Just keep them guessing…

We have written quite often about how, ever since the onset of the Great Recession in 2007-8, banks have been subjected to ever more onerous and complex regulatory rules across the whole spectrum of their business, with the intention of making Too Big (or Too Important) To Fail (TBTF/TITF) a thing of the past.

However, considerable skepticism remains as to whether a) bank behaviour has really changed; b) incentives are now properly aligned with personal risks; and c) the regulatory changes will have the desired stabilizing effect, even in economic and political stress scenarios.

So it is worth considering whether all the complexity and seeming arbitrariness of much of current and proposed regulation is, in fact, part of a “cunning plot” on the part of the BIS and its acolytes to game the banks into submission, by keeping them guessing and on the back foot so to speak.

In making this point we are perhaps being a little facetious. However, when one surveys the seemingly never-ending and absurdly voluminous and complex range of published and threatened regulations and constraints, one does begin to wonder whether there is method in the apparent madness. After all, if one has to keep increasing the number of compliance officers and lawyers; make regular visits to [fill in name of building and city] to perform obeisance; is kept guessing as to what will dreamed up yet; and keeps woodcutters in business with the amount of paper being delivered, how is one to find the time or have the inclination to cause further trouble by daring to perform one’s supposed purpose of ensuring that the world’s economy continues to thrive and prosper, or the spare mental capacity to dream up new financial weapons of mass destruction.

Of course, human ingenuity should never be underestimated and the banks have deep pockets (hence, their attractiveness as targets for ever-increasing fines and penalties), but distracting them and their armies of lobbyists by keeping them guessing as to which new rule or amendment may be coming next, clearly serves a purpose in at least slowing down their ability to influence and change policy making to their advantage, or to lessen constraints; even though the US has recently seen a classic example of “influence” being exercised in the roll-back of part of the Volcker Rule.

Similarly, setting repeated and layered stress tests, and including not only quantitative but qualitative factors, makes it more difficult for those running capital and regulatory models to achieve the most advantageous outcome; while publicly chastising the banks for not being up to the expected standard in terms of their ability to comply with new rules or requirements (such as “living wills”, or capital buffers) serves to keep senior management and Boards on edge, although’ we do wonder whether regulators would really enforce draconian outcomes on key components of the financial system in an environment where the effects of the Great Recession still linger.

At Awbury, we continue to monitor regulatory developments across the various regimes affecting banks and the overall economy, so that we can understand both the specific changes that result from new or amended rules, as well as how they fit within the pattern of broader industry changes resulting from regulatory behaviour.

-The Awbury Team


Decisions, decisions… (Part 1)

We have written previously about the decision-making process, and how and why individuals and groups make a decision, or assess a probability. No doubt, many of our readers will have read Daniel Kahneman’s fascinating book “Thinking, Fast and Slow”.

However, we thought we would return to the topic, because we recently came across a fascinating new paper entitled “How Are Decisions Made when Probabilities Are Not Available?”, published by two researchers from Germany’s well-regarded Max Planck Institutes, Timo Ehrig and Konstantinos Katsikopoulos. A key conclusion is that even ostensibly similar organizations, operating in supposedly the same environment, can have very different and even mutually exclusive decision-making processes, which may produce strikingly different outcomes from identical inputs in identical circumstances.

As obvious as the need to understand the topic may seem, apparently there has been little academic research into what financial professionals actually do when faced with making decisions that do not realistically lend themselves to risk modeling and tend towards uncertainty given all the interactions, contradictions and complexities which govern the real world. While the subjects of the study were investment bankers within an unnamed global financial institution and officials within an “influential” central bank, the results are clearly of broader relevance and potential application.

The researchers undertook a range of systematic interviews “in the wild” as they termed it, with a range of participants across both organizations as the means of eliciting information and testing hypotheses on dealing with both model and strategic uncertainty. Clearly, this was not the classic “double-blind” approach rightly beloved of scientists and the sample sizes were necessarily small. Therefore, the conclusions are open to challenge. However, the researchers’ counterargument was that their approach was as structured as possible given the purpose and subjects being tested, and that their findings are meant to be informative, not definitive.

One interesting, and perhaps unexpected conclusion, which may be of relevance when considering applying the study’s range of outcomes in the (re)insurance industry is that while many of the mental processes which the investment bank and central banks participants used to deal with uncertainty were similar or comparable, there were some processes which appeared exclusive to one group or the other. The most obvious example cited was the fact that the central bankers made significant use of drawing analogies, whereas the investment bankers did not. While it cannot yet be demonstrated why there might be this difference, it seems probable that it is based on the fact that central bank processes tend to be deliberative and collaborative, while in investment banks (notoriously!) they are usually fast-paced and combative. It is, thus, worth bearing in mind with whom one is dealing in negotiating a transaction because, even within supposedly the part of the same “culture”, there may be significant cognitive differences which need to be accounted for; and that making broad assumptions about the behaviour of people supposedly in the same industry may well be counterproductive.

In further posts, we shall explore in more detail the study’s conclusions, because they offer some fascinating insights into how financial professionals are able to function and deal with uncertainty without (one hopes!) being reckless, or alternatively suffering from decision-paralysis, an issue which can afflict large, complex organizations of all types.

Within Awbury, we try to ensure that decisions are made openly, swiftly and definitively; but we are well aware that being complacent is dangerous; so we study the available literature for ways in which to improve and challenge our own processes.

-The Awbury Team


Make Me a Market…

Market-making is considered integral to the ability of most financial markets to function smoothly and efficiently, with banks or their broker-dealer subsidiaries seen as performing a key role in ensuring that markets are continuous and that price discovery continues even in stressed circumstances.

However, all is not well in Market-Maker Land, as a recent report from a study group chaired by the President of the New York Federal Reserve Bank (NYFRB) makes clear, because there are signs of increasing bifurcation in markets in terms of liquidity and fragility- with participants focusing on the most liquid instruments. Interestingly, Deutsche Bank also recently announced that it was withdrawing from making markets in many developed market CDSs, to focus on areas where it believed it could generate higher returns. At Awbury, we have long argued that “liquidity” is something of a myth in many areas of the CDS market, with both size and availability in terms of execution being somewhat less than supposed. The report supports our views. In effect, broker dealers have become more like “matchmakers”, taking a client’s order and working the market to match it with one from another client, rather than taking risk onto their own book.

Obviously, legislation such as the Dodd Frank Act and the so-called Volcker Rule have caused proprietary trading by banks to decline, which appears to have had knock-on effects in areas such as the trading of corporate bonds. This is something of a paradox and a concern, given the record levels of issuance being seen, as companies take advantage of low interest rates and compressed spreads. Logically, one would expect to see larger transactions and the maintenance of bigger inventories, but the opposite is the case.

Their experience during the financial crisis appears to have reduced dealers’ risk tolerance and appetite in terms of scale, while conversely causing them selectively to seek higher risk premia; be less willing to deal in “size”; and to look more closely at the overall value of a particular business line. Of course, demand for being able to transact freely and in size has not gone away; and so-called “immediacy services” (ensuring market liquidity and aiding price discovery) are an essential part of the business models of the rising number of bond funds that promise “daily” liquidity in an environment where the reach for yield drives investors and their advisors to take more risk in terms of credit quality. A concern has to be that a “rush for the exits” will cause markets to seize up (as they have always tended to in moments of crisis or panic) at the very moment when liquidity and market-making are in most demand, a situation which may well be exacerbated by the dominance of a smaller number of very large asset managers. For example, the net bond holdings of the 20 largest asset managers comprise some 40% of their USD 23.4TN of net assets under management (AUM); while their share of the AUM of the top 300 firms rose from 50 to 60% over the decade to 2012.

At Awbury, we pay close attention to such matters, because, while we focus primarily on providing risk management solutions that are unfunded and do not expose us, or our partner (re)insurers to unexpected liquidity shocks, nevertheless, we need to understand how other market participants may behave in a crisis and the broader ramifications of such behaviour on credit quality and financial capacity.

And disruption creates opportunity.

– The Awbury Team


Aphrodite woz ‘ere… Laik(i) it or not…

As some readers may have seen, the New York Times recently obtained copies of a report on the collapse of the former Laiki or Cyprus Popular Bank, which at the time of its demise was the second-largest bank in Cyprus, and which almost managed to take down the Cypriot economy with it, in spite of the European Union’s best efforts to avoid a financial and economic implosion.

The report and the, no doubt, selective cache of memos, (many between the Governor of the Central Bank of Cyprus (CBC) and the President of the ECB) amount to a comprehensive indictment of the entire Cypriot political and technocratic elite during the financial crisis; and are an object lesson in why transparency and objectivity are fundamentally important in ensuring sound banking (and, frankly, economic) systems.

Reading through the documents gives an insight into how an almost willful denial of the parlous state of Laiki’s balance sheet and capital account, exacerbated by its exposure to the Greek market and sovereign and coupled with the level of complicity between politicians and CBC staff, enabled funding provided to Laiki by the CBC against supposedly “good” collateral though the Eurosystem’s “Emergency Liquidity Assistance” (ELA) concept to rise to the equivalent of some 60% of Cyprus’ then GDP before the ECB began to enforce some much-needed discipline and seek realistic proposals for resolving the bank. Astonishingly, while supposedly subject to a liquidity ratio of 20% by the CBC at one point a true assessment of the bank’s balance sheet would have produced a negative number! The government and CBC tied themselves in knots allegedly trying to conceal the true gravity of the crisis at the insolvent Laiki not only from the public, but also from the ECB. This allowed almost 4 years to elapse before Spring 2013, when the charade became unsustainable, leading to the now notorious attempts to “haircut” all of Laiki’s (and Bank of Cyprus’) depositors in order to provide “bail in” capital to save the Cypriot banking system and prevent an economic implosion.

The outcome was a period of significant financial and economic instability, during which the changing nature of the mechanisms suggested to re-capitalize the entire banking systems and avoid a “Greek-style” meltdown by Cyprus, only served to demonstrate the need for agreed rules for dealing with idiosyncratic and systemic risks within the EU’s banking systems. Ultimately, the outcome was the EU’s new Bank Resolution and Recovery Directive (BRRD), which is now intended to ensure that the risk of future Laiki-like situations- where, in effect, a government is held hostage by those running its key banks- are minimized, if not wholly banished.

At Awbury, we pay close attention to understanding how the financial systems of the world’s key economies function and the risks they face, not only because it informs our ability to underwrite the complex economic and financial risk management in which we specialize, but also because it enables us to design and structure products which can be used by both banks and governments to manage such risks.

-The Awbury Team


Oil does not always calm troubled waters…

The commentariat is currently having a field day with its pontification over the consequences of the recent fall in the price of crude oil- down roughly 40% from recent peaks, and volatile again after a period of stability. However, it is worth pointing out that the current angst arises in the context of price declines that are relatively modest in comparison with historical volatility. The Awbury team remembers USD 10 oil and the bankruptcy of Dome Petroleum (fondly remembered as “Doomed Petroleum”) and the perils of take-or-pay contracts.

So, frankly, we are somewhat less concerned about is general economic impact, given that it is of clear benefit to many oil importing economies (including the US, on balance), than we are about the potential geopolitical consequences.

It is a statement of the obvious that the combination of lower oil (and natural gas) prices and financial and economic sanctions will place increasing pressure of the Putin regime. One only has to look at what it took to bring Iran to the negotiating table on its “nuclear conundrum”. However, stressed and brittle regimes with nuclear weapons are rather more dangerous than a middle-ranking regional power, which has yet to “break out”. We are, therefore, somewhat concerned about the Russian government’s likely need somehow to continue to distract  a general population which, for all its overt patriotism, is less likely simply to accept the consequences of its political class’ revanchism and military adventures once it begins to lose the previous level of benefits that the Russian petro-state enjoyed.

A key question to consider more generally is the assumptions that oil-exporting states have used for oil prices when setting their fiscal budgets. Many, if not most outside Europe, have endemic problems of underemployment; inefficient and distorted allocations of capital;  malinvestment; and a wealthy elite or citizenry which depends upon an underclass to keep services functioning. States such as Saudi Arabia and Kuwait have significant resources to tap in the form of externally-invested sovereign wealth funds (SWFs), but economic basket cases such as Venezuela, or autarkic states such as Argentina, have little if anything in the form of investment reserves. As such, an unexpected fall in actual revenues, coupled with a budget assumptions that border on the delusional, will only increase the strains and potential for economic and social disruption in societies where many are already barely getting by.

In such circumstances, regimes that are kleptocratic, paranoid, corrupt and incompetent do not bode well for a stable international environment, even if they do not pose the existential threat that a state such as Russia would should its regime miscalculate its reach and capabilities.

Of course, with disruption and fear comes opportunity; and we continue to monitor the scope for providing our economic and financial risk management capacity through our E-CAT business model to our broad client-base.

-The Awbury Team