Hedge fund metric could answer Volcker Rule riddle

May 12, 2011

By Rob Cox and Antony Currie
The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

The central aim of the U.S. financial reforms put forward by former Federal Reserve chief Paul Volcker was quite simple: Stop banks from behaving like hedge funds. But turning a key piece of this noble goal — ending proprietary trading — into a workable framework is proving devilish. Yet there may be a partial solution. Regulators should treat Wall Street trading desks as if they were hedge funds.

That may sound like circular logic. But at present regulators are in a bit of a fix over how to distinguish risk-trading done on behalf of clients from proprietary trading. Volcker may be right in adopting Justice Potter Stewart’s “know it when I see it” definition of what constitutes a prop trade. But spotting such transactions efficiently among tens of thousands made on trading floors around the world every day is a Herculean task.

However, there may be a way to do it in aggregate by applying a measure, known as the Sharpe ratio, to bank trading businesses. The idea was even floated as a possible metric in the Financial Stability Oversight Council’s Volcker Rule recommendations in January. Regulators have until October to hash out the various ideas among themselves and with banks and implement these provisions of the Dodd-Frank Act.

Named for its creator, Nobel laureate William Sharpe, the ratio basically measures risk-adjusted returns. That’s why it is often applied by big investors like pension funds to the managers overseeing their assets. It calculates the excess return earned over the risk-free rate when taking the volatility of the relevant assets’ prices into account.

A market-making franchise executing trades for clients ought to be far less volatile than speculative prop trading. So a largely customer-focused business should have a much higher Sharpe ratio than a hedge fund — as a guide, the better hedge funds have Sharpe ratios somewhere in the region of 2.5. So a high Sharpe ratio should indicate profitable low-risk client business, while a relatively low one would more likely derive from prop trading.

The trick is to determine how high a ratio purely client-driven trading businesses should generate and how much leeway to allow for riskier client-related positions. One of the metric’s drawbacks is that losses incurred from non-proprietary trades could reduce a bank’s Sharpe ratio, producing what is known as a “false positive.”

There are ways to handle this. For example, when a bank’s traders score poorly, regulators could investigate the positions more closely — in effect, exercising the judgment that Volcker himself suggests is a relatively easy process of observation.

But as an early and broad warning sign about the level of proprietary risk a bank is taking with its capital, the Sharpe ratio might do the trick. Moreover, Sharpe’s calculation can be uniformly applied across all different trading platforms — from currencies and commodities to foreign exchange and equities — and from one bank to the next. That means regulators need not worry that the banks are using different formulas. It does mean having to trust some of their inputs — but regulators can always verify them.

It’s not foolproof, by any means. Trading is an enormous business. The top nine global securities firms raked in revenue of $100 billion in fixed income, currencies and commodities last year alone. Even with effective management, processes and controls, there will be occasions when traders take undue, non-client risks with bank capital.

And the Sharpe ratio is not a measure of systemic risk. Indeed, it suffers from the same flaws that caught regulators, investors and bankers off guard in the housing market crash that led to the financial crisis of 2008. Like the risk models that failed then, the standard deviation in a Sharpe ratio would use historic data on volatility and assume a normal distribution for market moves. So-called Black Swan events, like America’s first ever steep decline in house prices, can and will still occur.

Finally, it bears remembering that a low Sharpe ratio wouldn’t necessarily be proof of a slide into prop trading: a firm may simply be so inept that it keeps losing money on customer trades. Then again, that’s something regulators, investors and competitors might like to know anyway.

It may not be the whole answer. But treating bank trading floors like hedge funds and having them disclose their Sharpe ratios — whether in response to the Volcker Rule or not — seems like a sensible step forward.

Comments

makes good sense.

Posted by johnwerneken | Report as abusive
 

The first ever steep decline in house prices was preceded by America’s first ever multi year rise more than 3 times the previous decades average. Homes doubled in price from 2000 to 2006. That was allowed to happen, while at the same time the traditional bank holding a long term mortgage turned into a casino with CDO, GSE, derivative products with brokers, Wall St. and banks taking a large commission selling garbage rated AAA by companies they paid. 40% of mortgages sold in 2006 were not primary residences, a record. Subprime, sub A % doubled from 2003-2006 while products with these mortgages continued to get AAA rating. Bank mortgage defaults were not any problem when price rise covered most of the loss. The congress, executive and Fed. pumped borrowed against equity, unqualified bad credit borrower mortgages into the economy for a fake growth and tremendous bubble. Shady approval rose to an all time high 2005-6. Fannie/Freddie approved almost half the subprime mortgages made even worse when that 50% share of bad paper became close to 70% dumping the Countrywide type dung into their portfolio. After gov’t got control Fannie/Freddie needed 153 billion to stay alive or create another mortgage crisis. From Carter to 2003 they helped America, but the snakes at the top looking for major bonuses went from traditional to GSE type paper to cash out. Then in 2007 Goldman/Chase purposely used oil future bidding at nominal 5% of total, with no intention of contracting to suppliers to raise oil to $140, making gas prices set a record to burst the bubble and cash out. Goldman made bilions on their short position. Without TARP most banks would have been taken over by Chase, with the Goldman agents Bernanke and Geithner bailing out the big boys, even foreign banks (AIG) to cover Goldman’s position. Geithner held regional banks to high reserve retention while they were getting killed by mortgage defaults. The result was many going under in numbers not seen since the Great Depression, zeroing out FDIC (which had to increase rates), while Chase and the big boys picked up bargain assets from bankruptcy liquidations. I can’t fathom why the GOP wants less regulation, when the taxpayers have been played suffering for politicians and bankers being in bed. Obama is no better than Bush with window dressing financial regulation, no Glass-Steagall, and most important no Hunt Bros. type prosecution for market manipulation.

Posted by JamesChirico | Report as abusive
 

The Sharpe Ratio has a number of limitations. One not mentioned above is that it treats downside and upside volatility with the same disdain. Most investors don`t mind upside volatility, however. There`s a summary of the other limitations here: http://optimizeyourportfolio.blogspot.co m/2011/05/sharpe-optimal-portfolio-with- excel.html

Posted by FredDinnage | Report as abusive
 

May I suggest you use the Omega Ratio instead of the Sharpe Ratio to track hedge fund performance. The Omega Ratio contains all the information in the returns distribution (and does not approximate it like the Sharpe Ratio). Bear in mind that the Omega Ratio also acts as a downside-risk measure (as does the Sortino Ratio). There’s an Excel spreadsheet you can use the calculate the Omega Ratio here: http://investexcel.net/219/calculate-the -omega-ratio-with-excel/

Posted by RajeshPandai | Report as abusive
 

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