Behold — your financial crisis/accounting/structured finance/financial reform reading for the weekend:
The 126-page discussion paper is from the UK’s Financial Services Authority, and it deals specifically with banks’ trading activities — something which, believe it or not, played a role in the recent crisis.
Sharp-eyed readers of the 2009 Turner Review, for instance, will remember that the document called for a “fundamental review” of banks’ trading activities, after highlighting capital deficiencies. As a reminder — trading books have historically had less stringent capital requirements, though they did have to be accounted for at fair value, which meant they moved with the market.
With that, let the wonk-fest begin.
The trading book issue really strikes at the heart of the banking fiasco. Put simply, banks started securitising credit, but instead of selling it on to non-bank investors, they kept an increasing amount of the product/risk themselves. This was done either be intra-bank selling of things like CDOs, CPDOs etc, or if a bank kept part of the risk of a structured product via the equity tranche or a credit derivative or whatever.
In the Turner Review, the new business model is described as ‘acquire and arbitrage’ — an altogether different prospect from banks’ traditional ‘originate and distribute’ activities. To quote Turner, “the new model left most of the risk still somewhere on the balance sheets of banks and bank-like institutions but in a much more complex and less transparent fashion.”
Enter then, the FSA discussion paper.
One of the themes of the paper is a question: is credit ‘different,’ in terms of risk, to say, equities, commodities, and so on? If it were that would suggest the need for more stringent risk-mitigating requirements. Here’s what the paper says:
Intuitively, a hypothesis that the interaction between the banking system and credit markets is significantly different to the banking system’s interaction with other markets appears reasonable. The banking system as a whole acts as a credit provider. Intuitively, a hypothesis that the interaction between the banking system and credit markets is significantly different to the banking system’s interaction with other markets appears reasonable. The banking system as a whole acts as a credit provider to the real economy, but it is not a significant equity provider or, historically, a commodity buyer.
Some supporting data quoted in the FSA paper; Britain’s Office for National Statistics reported at the end of 2008 that less than 4 per cent of the shares (by market value) listed on UK stock exchanges were held by banks. In contrast, buyers/retainers of very opaque and complex credit structures like SIVs, equity tranches of CDOs, and the like — were overwhelmingly the banks themselves.
Instead of acting as financial intermediaries, the banks were evolving into financial endpoints, in more ways than one (ha). Back to the paper:
The rise of securitisation and credit derivative technology, leading to more commoditised credit products, might have led many to believe that credit risk was being transferred out of the banking system and therefore less would remain on firms’ balance sheets (we describe above the considerable increase in credit trading during the period leading up to the crisis). However, there is evidence that the overall risk of credit products largely remained within the banking/investment banking sectors, particularly in the more complex areas of traded credit.
The over-arching implication is that credit was — and probably is — still different.
When losses came, they came primarily on structured products. The Basel Committee on Banking Supervision has already sought to remedy some of the uniqueness of credit risk via the Incremental Risk Charge, which is meant to better capture some of the ‘special’ risk of structured credit.
But despite that new requirement — there’s still a difference between the approach applied to calculate risk on credit positions in the trading book, and credit positions held in the banking book.
No surprise then, what makes up Part II of our discussion of this discussion paper.
Related link:
FSA seeks to avoid financial ‘froth’ - FT