Rolfe Winkler

Gary Gensler — regulator and, yes, Goldman alum — has distinguished himself in Washington. As CFTC Chairman, he’s fought to impose stricter rules on OTC derivatives and recently proposed rules that would cut the leverage currency traders are allowed to deploy from 100:1 to 10:1. Lest we all forget how dangerous leverage can be when traders misuse it, there’s LTCM to serve as exhibit A. In a clear sign that Gensler is fighting the good fight, traders are screaming about the proposed rule. Fantastic.

From Carolyn Cui and Sarah Lynch at WSJ: Foes take on leverage curbs from CFTC

An attempt by regulators to protect investors from volatile global currency markets has triggered an uproar among lawmakers, currency dealers and thousands of small traders.

The Commodity Futures Trading Commission has proposed rules that would reduce the amount of borrowed funds that retail investors can use when investing in the U.S. foreign-exchange market to as much as 10-to-1, from the existing 100-to-1 for major currencies.

Under current rules, a customer putting up a security deposit of $1,000 in cash will be able to trade a notional amount of $100,000, a common contract size for currencies such as the dollar and the Japanese yen. The new rule would cap that amount at $10,000.

The rules also would require dealers to abide by new capital and disclosure requirements.

If the rules come into force, investors would be required to either put more capital in their accounts or pare their positions.

Unfortunately, what I’d like to start calling “the politics of easy credit” may get in the way of this sensible new rule:

“If our leverage rules are 10-to-1 and leverage rules elsewhere are 100-to-1, the business is going to move elsewhere,” House Agriculture committee member Jim Marshall (D., Ga.) said.

Thanks Congressman Marshall, for protecting American entrants in the race to the bottom.

As I argued yesterday, on the one hand we want tougher financial reforms, but reforms are related in the sense that they’re all designed to reduce the availability of credit. Call it what you want: leverage, credit, debt finance. Americans love the stuff because it magnifies rewards. The less you put down for an investment — whether you’re a bank, mortgagee or currency trader — the more juice that comes back to you if a trade goes right.

If the trade goes wrong you risk outright collapse, but bet big enough such that your failure is “systemically risky” and you can count on a bailout.

The article notes that the “huge risk-reward potential makes the [forex trading] market a hotbed for scams. From Dec. ’00 to Sept. ’09, more than 26k customers received $476m in restitution in 114 forex fraud cases pursued by CFTC.”

Over 106 months, 114 frauds. Yeah, we’re with Gensler on this one.

By Peter Thal Larsen and Rolfe Winkler

LONDON/NEW YORK, Oct 5 (Reuters) – Of all the reforms proposed by global financial regulators over the past 12 months, none looks as appealingly straightforward as the leverage ratio. What could be simpler than linking the total amount of assets a bank can hold to the amount of capital it has to absorb losses it makes on them?

Alas, such a task is more difficult than it appears. There is little international agreement about how to calculate banks’ assets or capital, let alone what the ratio between the two should be.

A few years ago, even the idea of such a simple measure seemed hopelessly out of date. Banks were busy building sophisticated computer models to measure the risks they faced. They were allowed to tweak the amount of capital they held against assets depending on how risky the computer thought those assets to be. Then those models failed.

Now bank regulators want a blunt measure that will cap banks’ expansion, regardless of what their models say. Despite the complexities, they are right to try.

Still, finding a consistent way to measure banks’ assets is a daunting challenge. For instance, U.S. accounting rules allow banks to report their net derivatives exposure. International Financial Reporting Standards used by most European banks don’t. Take Deutsche Bank: At the end of 2008 its gross derivatives book accounted for nearly half its total assets of 2.2 trillion euros. Using IFRS, Deutsche’s leverage ratio is 1.3 percent but under U.S. GAAP it’s 4.2 percent.

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Regulators agree that any calculation of leverage should adjust for these differences to discourage regulatory arbitrage. But barring an unlikely shift to global accounting standards, this will undermine the leverage ratio’s simplicity, which is central to its appeal.

Measuring capital is also a thorny issue. U.S. regulators believe that only tangible equity — cash raised from shareholders or retained through earnings — should count as capital. That is sensible: Only this capital occupies the true first loss position. Without it, investors higher up the capital structure tend to panic and run for the exits when losses mount.

But the emphasis on tangible equity has gone down badly with European banks, which have historically stuffed preferred shares and other forms of hybrid capital into their capital structures. If these are excluded from capital measures, European banks will have to find tens of billions of additional equity — or shrink their balance sheets even further. Another objection is that U.S. banks are currently allowed to count deferred tax assets as capital, even though these are worthless if the institution cannot make a profit.

Even if these problems can be overcome, the leverage ratio is not foolproof. After all, U.S. regulators have long imposed a 4 percent leverage ratio on banks. But this did not include off-balance sheet assets. More recently, Swiss regulators introduced a leverage ratio for UBS and Credit Suisse that explicitly excludes the banks’ Swiss loan books from their asset calculations. Some bankers argue that, because the ratio does not adjust for balance sheet risks, it may even encourage banks to load up on risky assets.

Placing an appropriate cap on the expansion of banks’ balance sheets is crucial to the future of banking regulation. If it’s too loose, banks may rush into another crisis. If it’s not applied consistently, banks will arbitrage differences between regimes. Some will argue that if it’s too tight, banks will constrict lending or will dump safe assets in favour of risky ones.

But this misses the point. The leverage ratio is not designed to replace risk-based measures of capital: it is a safety net in case those measures fail. Despite the difficulties involved, regulators should not be deterred from introducing it.

(e-mail: peter.thal.larsen at thomsonreuters.com; rolfe.winkler at thomsonreuters.com)

The people who brought you the Long-Term Capital Management debacle want banks to get serious about cutting their own leverage, applying fair value accounting to a wider range of assets.

Writing with two colleagues in the Financial Times on Tuesday, Nobel Laureate Robert Merton said banks, their regulators and legislators are conspiring to conceal depressed asset prices in order to avoid dealing with the consequences of insolvency. He wants wider adoption of fair value accounting to force banks to fess up to losses and raise more capital.

Speaking on Bloomberg radio, Merton’s long-time associate and fellow laureate, Myron Scholes, concurred.

This is very refreshing, an honest appraisal of the disease still infecting the financial system—leverage—from two prominent economists who learned the hard way that leverage kills.

These days it’s de rigueur to declare that the worst of the recession has passed, that we’re on our way to “recovery.” Never mind that big banks remain insolvent. Take away the government guarantees that provide them cheap financing and protect the value of their assets and many would be at risk of collapse.

As I argued earlier this week, the fall in real estate prices implies huge losses for bank loan portfolios, losses that could wipe out what’s left of their meager capital.  We got another reminder on Monday of just how bad the losses might be. BB&T said it marked down loans acquired from failed Colonial Bank by 37 percent.

A loss rate half again as large, if applied to Citigroup, Bank of America and Wells Fargo, would wash away what’s left of their equity capital. In other words, despite recent capital raises, their leverage remains way too high.

Merton and Scholes know about the risk of leverage. Their hedge fund,Long Term Capital Management, was levered 25 to 1 before losses wiped out capital, pushing leverage to 100 to 1. It took a bailout from Wall Street firms to make up LTCM’s capital deficit and prevent a systemic collapse.

Even after the stress test, big banks are still levered more than  20 to 1. Far higher when you consider losses they are hiding and off balance sheet assets they have not recognized.  FASB has already instructed them to recognize off balance sheet assets beginning next year and their fair value proposals would, if adopted, kick in a year later.

True, it won’t be easy to put into effect. Banks’ existing fair value estimates are highly questionable. It’s not clear what assumptions they’re plugging into internal models in order to arrive at them. That’s why Merton argues estimates should be “independently validated by external auditors.” If that’s expensive or difficult –  well, then that’s a price banks should bear for investing in hard-to-value assets.

One legitimate criticism with fair-value accounting is its procyclicality. Marking assets to market can inflate capital during bull markets and deflate it during bear markets, exacerbating market swings.

But not if regulators respond dynamically to market conditions. As bubbles inflate, regulators should increase capital requirements so that leverage doesn’t get out of hand. That way when markets turn south, banks will be well-capitalized to handle them.

Unfortunately, regulators don’t have the flexibility to be forgiving right now. Banks didn’t build up reserves during the fat years, so regulators must force them to do so during lean ones.

The first step in solving a problem is admitting you have one. Fair value accounting would force banks to admit they still have a leverage problem and, hopefully, inspire regulators to jack up their capital requirements.

It was a surreal moment two weeks ago when analysts on Goldman Sachs’ earnings conference call pressed CFO David Viniar to jack up leverage. They seem to think that the worst of the credit crisis is behind us, so Goldman should goose its risk profile to increase returns. This is remarkably short-sighted.

Yes, leverage is down, but only relative to the obscene levels reached a year ago.  Measured by tangible common equity, the biggest banks are still levered over 20 to 1. If banks learn nothing else from the financial crisis, it’s that they should err on the side of prudence, carrying substantially more capital than appears necessary.

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Tangible common equity remains the crucial measure of bank capital because it’s the primary cushion to absorb losses. When that cushion gets low, creditors panic. Bank runs ensue and the financial system ceases to function.

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