all risk management had been done within a “local” framework, rather than genuinely extreme stress tests. If regulators, rating agencies or, for that matter, bond and equity investors had demanded analysis based on extreme stress tests, many of the repercussions in the system could have been identified. The main point is that a stress test has to be internally consistent.

Secondarily, large numbers of these transactions were entered into, not as genuine hedging transactions, but as portfolio management or “window dressing” measures.  Having the insurance in place made exposure numbers reported to regulators and stakeholders more palatable, and obscured the true magnitude of the risks undertaken.  These window dressing transactions worked together with true hedging contracts to increase systematic risk by creating a highly interconnected web of contingent exposures across leveraged institutions. 

Many of these investor groups are, however, subject to an extensive regulatory framework, making them unable to hold such risks in their portfolios, in many cases even as a very small fraction of total assets. There is a potentially difficult tradeoff here between public policy objectives of appropriate investor protection and systemic stability considerations. That probably deserves to be debated more fully. It is clear, however, that highly leveraged institutions such as banks and hedge funds are not really suited to be the ultimate repositories of extreme tail risk

Reputational Risks in Tail Events

In certain circumstances, “a market participant may voluntarily choose not to enforce a contract that is “in the money” if the reputational repercussions are perceived to  cause more damage than whatever could be gained financially by enforcement.”  According to Fisher, this course may seem irrational on the surface, but is driven by classic time inconsistency, and may make perfect sense in practice. 

Fisher uses the structured investment vehicle (SIV) crisis to illustrate.  In 2007, when the asset backed commercial paper markets closed suddenly, SIVs were starved for funding.  Banks sponsoring the SIVs had only very limited legal obligations to the SIVs, but seeing the reputational damage sinking SIVs would have, most stepped up, collapsed the SIVs, and moved them back to their balance sheets or directly funded them. 

At this juncture, one would think that the optimal economic behaviour for the banks with outstanding SIVs, would be to let the SIVs unwind according to the legal construct in place, rather than accept responsibility. In fact, all the banks except one decided to collapse the structures and repurchase the securities. 

The case of SIVs demonstrates some short-term and long-term thinking on the part of the banks.  In the short term, the bank would absorb the troubled assets of the SIV into its already over-extended balance sheet, but in the long term would signal that the bank was sufficiently strong to do so.

From an investor protection standpoint, one may have drawn a sigh of relief, as any potential issues about misrepresented risk profile disappeared, but from a financial stability perspective, it was obviously disturbing. In a short space of time, billions of assets showed up on already over-extended bank balance sheets.

One may think it somewhat surprising that (almost) all the banks decided to absorb their SIVs, especially since it must have seemed likely that the SIV structure would not come back any time quickly as a viable funding structure. We believe that the main reason for doing this was that not doing so would have sent a distress signal to the market. In other words, if a bank chose not to absorb this problem, the perception would be that they simply could not afford to do it, thus telling the market that they were in even worse shape than previously feared. There may also have been an element of “repeat game”. If one lets one’s investors take the pain, then they may not return for future transactions.

Designing Contracts With Contingent Exposures in Mind

In order to match up the value of a transaction with market realities, participants should perform a rigorous and critical evaluation of contingent exposures and stress correlations.  Capturing tail events properly depends almost entirely on proper design of stress tests. 

A crucial component of this analysis is the proper design of stress tests. Obviously, scenarios have to be rather draconian in order to serve the purpose of challenging the “unthinkable”, but at the same time there are difficult decisions to be made, for example, in deciding how much bank capital (contingent or not) banks should hold – and what the probability is of it being wiped out. We believe that it is better to have a collection of ex ante determined stress scenarios that illustrate banks’ potential weaknesses publicly, even if the actual regulatory capital is not sufficient in all those scenarios. In other words, stress tests should not always be a check list “pass” or “fail” (after all, to make a bank fail or pass a stress test is just a question of scaling the test). Comparable, tail event stress tests could be an important piece in the information set that investors and regulators analyse to determine the relative value and risk profile of the institution.

Fisher advises that contract design features which are exclusively relevant to the extreme tails should be avoided, because these features are never taken seriously.  Fisher also finds fault with market participants for expressing surprise at banks’ exercising the option to absorb SIVs.

Market participants need to make sure that an exercise of an option is seen as just that, a normal exercise of an option. No more and no less. Sophisticated market participants should not be genuinely surprised (or feign surprise) by another market participant trying to optimise its behaviour consistent with a contract. The implications of a contract should be clear and the structures should be as transparent as possible.

Lessons Learned

As the debate about the higher levels of capital banks must hold rages on, it is important also look at how these new levels of capital will be achieved.   Despite the financial crisis, contingent capital instruments remain attractive, and should be evaluated on how they would perform in a crisis.   Whatever is decided in terms of capital requirements, the numbers should be calculated with tail event analysis in mind.

Fisher applies two lessons from the preceding examples to contingent capital instruments.

First it has been suggested to us by market contacts that the trigger point in existing contingent instruments is such that many investors have bought them on the assumption that these contingent capital securities never will be called (or worse, that there will be official support before that point). If that were to be the foundation for this market, we believe that the very purpose of contingent capital may be subverted, creating a risk to financial stability in a crisis situation. The whole point of contingent capital securities should be that the recapitalisation is triggered without any grand repercussions, making it easier than raising fresh capital in the market. If triggering the conversion were to cause the sort of damage reported in our examples above, then the market could be severely disrupted just when it was most needed. The contract design must therefore reflect a need for the trigger to be as smooth as possible.

Second, it is obviously crucial from a financial stability standpoint that contingent capital securities do not end up largely in the hands of other highly leveraged financial institutions, where losses could cause further spill-overs and thus generate financial instability. We believe that regulators could play a constructive role in allowing a broad range of “real money” investors to own sensible amounts of this systemic risk.

The balance between public policy objectives of appropriate investor protection and systemic stability entails some difficult considerations. Over all, however, it is readily apparent that highly leveraged institutions such as banks and hedge funds are ultimately not well suited to be the final repositories of extreme tail risk. 

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative. 

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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